The euro - a stable international currency
Prof. Otmar Issing, Member of the Executive Board of the European Central Bank, Budapest, Academy of Sciences, 27 February 2003
Ladies and Gentlemen,
Let me first extend a warm thank to the Institute for World Economics of the Hungarian Academy of Sciences for inviting me here today to share a few thoughts on the euro as a stable international currency.
When the euro was launched on 1 January 1999, the European Central Bank (ECB) assumed responsibility for monetary policy in the euro area – the second largest economic area in the world after the United States. The legal basis for the single monetary policy is the Treaty on the European Community, which in its Article 105 states that "the primary objective of the European System of Central Banks shall be to maintain price stability". I wish to argue in this speech that this clear objective in conjunction with the economic size of the euro area constitute the key fundamentals for the euro to become a stable international currency.
The Oxford dictionary of economics defines international money as "money which can be used in settling international transactions". Indeed, a currency acquires the status of international money if it assumes the role of a vehicle in international transactions, if it is used internationally to denominate assets and if it is stored as official reserve.
I will argue that the economic size of a country is an important factor for having its corresponding currency getting the status of international money. This factor alone, however, is not sufficient. Institutions of the issuing country matter as well. In other words, a sound institutional and regulatory framework of the issuing economy as well as the credibility of the relevant institutions is also a fundamental determinant of international money. I wish to emphasise that we at the ECB contribute to the international role of the euro through our efforts to achieve the price stability objective.
2. Determinants of the international role of a currency
What can we say about the factors determining international money? The main factors underscoring the international status of a country's currency can be classified in three main groups: (1) the economic size of the issuing country; (2) the soundness of its institutional framework; (3) the previous use of its currency.
2.1. Economic size of the issuing country
With regard to economic size, it is common to look at the Gross Domestic Product (GDP) of the issuing country and its global trade. Ceteris paribus, the larger the GDP of a country and the more open its economy, the larger its international trade. A large cross-border goods trade volume of a country generally implies lower transaction costs in using this country's currency to channel global trade. If traders find it convenient to use this country's currency as a means of exchange also for transactions with other countries' traders, then it becomes a vehicle currency and its status is enhanced to international money.
Although GDP and trade are seminal factors for a currency to acquire international status, recent literature has given increasing importance to the size of the financial markets. The deeper and wider the financial markets of a country, the greater the likelihood that its money is chosen as an international currency, as large and liquid markets imply low transaction costs. In other words, to conduct their financial transactions, foreign agents have an economic incentive to use this country's financial markets or financial instruments denominated in its currency as opposed to another currency with larger transaction costs.
As it is well known, the United States has the highest real GDP and the largest capital markets. Both real GDP in 2001 and the sum of stock market capitalisation, debt securities outstanding and bank loans outstanding in 2002 in the United States are 70% larger than that in the euro area. Similarly, these variables in the euro area are 50% larger than that in Japan. In terms of foreign trade in goods and services, total trade of the United States and the euro area is roughly the same amounting in 2001 to EUR 2.6 trillions, about 2.7 times the total trade of Japan.
When comparing with other countries, the data relative to economic size suggest that the United States, the euro area and Japan are the largest economies in the world, thus fulfilling one of the key criteria for their respective currencies to be chosen as international money.
2.2. Sound and effective institutions of the issuing country
With regard to the role of institutions, political stability and good governance in the issuing country are important determinants for the international role of currencies. Economic agents must be confident that the country whose currency is chosen to be international money is committed to provide a market friendly regulatory framework and to deliver good governance. Thus, the country with a wise fiscal authority, a sound legal and judicial system, efficient regulatory authorities (i.e. banking supervision, anti-trust, etc.), and with a monetary authority geared towards achieving price stability is more likely to have its currency used as international money.
In this regard, price stability is an important precondition for the development and maintenance of the international role of a currency. It is a necessary condition for foreign investors' confidence that their purchasing power will be preserved. Internal monetary stability is also a precondition for external stability in the sense of contributing to lower exchange rate volatility and helping in preserving the confidence in the currency.
