Member of the Monetary Policy Council, Bank of France1
Former Ambassador of France to the Netherlands
THE EURO: A HARD OR A SOFT CURRENCY?
Lecture in the Cicero Foundation Great Debate seminar "The Euro - An Assessment of Its Growing Global and Regional Role", PARIS, 15 June 2001
Although a wide range of often diverging views on the international role of the euro had been put forward well before January 1999, the derpreciation of the euro took most commentators by surprise. It is somewhat ironic that one of the few widespread beliefs about the euro - namely that the European currency would rapidly appreciate against the dollar - was invalidated soon after the launch of the new currency. This episode suggests that one should be extremely cautious when it comes to addressing the issue of the strength of a currency.
The next question is: does it matter? In other words, are we sure that the question of whether a currency, in this case the euro, is soft or hard is necessarily relevant? In order to address this issue, we should first consider the historical and political background of the euro. Indeed, we tend to forget that the new currency is deeply rooted in European history and was not intended to change the international monetary system or to rival the dollar. I will then argue that, even without active efforts on the part of European monetary authorities, the euro is bound to become a major reserve currency, namely at least the second most widely used in the world. It is, however, too early to say if - and when - the potential of the euro to challenge the prominent role of the dollar will materialise in international capital markets.
1. The euro is deeply rooted in European history and was not designed to change the international monetary system or to rival the dollar
1.1. The euro is primarily a European matter
The international dimension of the euro should be seen against the background of the European integration process. Like other major steps in recent European history, the creation of the euro is deeply rooted in the political context of the post war period, that is to say the political will of core European countries to create the conditions for peace. From the start, the economic integration of European economies was viewed as a crucial pillar of the institutional and political framework: free trade, monetary co-operation and common policies were intended to strengthen the relationships between the members of the Union while at the same time fostering economic growth and prosperity. The institution of a single currency was a logical step, once Europeans had decided to establish a single market for goods, services and capital transactions.
1.2. The euro in the International Monetary System
Against this background, it would be misleading to interpret the creation of the euro as the instrument of European governments to rival the dollar.
The single currency is actually expected to protect a large and relatively closed area from the destabilising exchange rate movements with which European economies were faced during the 1980s and the 1990s. From this standpoint, it is interesting to recall that even before the official launch of the single currency, European exchange rate markets were virtually unaffected by the market turbulence in autumn 1998, something which would have been unbelievable two years earlier. With a fully-fledged monetary union, the exposure of euro area countries to their external environment has changed dramatically. Before 1999, the average ratio of goods exports to GDP was about 35%. The same ratio stands at 13% for the whole euro area. This figure means that the euro area is partly insulated from developments abroad. Incidentally, this is what is happening now: for the first time since 1995, the growth differential between the euro and the US has been in favour of Europe. This is not only good news for Europe but also for the world economy. With no clear recovery of the Japanese economy in sight, it was important that the euro area contributes to a more balanced growth pattern at world level.
That said, Europeans themselves have yet to realise that exchange rate flexibility is unavoidable in a world of large and still heterogeneous economic areas, such as the US, Japan and the euro area, and one should not overreact to short-term fluctuations of the euro on foreigh exchange markets. One should realise that for medium-size European economies that were used to pegging their currencies to the Deutschmark, the external relations of the euro area require a rather different cultural attitude.
For their part, European monetary authorities, that is the Eurosystem of central banks2, have consistently emphasised that the international use of the euro and its exchange rate will be basically a market-led process. In other words, the question of if and when the euro will affect the dollar's role is left to the market's perception of policy as well as economic and financial developments inside and outside the euro area.
1.3. Implications for the exchange rate of the euro against the dollar
The policy implication of the approach I have just described is that the Eurosystem does not have an exchange rate target. Therefore, what role does the exchange rate play in the ECB's monetary policy? All in all, I would argue that the Eurosystem's views on this policy issue are very close to those of the Fed. Like the US authorities, the focus of the ECB is on price stability and, in that context, the exchange rate is used by the ECB as one of the various indicators and factors of inflationary pressures. In extreme circumstances, the overshooting of major exchange rates, with the potential to destabilise international capital markets, might also trigger a policy reaction.
This is basically the background of the ECB's attitude towards the depreciation of the euro that started in early 1999. During most of 1999, market trends were not seen as particularly worrisome in the context of cyclical growth divergence between the US and the euro area. Moreover, the appreciation of the dollar contributed to counteracting inflationary pressures arising in the buoyant US economy. However, by mid-2000, the picture had changed significantly: with more balanced growth between the euro area and the US in 2000, the euro/dollar exchange rate appeared out of line with macro economic fundamentals, adding to inflationary pressures in the euro area. Because of their "shared concern about the potential implications of recent movements in the euro for the world economy", the G7 authorities joined forces with the European Central Bank on 22 September in concerted intervention in exchange markets. The Eurosystem intervened again later on in order to reinforce the impact of the first wave of intervention.
What can be said about these interventions in retrospect? On the one hand, markets have realised that speculating on the USD/euro market is a "two way risk" strategy. This was not so clear before the interventions: market participants were not necessarily convinced that the ECB was actually worried about the exchange rate of the euro. On the other hand, to convince markets that you are right and they are wrong is not that easy: in spite of an unambiguous growth differential in favour of the euro area, markets continue to cajole the dollar. A lot has been said on the subject and I don't pretend to have much to add. Clearly, the current situation is puzzling. The strength of the dollar is not fully consistent with an increasingly large US current account deficit. At the same time, as long as markets are willing to finance this deficit, in other words to invest in US $ denominated assets, we should not overstate the problem for the world economy.
2. What can be said about the international role of the euro?
If the external value and the international use of the euro are to be a market-led process, what can be said about the factors that could contribute to fostering the use of the euro outside the euro area?
