Axel Bertuch-Samuels and Parmeshwar Ramlogan
Eurotower in Frankfurt, Germany.
MORE THAN eight years ago, the euro was launched amid enormous hopes and expectations about its future international role. Some even speculated that it might someday supplant the U.S. dollar as the most important international currency. There is no question its introduction was an unqualified technical success. The euro has quickly and firmly established itself as the world’s second most important international currency. Today, its international prominence far surpasses not only that of the legacy European currencies the euro replaced, but also that of the pound sterling and the Japanese yen, the other main international currencies. And even though the European Central Bank (ECB) is not actively seeking to promote the euro’s use abroad, its role continues to grow.
An international currency is one that is used by residents both outside and inside the country of issue. In contrast, a domestic currency is used only inside the country of issue. In the case of the euro, international use would mean use by residents outside the countries comprising the euro area. On the plus side, having a strong international currency confers political and economic advantages on the issuing country or group of countries. Politically, the country or group gains international prestige and its global influence expands. Economic benefits include lower transaction costs and interest rates and higher profitability of financial institutions, resulting from increased activity and efficiency in domestic capital markets; the ability to finance current account deficits in the country’s own currency, thus avoiding the need to accumulate foreign reserves; and seigniorage revenue from the country’s issue of non-interest-bearing claims on itself in exchange for goods and services.
But internationalization of the currency also carries risks and responsibilities. Sound macroeconomic policies to maintain price and exchange rate stability will be crucial. But even with sound policies, the country becomes more exposed to volatile capital flows that could generate financial and macroeconomic instability and constrain policy choices. At the same time, specification of a monetary target becomes more difficult because part of the currency is held abroad, which complicates the conduct of monetary policy.
How the euro is currently used
The euro’s advance as an international currency has not been even. From a functional perspective, it has made the most progress in international financial transactions—particularly as a currency in which international debt securities are denominated—and the least progress in international trade transactions. From a geographical perspective, the euro’s role as an international currency is still confined largely to countries that have regional and political ties to the euro area, including European Union (EU) members that have not adopted the euro, EU accession countries, and the CFA franc zone in Africa. Some may argue that the euro’s limited geographical role means it is still not in the same class as the dollar.
So how does current use of the euro as an international currency compare with use of the dollar? In official use, roughly one-third of countries that peg their currency in one form or another use the euro as their anchor currency. They comprise mostly non-euro area EU members, EU accession or potential accession countries, and French-speaking African countries. Most of the remaining two-thirds—in Asia, Africa, the Middle East, and Latin America—use the dollar as their anchor currency. Reflecting this, at the end of September 2006, dollar-denominated foreign exchange reserves comprised almost two-thirds of total world holdings of official foreign exchange reserves for which the currency composition is known (see Chart 1). Euro-denominated reserves comprised one-fourth of the total whereas yen- and sterling-denominated reserves together comprised only 7 percent. The euro’s share has risen at the expense of the dollar and the yen. Developing countries hold a larger share of their reserves in euros than do industrial countries, reflecting the dominance of euro reserves in countries neighboring the euro area and in French-speaking Africa.
Chart 1.Coming in second for reserves
Sources: IMF and Urn (2006).
1 Asia plus Western Hemisphere plus other countries that largely peg to the dollar.
2 Countries around the euro area plus several countries in Africa.
In private use, the euro has surpassed the dollar as the most important currency of issue for international bonds and notes (defined as foreign-currency issues and domestic-currency issues targeted at nonresidents). Indeed, net issues in euros have risen faster than issues in other currencies, and by end-September 2006, euro issues comprised nearly half the outstanding global stock of international bonds and notes (see Chart 2). In central Europe and the Baltic states, 83 percent of outstanding international bonds, on average, were denominated in euros at the end of 2005, whereas in Asia and Latin America issues in euros remain very small.
Chart 2.Taking the lead on bonds
Source: Bank for International Settlements.
In international banking, 39 percent of all loans and 28 percent of all deposits were denominated in euros at end-June 2006, compared with 41 percent and 48 percent, respectively, denominated in dollars. Again, most transactions involved the non-euro area countries in Europe; the euro is not used much in international banking outside Europe. In foreign exchange markets, the euro is currently the second most widely traded currency after the dollar, and euro-dollar the most frequently traded currency pair, suggesting that the euro is a significant vehicle currency in foreign exchange transactions. Limited invoicing data available from the ECB indicate that the euro is the most important currency for invoicing trade between euro area and non–euro area countries in Europe, but that it is rarely used in international trade transactions outside the euro area (see Chart 3). This may reflect, in part, the fact that trade in commodities is traditionally invoiced in dollars.
Chart 3.Not much of a trade impact
Sources: European Central Bank: and IMF staff calculations.