2.3. Incumbency advantage and inertia of an existing international currency
The third factor determining international money is linked to the previous use of the currency. Traders' preferences for a specific currency appear to change very slowly, because imperfections in goods and asset markets generate economies of scale in using the existing currency. As often pointed out, the pound sterling kept its international status for decades despite the strength of the US economy relative to the British economy.
Typical examples are the international commodity markets, which generally trade in the same currency over the years. This inertia in financial and commodity markets can outweigh the forward-looking behaviour of economic agents.
2.4. A snapshot of the main three international currencies
Putting all three categories of factors into perspective, it is accurate to say that the US dollar satisfies all of these three criteria (i.e. economic size, soundness of institutional setting and previous use of the currency), while the euro satisfies the first two.
It is not surprising that the US dollar is the global leading currency in accordance with the main criteria used to rank international currencies and represented by the share in foreign exchange reserves, the share in foreign exchange market, the share in the denomination of international debt securities and international trade transactions. Data on the currency breakdown of international trade transactions remain highly limited. However, there is no doubt that the US dollar is the global vehicle currency for transactions between almost all currency pairs. International commodity markets, such as the crude oil market and the gold market, trade in US dollars.
Given the weight of the euro area in the world economy and the legacy of the former national currency, which have been replaced by the euro, the euro is the second most widely used currency behind the US dollar, despite its recent birth, while the Japanese yen has a smaller role.
3. The ECB and the euro after 4 years
Having discussed the determinants of international money and the relative share of the three international currencies as of 2001, let me investigate in some detail how the euro as an international currency has developed since its launch in 1999.
3.1. The evidence
Available statistical sources indicate that the international role of the euro has grown, although gradually. While no important changes have so far been identified on the official reserves and on the foreign exchange markets, the use of the euro appears to have increased in commodity trade transactions and noticeably in global debt securities markets.
With regard to the euro's role in the foreign exchange markets, data on daily foreign exchange market turnover indicate that the euro in April 2001 entered 19% of all foreign exchange transactions. This share is higher than the Deutsche mark's share in 1998 (15%) but lower than that of all euro constituent currencies taken together in the same year (26%). As pointed out by the BIS, this is mainly due to the elimination of trading between the euro's legacy currencies. With regard to the other two main currencies, the dollar's and the yen's share in foreign exchange markets edged up respectively from 44% and 10% in 1998 to 45% and 11% in 2001. The BIS Survey also indicates that the dollar/euro was by far the most traded currency pair in 2001 and accounted for 30% of global turnover. It was followed by the dollar/yen pair with a 20% share.
Data on the currency breakdown of international trade transactions remain highly limited. They indicate that the international role of the euro has a strong regional dimension, as the euro is often used as a vehicle currency with countries that are geographically close to the euro area, most notably the Central and Eastern European countries, whose trade share with euro area countries is relatively high. Harmonised and aggregate data for the euro area as a whole on the use of the euro for settlement and/or invoicing of international trade and services are not available. However, data from some Member States as well as from some third countries exhibit a marked increase in the use of the euro in international trade. In this regard, a first source of information is the balance of payments statistics of some euro area countries (namely, Belgium, France, Portugal and Spain). The data reveal that there has been an increase in the use of euro transactions with residents outside the euro area for both exports and imports of goods in 2001 relative to 2000. Regarding international transactions in services, available data for Belgium, France, and Portugal also indicate a rise in the use of the euro in both exports and imports. A second source of information is data from third countries on the currency breakdown of their trade. The data in goods trade for Bulgaria, Poland and Japan indicate that the euro's share has increased at the expense of the US dollar.
Regarding the global debt securities market, the amount outstanding of the euro-denominated issues by non euro area residents showed a steady upward trend, rising from 19% at the end of 1998 to nearly 30% in the third quarter of 2002. This share compares with 44% for the US dollar, whose share decreased gradually since the launch of the euro, and with 12% for the Japanese yen, whose share showed a marked decline since 1997.
