The euro: a driving force in a globalised financial system
Speech by Eugenio Domingo Solans, Member of the Governing Council and of the Executive Board of the European Central Bank, Official Spanish-Swiss Chamber of Commerce, Zurich, 11 November 2002
Ladies and gentlemen, it is a pleasure for me to participate in an event organised by the Official Spanish-Swiss Chamber of Commerce. Thank you for the invitation.
Here in Zurich, which means outside the euro area, and at an event organised by an international chamber of commerce, I thought that the role of the euro in a globalised financial system could be an appropriate subject for my speech. One way to explain this role is to focus on the international role of the euro, which should be assessed keeping in mind the youthfulness of our central bank and our currency, but also the heritage it received from the national central banks of the Eurosystem and their currencies.
In June next year the European Central Bank (ECB) and the European System of Central Banks (ESCB) will be five years old. The fact that not all members of the ESCB have adopted the euro made it necessary to introduce a new term to describe the ECB and the central banks of the European Union countries that have adopted the euro as their own currency and participate in the decisions on the common monetary policy of the euro area and related issues: this new term, which I mentioned before, is the "Eurosystem". Thus, the Eurosystem is de facto the central bank of the euro area in charge of the euro and the single monetary policy.
Five years is a very short period of time in the normal life of a central bank. For example, the central bank of the Swiss Confederation, the Swiss National Bank, started business in 1907 to "follow a monetary policy which serves the general interest of the country" as set out in Article 99 of the Federal Constitution. Banco de España, to give another example, was created under the name Banco de San Carlos in 1782, which means that it is over two centuries old. Nevertheless, in less than five years the Eurosystem has become a fully-fledged central bank which formulates and implements a stability-oriented monetary policy, administers an efficient payment system and has created and developed the second most important currency of the world economy.
A decisive step towards having a fully-fledged central bank for the euro area took place this year with the introduction of the euro banknotes and coins in the 12 countries of the system. It was, indeed, a very difficult logistical operation but ultimately a successful one thanks to the highly valuable co-operation of all the professional parties involved and, of course, the acceptance and, in some cases, even the enthusiasm of the European public. Incidentally, I am pleased to see that euro banknotes and coins are normally accepted in neighbouring countries such as Switzerland. The acceptance of euro banknotes and coins is the most tangible evidence of the success of the Eurosystem. The importance that the common euro banknotes and coins have as a catalyst not only for the economic but also for the social integration of Europe should not be belittled or underestimated. The euro banknotes and coins have enhanced the role that the euro is playing as an international currency since 1 January 1999.
Basic factors behind the international role of the euro
In a globalised financial system the existence of a new international currency is of paramount importance. The euro area as a whole is a source of economic and financial stability. The wide use of the euro in global markets and in exchange rate policies four years after its inception means that the euro area is "exporting" stability to the rest of the world. The Eurosystem, its monetary policy and, as a result, the stability of the euro is a relevant driving force, a catalyst, which has enhanced the economic and financial integration of the world economy.
The first general conclusion that we reach when analysing the facts and figures is that the international role of the euro is growing gradually and steadily. Even taking into account the relevant fact that the euro inherited the international role previously played by some of the national currencies of the euro area states, namely the German mark and the French franc, our currency shows a constant and firm tendency towards greater internationalisation.
The growing international role of the euro has some bearing on the Eurosystem's monetary policy. In this respect it should be mentioned that the ECB's monetary policy is based on a rather flexible strategy which is also consistent with the international role of the euro. Hence, having a world currency is an additional reason to take monetary policy decisions on the basis of flexible criteria, avoiding the inflexibility of a strategy based on rules.
It is important to clarify that the growing international role of the euro is not the result of a policy goal set by the ECB. The ECB has adopted a neutral stance concerning the internationalisation of its currency, which implies that it neither fosters nor hinders this process. It rather accepts that the international role of the euro is mainly determined by the decisions of market participants in a context of increasing market integration and liberalisation at international level.