2.1. Factors driving the internationalisation of currencies
There is no obvious answer to this question, but historical evidence tends to suggest that at least two factors are key conditions of the international use of currencies.
First, international markets require the "hosting" country, namely the country that issues the currency, to deliver sound policies. In particular, price stability is a major precondition for a currency to play an international role. Clearly, investors or official institutions would be reluctant to hold euro-denominated assets, to borrow in euros or to peg their currency to the euro if they didn't trust the commitment of the ECB to price stability. Therefore, the central bank of the reserve currency should display a strong non-inflationary track record. In addition to price stability, the attractiveness of the currency depends on how markets assess the growth performance of the "hosting" country since investors' decisions are also based on the expected return on the assets denominated in the reserve currency.
A second requirement for becoming an international currency is for the hosting country to provide investors with large and liquid capital markets where they can easily buy and sell assets denominated in the vehicle and reserve currency. This means in practice that capital markets should offer a wide range of financial products and maturities.
2.2. The potential of the euro as an international currency
It is my contention that the euro has the potential to challenge the prominent role of the dollar in international markets, although we do not know if and when this will materialise. Firstly, the euro is potentially a major reserve currency because the euro area fulfils the requirements I have just mentioned: sound policies, and large and liquid capital markets. Second, this does not mean that the euro will challenge the dollar in the foreseeable future. One reason for this is the fact that inertia will favour the continued use of the dollar for a long time. In addition, Euroland is still lagging behind the US in two areas.
First, euro markets still lack in some areas (of example the repo market) the degree of integration and liquidity of US capital markets, although it is fair to say that euro area capital markets have developed much more rapidly than expected [see 2.3.].
Second, because of the newness of the euro area institutional framework, European policy-makers have yet to deliver a credible track record in two policy areas that are crucial to growth performance: the adequacy of the policy-mix and the success of the ongoing structural reforms. While nobody questions the ability of the ECB to deliver price stability, the growth performances of the euro area does not give rise to the same favourable judgement. Substantial progress has been made during the 1990s, but productivity, employment, and growth figures for the euro area have not yet matched the performance of the US economy. Although I am extremely confident about the potential of Europe over the medium-term, which is the time-horizon that ultimately matters, Europe has still far from reaped the full benefits of the ongoing transformation process of euro area economies and monetary unification.
These are, in my view, the main reasons why, for the time being, it would be premature to claim that the euro will challenge the international role of the dollar in all, or specific segments of international markets.
I will turn now to developments in international markets since the launch of the euro on 1 January 1999.
2.3. Recent developments in international capital markets: a preliminary assessment
The first observation is that the euro is already the second most widely used currency after the US dollar. The fact that the euro/dollar foreign exchange market is the largest in the world should not come as a surprise. The share of the euro in exchange rate and capital markets is the mechanical outcome of the weight of the euro area in the world economy and the legacy currencies of the euro (Deutschmark, French franc, etc.). A few figures are relevant here. The euro area population is 302 million against 272 million in the US. The share of the euro area in world GDP is 16% against 22% for the US.
It was perhaps not very forseeable that non-residents would use the euro as a "financing currency" (i.e. the currency to denominate debts). Some interesting figures are worth mentioning in this regard. Between 1999 and early 2001, gross issuance of long-term debt securities denominated in euro amounted to 1,754 billion against 1,688 billion for debt securities denominated in US dollars. About 40% of international debt securities issued over the past two years have been in euro.
By contrast, we have some indications that the use of the euro as an investment currency by non-residents has been more limited. An indirect way to measure this role is to consider the balance of payments of the euro area and the US: clearly, substantial capital inflows, including from the euro area, massively benefited the US in 1999 and 2000. This is an indication that dollar denominated assets are still valued by international investors. However, as I suggested earlier, the current market situation is not entirely sound. The market for US denominated assets also mirrors the low savings in the US.
Finally, there is some evidence that the US dollar continues to play a prominent role as a payment currency in the exchange of goods and services and as an invoicing currency in international trade. The share of the euro-denominated international trade is about 15%. As I suggested earlier, this is an area where inertia will favour the continued use of the dollar for a long time to come.
Turning now to the use of the euro by official institutions, a couple of points can be made.
First, on the basis of the official reserves statistics collected by the IMF at the end of 1999, the euro accounted for about 13% of total reserve holdings (against 70% for the USD). This share is comparable with the weight of the legacy currencies of the euro in 1998 (Deutschmark, French franc, etc). This figure may confirm that management of reserve holdings by central banks tends to be conservative. A second interesting figure concerns the use of the euro as a nominal anchor for exchange rate regimes adopted by third party countries: over 50 countries' policy frameworks include a reference to the euro (currency boards, pegs, managed floating). Most of them are European and African, which is not surprising since those countries have close trade and financial links with the euro area.
3. Concluding remarks
It was probably unavoidable that the exchange rate of the euro, as the symbol of the new monetary union, would be the main focus of the media and observers. On the other hand, I do not think this has necessarily been helpful. The weakness of the euro has indeed steered observers and policy makers away from making a more pragmatic assessment of the euro area economic situation and the international role of the euro.
As regards the latter, I have argued that the European authorities do not intend to develop as such the international use of the euro, and rightly so. However, it would be misleading to believe that the role of policymakers is, or should be, a limited one. Indeed, the conditions for the internationalisation of the euro are consistent with otherwise desirable objectives for European policymakers: sound policies on the one hand and large and liquid capital markets on the other hand.
1 Mr. Bernard is expressing his personal view.
2 The Eurosystem is made up of the ECB and the national central banks of the 12 euro area countries (eleven countries mentioned earlier and Greece since 1 January 2001).