As pointed out in the 2002 annual review of the international role of the euro, the rise in the euro's share over the past few years can be partly explained by an expected and actual increase in liquidity owing to the creation of an integrated money market.
However, the issuers of debt securities are mainly non-resident corporations and federal agencies, concentrated in a few industrial economies, especially the US and the UK; while the buyers are mostly euro area investors. Data show that this phenomenon is well known to bond issuers: when they issue bonds in US dollar, they target worldwide institutional investors; when they issue bonds in euro, they target retail investors in the euro area, as well as London and Switzerland.
The evidence on international trade and financial transactions indicates that the international role of the euro has a strong regional dimension, whereas the US dollar is used more globally. This feature can also be seen in the exchange rate policies of third countries. The euro is the anchor currency in several countries and regions in the broad geographical neighbourhood of the European Union, especially in Central and Eastern Europe but also in North Africa as well as parts of sub-Saharan Africa.
In summary, against the background that the role of international currencies tends to change only slowly, it can be argued that the international status of the euro has increased gradually and steadily since the start of the third stage of EMU in January 1999.
3.2. Maintenance of price stability
The underlying factors behind the gradual increase of the international role of the euro are difficult to identify. However, since price stability is an important precondition for the development of the international role of a currency, the credibility of the ECB in maintaining price stability in the euro area will have played a role.
Given the importance of the institutional setting for achieving price stability, it is worthwhile describing the new policy framework in Europe. The Treaty establishing the European Community laid down a solid institutional foundation for economic policy-making in Europe, allocating the policy responsibilities among the European institutions. The specific design of the Economic and Monetary Union transfers the competence for monetary policy to the Community level, while leaving the responsibilities for fiscal policies, labour market policies and many microeconomic and structural policies in the hand of national, or sub-national, authorities. The Treaty has established the Eurosystem (comprising the ECB and the National Central Banks of the participating Member States) – with the ECB at its core – and assigned to it the primary objective of maintaining price stability in the euro area. Moreover, the Treaty has made the ECB one of the most independent central banks in the world. Institutional independence of the central bank is a crucial pre-condition for successfully pursuing a monetary policy oriented at maintaining price stability. By protecting the central bank against short-term political concerns and influences, it puts the central bank in the position to take all required decisions to pursue its goal.
At the same time, the Treaty requires that the governments respect a common code of fiscal conduct that is expected to uphold discipline in the management of public finances. The fiscal rules are laid down in the Stability and Growth Pact. By promoting sound government finances and thereby imposing explicit and implicit limits to budget deficits and public debts, the Treaty reinforces the conditions for both price stability and strong sustainable economic growth in the euro area.
The ECB Governing Council has defined price stability as a yearly increase of the harmonised consumer price index (HICP) by less than 2%, with a medium-term horizon. This implies that the ECB's monetary policy needs to be forward looking and be geared to pinning down inflation over the medium term, rather than trying to counteract short-term fluctuations. Since the monetary policy of the ECB is carried out with this clear objective, the stability of the euro should be preserved, provided the policy is perceived as credible.
Is the monetary policy of the ECB credible? Available indicators of private sector expectations for euro area inflation suggest that the ECB policy is indeed credible. Both professional forecasters surveys carried out independently by the ECB and Consensus Economics as well as the ten-year "break-even" inflation rate for the euro area suggest that the long-term expected inflation is currently below 2% and, most importantly, it has been quite stable over the last four years.
Over the last four years, inflation has been kept under control even in face of substantial adverse price shocks, such as the tripling of oil prices in 1999-2000. Moreover long-term bond yields in the euro area have been persistently in line with the expectations of price stability over the medium and long term, thereby reflecting the confidence that investors place on the ECB. Despite all initial doubts and uncertainties, it is undeniable that the credibility of the new European institution entrusted with the responsibility of the single monetary policy has been established.