1 Selected countries.
2 FYR Macedonia and Ukraine.
3 Australia, Indonesia, Japan, Korea, Pakistan, and Thailand. Data for these countries refer to 2003.
n many countries surrounding the euro area, the euro is also used alongside or in place of the national currency—what is called euroization. This growing trend is evident for all the functions of money: as a means of payment (cash and credit), as a store of value (bank deposits), and as a unit of account (loan contracts). It is not surprising that this is happening. Many countries in eastern and southeastern Europe are aiming for EU membership (which entails adopting the euro once certain criteria are fulfilled), and loans in euros often carry lower interest rates. But the largely unhedged borrowing and lending in euros have made these countries more vulnerable to swings in investor sentiment, not least because they expose residents to foreign exchange risks.
Factors influencing use of the euro
The euro’s role as an international currency is shaped largely by the following four factors:
Economic size and openness. The larger and more dynamic an economy, the greater the potential global economic influence it wields, in part because economic size and openness are highly correlated with capital and trade flows. With a population larger than that of the United States, and an aggregate economy that is relatively open and almost as large (or potentially larger when the entire EU is considered), the euro area is well placed to forge a major international role for the euro. However, the euro area’s economic growth has lagged that of the rest of the world, averaging only 1.4 percent during 2003-05 compared with 5.7 percent elsewhere. Higher growth would boost the attractiveness of the euro area as an investment destination, as well as confidence in the euro area economies and in the euro, and would likely lead to larger capital inflows of a longer-term nature. Policies that strengthen the foundations for economic growth, including a sustained qualitative improvement of public sector balance sheets and structural reforms to raise productivity and labor use, will also matter.
Price and exchange rate stability. The greater the issuing country’s price and exchange rate stability, the lower the cost and risk in financial markets and the higher the confidence in the currency. The Maastricht Treaty has given the ECB a firm mandate and operational independence to maintain price stability, and the ECB’s track record has been strong. Inflation and inflation expectations in the euro area have been low and stable, and exchange rate volatility has also been low. The euro itself has facilitated the conduct of monetary policy and the maintenance of price stability by stimulating money market development.
Financial market development and integration. The existence of well-developed and integrated domestic financial markets is critical. Such markets provide liquidity; lower transaction costs; reduce uncertainty and risk and, hence, hedging costs; and lead to lower interest rates. They also boost productivity and economic growth and strengthen confidence in the euro. All these factors influence the degree to which the euro is used as a global currency for saving, investing, and borrowing.
Traditionally, euro area financial systems have been largely bank-based, with euro area financial markets less developed and less integrated than those of the United States. However, European financial systems have been undergoing a steady transformation over the past two decades—a process that accelerated with the euro’s introduction and the adoption of the Financial Services Action Plan (FSAP) in March 2000. The plan’s objective is to create a single market for financial services by removing regulatory and market barriers to the cross-border provision of financial services, thereby encouraging the free movement of capital within the EU.
The ongoing development and integration of European financial markets manifests itself in several ways. First, corporate and government bond markets in Europe have expanded significantly and become much more liquid since the euro’s introduction. Second, there is evidence of increased integration of stock markets within the euro area. Co-movements of stock prices have increased, the share of Europe-wide funds in the aggregate equity market has risen substantially, and market participants are paying more attention to industry and company factors and less to country-specific factors in valuing stocks. Third, sovereign interest rate differentials across euro area countries have come down. Fourth, financial innovation is progressing rapidly. Market infrastructures are being transformed, the range and complexity of financial instruments have increased, and trading volumes have expanded.
Even so, European financial markets are not yet fully integrated. The markets for debt securities and retail finance remain fragmented, the commercial paper market is underdeveloped, and national stock markets are not sufficiently harmonized. Several obstacles to greater financial market integration persist. First, the legal systems governing securities issuance are not standardized across countries, leading to a heterogeneity of securities that are not readily interchangeable. Second, securities clearing and settlement systems vary from country to country. As a result, accounting and other business conventions are different and cross-border transaction costs are relatively high. Third, differences in tax structures, consumer protection, and commercial law still discourage cross-border financial investments. Fourth, the segmented supervisory framework hinders cross-border optimization of banks’ operations and is not cost-efficient. Over time, the full implementation of the FSAP should help remove these obstacles and contribute to a much more efficient and integrated pan-European financial market.
Habit and inertia. Economies of scale increase efficiency and lower transaction costs, and the convenience and availability of a wider range of financial market instruments provide strong incentives for economic agents to continue to use the incumbent dominant currency. For example, the pound sterling continued to be the primary world currency in the first half of the 20th century, long after Britain had lost its 19th-century status as the world’s leading military and economic power. The dollar gradually replaced sterling as the main international currency, becoming the dominant currency only after the Second World War, when the stability of the pound had been seriously undermined and New York’s financial markets had developed sufficiently to rival London’s. From this perspective, it will take a long time before the euro becomes a truly viable alternative to the dollar.