The euro fulfils the necessary conditions to be a leading international currency alongside, rather than in competition with, the US dollar. There is enough room for both currencies in the world economy. The necessary conditions for a currency to become international are based on two broad factors: low risk and large size. The low risk factor is related to the confidence inspired by the currency and its central bank, which in turn mainly depends on the internal and external stability of the currency. Moreover, the low risk factor has to do with diversification among international currencies, since diversification is a means of reducing overall risk; it acts like a centrifugal force or a factor of dispersion. By contrast, the large size factor relates to the relative economic, financial and demographic importance of the area for which the currency serves as legal tender – in other words, the "habitat" of the currency. The large size factor generally favours centralisation around a few key international currencies. It can be seen as a centripetal force, a selective factor able to trigger a virtuous circle, which will tend to lead to the increasing use of the euro as an international currency. Let us consider these two factors in more detail.
The first factor, low risk, concerns credibility and stability. The stability of the euro is a priority for the ECB. The basic factor that determines the importance of the euro as a widely used currency in the world economy, in addition to the economic, financial and demographic dimensions of the euro area, is, without a doubt, the stability of the new currency, understood as a means of maintaining its purchasing power.
Stability is the basic requirement for a good currency. It is what we at the ECB sought for the euro. We want a stable euro and the euro will tend to derive strength from its stability. Does anyone know a stable currency that does not become a strong currency in the medium term?
The stability of the euro is the basis for the confidence in and the credibility of the ECB, without which a large international role for the euro would be unthinkable. Stability is proof that the institution is performing well. Yet, in order to be credible, it is not sufficient for the ECB to maintain stability. Other parameters of its action must be considered: accountability, transparency, communication, etc.
These parameters or conditions for the credibility of the euro are certainly demanding. However, the achievement of these conditions is the aim of all of us who have responsibilities with regard to the functioning of the Eurosystem.
The second factor, which we have called the large size factor or the habitat of the euro, is important because without a certain critical mass a currency cannot achieve international relevance, regardless of its degree of stability.
The figures for the population and the GDP of the euro area (based on data for 2000) illustrate this. With 305 million inhabitants, the euro area population exceeds that of the United States (283 million) and Japan (127 million). On the other hand, the GDP of the euro area (EUR 6,572 billion) amounts to 75% of the GDP of the United States, but is 225% larger than that of Japan.
However, even more important than the current figures is the potential for the future development of the euro area, in terms of population and GDP, if and when the so-called "pre-ins" (Denmark, Sweden and the United Kingdom) join the Eurosystem.
The entry of these countries would result in a monetary area of 379 million inhabitants, 34% higher than the United States' population and almost triple that of Japan, with a GDP of EUR 8,188 billion, only slightly less than US GDP and 281% higher than Japan's.
All these facts and figures which demonstrate the economic and demographic importance of the European Union would be further strengthened by enlargement to eastern Europe, if and when the accession countries join the euro area. If we consider an enlarged euro area with both the pre-ins and the 12 accession countries, then on the basis of 2000 data the resulting economic area would have a GDP of EUR 9,070 billion, slightly higher than that of the United States and three times that of Japan. The gap would be even wider in terms of population, since the resulting area would have 484 million inhabitants, 159% of the United States' population and 381% of Japan's.
The size or habitat of an economy depends not only on economic and demographic factors; it also depends on the financial base or dimension of the area. Considering the financial dimension of the euro area, the first relevant feature to observe is the smaller role played by the stock markets in the euro area in comparison with the United States.
Although this feature could give the impression that the euro area has a relatively small financial dimension in relation to its economic dimension, this is not the case. The lower degree of development in capital markets is offset by a higher degree of banking assets. This means that the financial base of real economic activity in Europe is largely founded on bank intermediation, which is also a feature of the Japanese economy. For example, bank credit in the euro area amounts to 136% of GDP, while in the United States it is only 104%. Conversely, debt securities represent 108% of GDP in the euro area compared with 162% of GDP in the United States. There are therefore some differences in financing (albeit increasingly fewer) that have to be taken into account when assessing Europe's financial dimension compared with that of the United States and Japan.
The extension of the habitat of the euro to include the United Kingdom would certainly change the terms of the financial comparison between the United States and the euro area. Without a doubt, the euro area would benefit from embracing the world's second-largest financial market, exactly as the world's second-largest financial market would benefit from adopting the second world currency. In this respect I could even favour a marriage of convenience: if not for love, then at least for money (!). Prudence makes me refrain from extending the metaphor to the Zurich financial market, although I hope that in the Swiss case the weight attributed to love and money would be different.
