European Affairs

Winter 2000

 

The Euro as an International Currency
by Eugenio Domingo Solans

One year after its launch in January 1999, the euro has already established itself as the second most widely used currency in the world economy, behind the U.S. dollar and ahead of the Japanese yen.

According to economic theory, a currency fulfills three basic functions: it is a store of value, a medium of exchange and a unit of account. As a store of value, the use of the euro as an investment and financing currency is rapidly increasing, as investors understand the advisability of diversifying their portfolio currencies among those which are more stable and more internationally used. The euro is developing at a slower pace as a medium of exchange or payment currency in the international exchange of goods and services. This can easily be explained by the predominance of the dollar. The use of the euro as a unit of account is linked to its use as a store of value and a medium of exchange.

There are good reasons to expect an increase in international public use of the euro as a reserve, intervention and pegging currency, inasmuch as the public authorities understand that it is worthwhile to allocate their foreign reserves among the main international currencies and to give the euro a relevant share in accordance with its internal and external stability and the economic and financial importance of the euro area.

As for the use of the euro as a pegging currency, approximately 30 countries outside the euro area currently have exchange rate regimes involving the euro to a greater or lesser extent. These exchange rate regimes are currency boards (Bosnia-Herzegovina, Bulgaria, Estonia); currencies pegged to the euro (Cyprus, the Former Yugoslav Republic of Macedonia and 14 African countries in which the CFA franc is the legal tender); currencies pegged to a basket of currencies including the euro, in some cases with a fluctuation band (Hungary, Iceland, Poland, Turkey, etc.); systems of managed floating in which the euro is used informally as the reference currency (Czech Republic, Slovak Republic and Slovenia); and, last but not least, European Union currencies pegged to the euro through a cooperative arrangement, namely the exchange rate mechanism known as ERM II. Denmark and Greece joined ERM II on 1 January 1999 with a ± 2.25 percent fluctuation band for the Danish krone and a ± 15 percent fluctuation band for the Greek drachma. Although the euro remains in second position after the dollar in terms of its official use, the role of the euro will increase in the future, without a doubt, especially after the year 2002, when the euro banknotes and coins will begin to circulate.

Taking the current situation as a starting point, the Eurosystem's position concerning the future international role of the euro is crystal clear: we shall not adopt a belligerent stance in order to force the use of the euro upon the world economy. (The Eurosystem is the name given to the European Central Bank, which is the hub of the system, plus the eleven national central banks of the euro area countries.) We are convinced that the use of the euro as an international currency will come about anyway. It will happen spontaneously, slowly but inexorably, without any impulses other than those based on free will and the decisions of market participants, without any logic other than that of the market. In other words, the internationalization of the euro is not a policy objective of the Eurosystem; it will neither be fostered nor hindered by us. The development of the euro as an international currency will be a market-driven process, a free process.

The euro fulfills the necessary conditions to be a leading international currency with the dollar and not against it. There is enough room for both currencies in the world economy. The necessary conditions for a currency to become an international currency 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. The large size factor relates to the relative demographic, economic and financial importance of the area which supports the currency; in other words, the "habitat" of the currency.

The first factor concerns low risk, credibility and stability. The stability of the euro is a priority for the ECB. The Treaty on European Union or Maastricht Treaty states that the primary objective of the Eurosystem "shall be to maintain price stability." Although the ECB is also required to support the EU's general economic policies, such as those covering economic growth, employment and social protection, those objectives remain secondary.

The basic factor that will determine the importance of the euro as a widely used currency in the world economy, in addition to the demographic, economic and financial dimensions of the euro area, is, without a doubt, the stability of the new currency, understood as a means to maintain the purchasing power of savings. Stability is the basic requirement for a good currency. It is what we at the ECB want for the euro. We want a stable euro and we are convinced that, in the long term, the euro will derive strength from its stability. Does anybody know a stable currency which is not 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 the proof of the effectiveness of the institution. 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 and communication, a Europe-wide perspective, etc. These parameters or conditions for the credibility of the euro are certainly demanding. However, the achievement of these conditions is the aim of those 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 have international relevance, however high its degree of stability. The figures relating to the population and the GDP of the euro area illustrate this. With 292 million inhabitants, its population exceeds that of the United States (270 million) and that of Japan (127 million). The GDP of the euro area is, on the other hand, equal to 76 percent of the GDP of the United States (EUR 5,774 billion compared with EUR 7,592 billion), though it is higher than that of Japan (EUR 3,327 billion). The source of this information, which refers to 1998, is Eurostat.

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, Greece, Sweden and the United Kingdom) join the Eurosystem. The entry of these countries would result in a monetary area of 376 million inhabitants, 39 percent more than the United States and almost triple the size of Japan, with a GDP of EUR 7,495 billion, only slightly less than that of the United States and 125 percent higher than that of Japan.

All these facts and figures which demonstrate the demographic and economic importance of the European Union would be further strengthened by enlargement into Eastern Europe. Our continent has a historical, cultural and geographical identity - from the Iberian peninsula to the Urals, with certain additional external territories - which, in the future, may also come to form an economic unit. However that is, for the moment, a distant prospect.

The size or habitat of an economy does not only depend on demographic or economic factors; it also has to do with the financial base or dimension of the area. In considering the financial dimension of the euro area, the first relevant feature to observe is the low level of capitalization of the stock markets in comparison with the United States and Japan. Although this feature could give the impression that the euro area has a relatively small financial dimension relative to its economic dimension, this is not the case.

The lower degree of development of the capital markets is offset by a higher degree of banking assets. This means that the financial base of real economic activity in Europe is founded on bank intermediation, which is also a feature of the Japanese economy. For example, private domestic credit in the euro area amounts to 92.4 percent of GDP, while in the United States it is only 68.9 percent. Conversely, fixed domestic income represents 34.2 percent of GDP in the euro area compared with 66.1 percent of GDP in the United States (statistics from the International Monetary Fund and the Bank for International Settlements as of the end of 1997, taken from the Monthly Bulletin of the European Central Bank). We, therefore, have two distinct models of private financing which clearly have to be taken into account when assessing Europe's financial dimension compared with the United States or Japan.

The euro, the Eurosystem's monetary policy and, in general, the activity of the ECB and 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 institutional changes brought about by the euro have also made it possible for Europeans to speak for the first time with one voice in monetary and financial matters. By reducing the number of key players in the International Monetary System, the euro will contribute to simplifying international policy cooperation between the major regional blocs. It will make this process more efficient by facilitating the exchange of information and the ability to reach consensus on worldwide issues. Each of the main partners - the United States, the euro area, and Japan - is now in a position to speak for a relatively large economic region.

The euro is thus set to propel the euro area into a role of systemic importance. The Eurosystem's role on the international scene will tend to expand and develop over time, as it gains experience. Assuming this new responsibility for the stability of the international financial system as a whole, however, should not be misinterpreted as a move towards managing exchange rates between the world's three leading currencies. In our view, exchange rates are primarily the outcome of current and expected monetary, fiscal and structural policies as well as cyclical and other economic developments, rather than an objective or target of monetary policy. Having said that, the Eurosystem does not regard the exchange rate with "benign neglect." The external value of the euro is an important policy indicator insofar as it has impact on the policy objectives of the Eurosystem and influences the euro area's role in the world economy.