What the future may hold
If the euro is to become a truly global currency, it will need to extend the frontiers of its international use beyond the immediate vicinity of the euro area. The ability of the euro to rise to this challenge will depend in large part on the extent to which structural and other impediments to economic growth and financial market development in Europe are overcome. The ability of Europe to speak increasingly with one voice in the international arena, including on international financial issues, will also be important.
A promising sign for the euro is that net foreign capital inflows into the euro area have risen since its introduction, reflected in a more than doubling of the stock of net assets held by nonresidents between 1999 and the end of 2006. The increase was particularly rapid during 2002–04, when net inflows to the euro area grew faster than net inflows to the United States. These trends may reflect exchange rate developments (the euro appreciated against the dollar during 2002-06, except for a break in 2005) but may also indicate that the euro area remains a competitive investment destination. The enactment of the U.S. Sarbanes-Oxley Act in 2002—particularly Section 404, which requires certification of internal controls—has probably made it less attractive for foreign companies to list their stocks in U.S. capital markets. Evidence of this is an increase in the number of foreign companies delisting their shares from U.S. stock exchanges, a decline in the number of initial public offerings (IPOs) in the United States by foreign firms, and the fact that London’s stock exchange has overtaken New York’s as the location of choice for IPOs by foreign firms. There has also been an increase in IPO activity in continental European stock exchanges, especially in the alternative exchanges for smaller companies (this is also the case in the United Kingdom). If the United Kingdom decides to join the euro area and European stock exchanges consolidate, this could further boost liquidity in European capital markets to the detriment of U.S. capital markets.
Two other developments could influence the euro’s future role. The first is the extent to which global imbalances will adjust through changes in the dollar exchange rate and a shift in global asset allocation. There is a large body of research on this issue. For example, recent editions of the IMF’s World Economic Outlook and Global Financial Stability Report examine alternative scenarios of gradual and abrupt exchange rate adjustment, and the conditions and policies under which each of these scenarios is likely to materialize (IMF, 2005 and 2006). There is a consensus that adjustment of global imbalances will involve efforts to rebalance global saving, investment, and consumption and that there are several ways in which this can come about. The question is to what extent and how fast the adjustment will take place. Global asset allocation preferences are crucial in this debate. The gradual adjustment scenario depends partly on the willingness of foreigners to continue to purchase U.S. assets. A sudden shift in portfolio preferences away from U.S. assets could precipitate a sharp deterioration in the dollar, altering relative confidence in the euro and the dollar and boosting the euro’s use as an international currency at the expense of the dollar. But a more gradual correction of current account imbalances that avoids a sudden and substantial depreciation of the dollar is unlikely to significantly affect the euro’s international role.
According to U.S. treasury data, investors from Asian countries are by far the largest foreign holders of U.S. treasury securities (57 percent at end-October 2006), followed by those from European countries (21 percent). Oil-exporting countries account for a relatively small share (less than 5 percent). But investors from European countries are the biggest foreign holders of U.S. equities (53 percent in June 2005), followed by those from Western Hemisphere countries (26 percent) and Asian countries (18 percent). Investor behavior in Asia and Europe thus appears to be a key factor in the continued strong demand for dollar assets. This demand mirrors the strength of the U.S. economy, the depth and liquidity of U.S. capital markets, and interest rate differentials. The willingness of public and private investors in these two regions to continue to hold dollar assets if the risk of a substantial dollar appreciation intensifies will be crucial for orderly global adjustment and the euro’s international role.
The second development is China’s and India’s continued rapid economic growth and the accumulation of foreign reserves by Asian countries. The rise of these two economies would reduce the relative global importance and influence of the euro area and shift trade and capital transactions to the Chinese and Indian currencies. But it is not certain that international usage of these two currencies will grow over the foreseeable future at a pace commensurate with the growth of the real economy. Thus, the important question is what direction China’s and India’s increased participation in world trade and financial markets is likely to take. And because Asian countries hold a substantial portion of global official reserves, their reaction to a potential continued depreciation of the dollar will also matter greatly.
Axel Bertuch-Samuels is Deputy Director in the IMF’s Monetary and Capital Markets Department, and Parmeshwar Ramlogan is Assistant to the Secretary of the IMF.
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Bertuch-SamuelsAxel2006 “The Role of the Euro as an International Currency,” in Conference on Experience with and Preparations for the Euro ed. by FranzNaushnigg and PaulSchmidt (Vienna, Austria: Oesterreichische Nationalbank).
International Monetary Fund2005 “How Will Global Imbalances Adjust?” World Economic OutlookSeptember Chapter I Appendix 1.2 (Washington).
International Monetary Fund2006Global Financial Stability ReportSeptember (Washington).
LimEwe-Ghee2006 “The Euro’s Challenge to the Dollar: Different Views from Economists and Evidence from COFER (Currency Composition of Foreign Exchange Reserves) and Other Data,” IMF Working Paper No. 06/153 (Washington: International Monetary Fund).