The size of the euro area and the institutional framework established by the Treaty – in particular the price stability mandate assigned to the ECB – are key factors for the international role of the euro. In the context of its price stability strategy, however, the ECB has a rather neutral attitude vis-à-vis the international role of the euro. More specifically, the ECB holds the view that it would be neither feasible nor desirable to directly promote or hinder the internalisation of the euro and that, ultimately, market participants choose international currencies.
4. A struggle for dominance?
Let me now turn to address the issue of a possible "rivalry" between the US dollar and the euro.
The literature has recently been debating the issue of whether the euro may eventually displace the US dollar as international money. Bergsten (2002), for example, pointed out that the reason for the supremacy of the US dollar since the second-world war was the lack of competition by other national currencies. He indicated that the euro is the first currency, which could challenge the US dollar's supremacy owing to the economic size of the euro area. However, he argued that the incumbency advantages of the US dollar ought not to be underestimated, and that the inertia in monetary markets could outweigh forward-looking behaviours of economic agents.
However, is there actually a struggle for dominance between the US dollar and the euro? I think that the dominance of a currency in international money, which can occur when the use of national currencies depends heavily on international trade in goods and services, is not longer a persuasive argument in a world where global financial transactions become preponderant. Indeed a single national currency, which is identified as the numeraire and medium of exchange in the foreign exchange trading, is economically more efficient. However, the liberalisation of the capital markets worldwide and the increased allocation of world savings in global portfolio equity securities and debt instruments call for risk management and higher diversification rather than dominance of one specific national currency. Investors use currencies to hedge their risks through diversification across international currencies. If international investors and issuers consider the US dollar and the euro stable currencies, they will hold US dollar and euro denominated assets to minimise risk in their internationally diversified portfolios.
An additional argument against the dominance of one single international currency is that global financial markets are less vulnerable to shocks if more than one currency is used as international money. The global financial turbulence in the autumn of 1998, the Y2k problem at the end of 1999, the burst of the equity bubble in 2000, the terrorist attacks on the United States in 2001 were all exceptional events that the global financial system handled well owing to some extent also to the investors' confidence in the euro.
Finally, Michael Mussa's point of view in his 2002 paper is an additional interesting argument for both the US dollar and the euro coexisting as leading international money. The "rivalry" between these two currencies in international finance should be best understood, in his words, "as a positive sum game, rather than a fight to the death". By reducing market inefficiencies, the euro contributes to promoting economic growth in Europe with positive spillover effects on the rest of the world. The creation of the euro has already generated welfare gains.
In summary, there is compelling evidence that international finance has already been benefiting from both the "coexistence" of the US dollar and the euro. International investors can reduce risk by diversifying their asset portfolio, commodity traders can make international contracts using easily one of these two currencies as a numeraire and, most importantly as far as the ECB is concerned, they can trust the single monetary policy which, through its pursuit of price stability, safeguards the purchasing power of the euro.
Let me conclude my remarks by recalling that the euro has been in existence for more than four years – since the beginning of 2002 also in the form of banknotes and coins. After many centuries, since the fall of the Roman Empire, a single means of exchange unifies Europe. However, unlike that remote experience, it is not the result of military imposition, but a consensual act by sovereign nations. Viewed in these terms, the euro represents much more than a currency. It is the expression of the desire of peace, political reconciliation and closer integration in Europe after a history of frequent hostilities, culminating in two worldwide wars.
Within the policy framework of Economic and Monetary Union created by the Treaty, the ECB has been assigned the fundamental task of safeguarding the value of the single European currency. The brief history of the ECB is already a success story. Initial uncertainties and concerns – and, to some extent, also scepticism – have been quickly dispelled. The young institution and the euro have already gained the confidence of the Euro area citizens.
International investors and commodity traders have been steadily and gradually increasing their euro-denominated economic and financial activities. By maintaining price stability, the ECB not only makes a contribution to improving economic prospects and rising living standards in the euro area, but it enhances also the international role of the euro. The ECB position vis-à-vis the international role of the euro, however, remains neutral.