The euro, the ECB's monetary policy and, in general, the activity of the ECB and of the Eurosystem play a key role in the integration of European financial markets and all markets in general. The euro is acting as a catalyst for European economic integration. And more integration will lead to a greater economic and financial dimension.
The use of the euro in global markets
Two very general aspects can be considered when assessing the international role of the euro. First, its use in global markets, i.e. securities markets, foreign exchange markets and markets for goods and services trade with countries outside the euro area. The second aspect to be considered is the use of the euro in third countries, both by the authorities as an anchor, reserve and intervention currency for their exchange rate policies and by private agents as a parallel currency in the form of cash holdings or foreign currency deposits.
In the international debt securities markets (i.e. leaving aside international equities which have a more limited statistical coverage) the share in outstanding amounts of euro-denominated instruments issued by non-residents totals 29%, compared with 44% for the US dollar and 13% for the Japanese yen. Available information point to a widening gap between an increasing euro share in the supply of international bonds and a flat – or even slightly receding – share in the demand for such securities outside the euro area, which suggests that a significant and increasing share of euro international issues is being absorbed by euro area investors. Non-resident issues are concentrated in the United States and the rest of Europe, while emerging market economies make only a limited use of the euro, with the exception of those that are geographically close to the European Union.
Debt securities issued in euro by non-residents account for 11% of the total issuance of euro-denominated debt securities markets (domestic and international), compared with a share of 9% in the case of the US dollar and 6% for the Japanese yen. This allows me to draw the conclusion that, in relative terms, non-resident issuers are more active in euro debt securities markets than they are in dollar or yen debt securities markets.
If we move from the supply side to the demand side, i.e. if we change our perspective from the use that issuers in debt markets make of the euro to the use of the euro by security holders, we can conclude that the share of euro-denominated bonds in portfolios directly managed by US financial institutions is insignificant, while, in contrast, this share is substantial (around 30%) in non-euro area European economies. In particular, the role played by the City of London is prominent, as more than half of the over-the-counter activity in secondary markets for international bonds is in euro-denominated securities.
In foreign exchange markets, the US dollar remains the global vehicle currency for transactions between almost all currency pairs, with the exception of some Nordic and eastern European countries where the euro appears to be playing this role. The fact is that the share of the euro in global spot trading amounts to about 20%, a percentage broadly similar to that of the Deutsche Mark in the past. In the case of swap trading, the euro's share has decreased compared to the share of the Deutsche Mark. Of course, it is important to take into account when assessing this fact that, with the introduction of the euro, former foreign exchange operations between the Twelve became domestic operations.
As members of an international chamber of commerce you will be interested to know that available data show a significant rise in the use of the euro for goods and services trade between the euro area and countries outside the Monetary Union, both for imports and exports. Data show that about one half of the euro area's external trade is conducted in euro.
The international use of the euro by public authorities
The use of the euro by public authorities in countries outside the euro area as an anchor, reserve and intervention currency is gradually increasing. Some 50 countries, with relatively small economies and mainly located close to the euro area, use the euro in their exchange rate regimes. These exchange rate regimes comprise: euroisation, either unilaterally (Kosovo, Montenegro, Andorra) or within the framework of monetary agreements (San Marino, Vatican City, Monaco, Saint-Pierre-et-Miquelon, Mayotte); euro-based currency boards (Bulgaria, Estonia, Lithuania, Bosnia-Herzegovina); peg arrangements based on the euro (CFA Franc Zone, French overseas territories, Cape Verde, etc.); peg arrangements based on a basket involving the euro to a greater or lesser extent, in some cases through the use of the Special Drawing Rights (SDR) (Latvia, Malta, Israel (which has a crawling peg with an automatically widening band), Seychelles, Kuwait, Morocco, Jordan, Libya, Qatar, Saudi Arabia, United Arab Emirates, etc.); managed floating with the euro as the reference currency (Romania, Slovakia, Slovenia, Croatia, the Former Yugoslav Republic of Macedonia, Yugoslavia, Tunisia) and last but not least the Exchange Rate Mechanism (ERM II), either officially (Denmark) or through a unilateral shadowing of ERM II (Cyprus, Hungary).
At the end of 2001, 13% of the identified official holdings of foreign reserves in the world were in euro, compared with 68.3% for the US dollar, 4.9% for the Japanese yen, 4% for the pound sterling and 0.7% for the Swiss franc. Recent official statements from several countries (China, Korea, Russia, Pakistan, Romania, etc.) indicate that these countries have increased their share of euro-denominated foreign exchange reserves or intend to do so. The use of the euro as a reserve currency is, of course, related to its use as an anchor and intervention currency: we can assume that the countries with exchange rate regimes involving the euro will keep a relatively higher share of euro in their foreign reserves. This is certainly the case of Croatia, Latvia and Slovakia, which publish the composition of their international reserves on their websites. We also know that in June 2002 the United Kingdom kept 53% of its foreign assets in euro, the United States 51%, Canada 39% and Australia 37%.
The private use of the euro outside the euro area
A relevant aspect of the international role of the euro is its use as a parallel currency by the private sector outside the euro area. I said before that the acceptance of the euro banknotes and coins is the most tangible evidence of the success of the Eurosystem. I can add now that the success of the euro cash changeover outside the euro area and the use of euro banknotes in third countries provide the most tangible evidence of the international dimensions of our currency.
The success of the euro cash changeover outside the euro area was based on the ECB Governing Council's decision to allow frontloading and sub-frontloading of euro banknotes to private credit institutions and to central banks outside the Eurosystem well in advance of the changeover (as of 1 December 2001, to be exact), subject to specific terms and conditions. Some 26 central banks were frontloaded, mainly in central and eastern Europe, the Mediterranean area and Africa.
The initial frontloading of euro banknotes outside the euro area plus cumulated net shipments, i.e. euro banknotes sent abroad minus euro banknotes received, amounted to some EUR 23 billion by the end of June 2002, around 7.5% of the euro's total circulation. It would be extremely difficult to know the specific final destinations of the shipped banknotes because large amounts were transferred to international banks based in industrialised countries, like Switzerland and the United Kingdom, which then redistributed them around the world.
If we compare the present circulation of euro banknotes outside the euro area with estimates of the circulation of the former national banknotes, mainly Deutsche Mark but also French francs and Austrian schillings, a gap of at least EUR 10 billion appears. This gap can be explained by three factors: euro legacy currencies not yet converted to euro; a switch from euro legacy currencies to banknotes denominated in other currencies, especially in the run-up to the cash changeover; and euro asset substitution through the conversion of legacy banknotes into euro-denominated deposits.
In co-operation with the central banks of neighbouring countries the ECB has collected information on the scale of the last factor I mentioned, the euro asset substitution. The main conclusion is that euro-denominated deposits rose significantly in the months preceding the cash changeover, by more than EUR 13.5 billion in total. The conclusion seems clear: euro asset substitution is the main factor which explains the existing gap between euro banknotes and legacy banknotes circulating outside the euro area. This conclusion is extremely positive because it implies that all the parties involved in the changeover gained from it: the authorities welcomed the strengthening of banking sectors, banks benefited from the increase in their deposit base and households were able to conduct the changeover at low risk and low cost.
These developments imply that the euro increasingly circulates in scriptural form rather than in paper form, although some economies are still largely cash based. In any case, be it in the form of banknotes or deposits, the conclusion that matters when analysing the role of the euro as a driving force in a globalised financial system is that our currency plays a relevant role as a parallel currency outside the euro area.
Ladies and gentlemen, in conclusion I would say the following. In all its different forms – as debt instruments, bank deposits, banknotes –, in different operations – foreign exchange, international trade –, and for different purposes – exchange rate policies, holdings of official reserves, private store of value –, the fact is that the international role of the euro is gradually growing and that it is the most widely used international currency after the US dollar and ahead of the Japanese yen. This means that savers and investors, banks and real sector companies, public authorities and citizens around the world are increasingly prepared to use the euro as a store of value, a medium of exchange and a unit of account, the three basic functions of money. If this is so it is because they have confidence in the quality of the euro, i.e. in its internal and external stability. The Eurosystem will of course honour this confidence.
KEY BACKGROUND DOCUMENTATION
ECB (2002) "Review of the international role of the euro".
PADOA-SCHIOPPA, Tommaso (2002) "The Euro Goes East", 8th Dubrovnik Economic Conference, 29 June.
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