More EURO Stuff On The Challenge To The USD.FWIW.
Why the euro will quickly rival
dollar as world coinage
The euro could become an international
currency with real clout more rapidly than many
people are expecting, argues VICKI BARNETT
THE introduction of the euro will transform Europe.
But the creation of the world's second-largest currency
area will also have a huge impact on the global financial
system. What is still unclear is whether the euro's
influence will be primarily regional or whether it will
come to rival the dollar as an international currency.
The answer has important implications for both Europe
and the US.
The US dollar has dominated the international finance
system for nearly a century. Because of its extensive
use by third parties, its importance in global financial
transactions far exceeds the US's 27% share of world
output.
The dollar accounts for 56% of the world's foreign
exchange reserves; 48% of export invoicing; and
participates in more than four-fifths of all foreign
exchange transactions.
It is no accident that just one currency has gained
pre-eminence. As the use of a currency rises, the
market becomes more liquid and transaction costs fall,
inducing even more people to use it.
Once a currency becomes widely used, it is hard to
dislodge. Neither the yen nor the D-Mark has made
significant inroads into the dollar's dominance. So why
should the euro be any different?
A big factor will be the sheer size of the euro area. The
11 prospective members have a combined gross
domestic product of $6.3-billion, against the US's
$8.1-billion.
The euro area will be the world's largest importer and
exporter, excluding intra-EU trade. And if, as planned,
the European Monetary Union (Emu) is extended to all
15 EU countries, the euro area will become the world's
largest economy.
A huge economy means a huge new capital market,
with much lower transaction costs. And, unlike Japan,
Europe's capital markets are fully open to foreign
investors.
The effect on liquidity will be dramatic. Avinash
Persaud, head of currency research at J P Morgan,
predicts that "transaction costs will collapse overnight".
This will immediately make the euro more attractive as
a vehicle currency for trade and foreign exchange.
The unification of the European currencies will also
lead to economies of scale, making it more likely that
foreign companies exporting to Europe will use the new
currency to denominate their trade.
Say, for example, a Japanese company exports 10% of
its output to Germany, 5% to France and 5% to Italy.
Before Emu, the trade would probably be transacted in
dollars because of the expense of dealing in several
different currencies.
After Emu, however, with a fifth of its exports going to
the euro area, it might well switch.
All this means the euro's use as a vehicle currency
could quickly expand. In particular:
Effects could be felt first in those countries expected
to join the next wave of Emu - the UK, Sweden,
Denmark and Greece. Hillary Thompson, head of
European strategy at NatWest, says many European
companies will ask their UK suppliers to invoice them
in euros.
Several of NatWest's larger UK clients, which have
European-oriented businesses, have been discussing
plans to switch their operations entirely into euros.
Many suppliers in non-Emu countries could end up
operating in euros to keep their customers happy - what
Thompson calls the "euro supply-chain effect". She
believes the euro could become a quasi-domestic
currency in the UK "within two to three years".
This process is already beginning. Last week, British
Steel became the second large UK company - ICI was
the first - to announce that it would ask its suppliers to
accept payment in euros.
The euro is also likely to be widely used in eastern
Europe and, to a lesser extent, north Africa, where
many local currencies are already pegged to European
currencies.
It may start to be used in transactions between the
euro area and countries outside Europe. Currency
transactions between Japan and Europe, for example,
are almost always intermediated through the dollar,
while most exports from Asia to Europe are also
invoiced in the US currency. As the euro gains
momentum, this could change.
Many of the world's central banks may also reduce
their high concentration of dollar holdings by switching
to euros.
Central banks want greater diversification in their
currency portfolios, after many made big losses when
the exchange rate of the dollar plunged in the late
1980s.
The euro's greater liquidity and lower transaction costs
(compared with individual European currencies) will be
a big attraction: a prime consideration in choosing a
reserve currency is its effectiveness for intervening in
forex markets.
The denomination of a country's trade is also an
important influence in the choice of currency. This
means that any shift towards using the euro in trade will
have a knock-on effect for the desirability of euro
reserves.
Given these expected changes, most economists agree
that sooner or later the euro will achieve international
status.
The question is when. The most common view is it will
take some time. Martin Brookes, international
economist at Goldman Sachs, says although a bipolar
financial system is economically logical, "it will take a
very long time before there is a big shift to the euro".
And the International Monetary Fund, in last October's
World Economic Outlook, said the new currency would
only achieve international status "in the medium to
longer term".
The reasons most often cited for such caution are that
the economic stability of the euro area has yet to be
proven, while European capital markets are
considerably smaller than their US counterparts.
But neither factor should have a decisive impact. On
the first point, it is true that an international currency
needs the support of a stable economy.
True also that the euro area could suffer significant
economic turbulence in the transition period. But these
will be primarily structural problems concentrated in
pockets of overheating or regions of sustained high
unemployment.
Such problems will not matter to international holders
of euros so long as the overall macroeconomic
performance of the euro area is stable and inflation
remains reasonably low. And, with the European
Central Bank likely to play it safe as it establishes its
reputation, continuing low inflation seems probable.
The second argument against the euro's rapid rise - that
European capital markets are too small - is more
relevant. The European domestic securities market is
only two-thirds of its US equivalent. And without a
central government bond issuer, European fixed income
markets will be more fragmented than in the US. The
early entry into Emu of the UK, with its deep financial
markets, will be crucial.
There is a counter- view to the idea that the euro will
take a long time to mature. Some economists suggest
the sudden fall in transaction costs will lead to the rapid
adoption of the euro worldwide. "The euro will become
an international currency in months, not years," says
Persaud of J P Morgan.
Academics Richard Portes and H‚lŠne Rey, in a paper
recently published by London's Centre for Economic
Policy Research, share this view. They suggest that the
shock Emu will bring to the international financial
system "is likely to be substantial and relatively
sudden".
The internationalisation of a currency is not just a status
symbol. It has significant economic and political
implications. First, the issuer of such a currency gains a
direct economic benefit in the form of seigniorage: in
exchange for almost costless notes, the issuer receives
real resources - net imports. A second benefit is the
greater liquidity in the bond markets that results from
internationalisation: this lowers yields, cutting the costs
of borrowing for both governments and companies.
A rapid rise in demand for the euro would also affect
the euro exchange rate. Unless it were offset by an
equally rapid rise in the amount of euro assets issued, it
would exert a powerful upward influence.
The exchange rate between the dollar and the euro will
become the most important in the world. But the US
and the EU, being relatively closed economies, are
unlikely actively to manage their exchange rates. This
combination of factors has led Fred Bergsten, director
of the Institute for International Economics, to warn
that a "quantum leap in transatlantic cooperation" will
be needed to avoid a damaging increase in exchange
rate volatility.
So far, US policymakers seem unconcerned at the
potential challenger to their currency's dominance. "The
dollar will remain the primary reserve currency for the
foreseeable future," deputy Treasury secretary Larry
Summers said last year.
"We expect the impact of the euro on the monetary
system to be quite limited initially and to occur only
gradually." Summers and the rest of the US
establishment, it seems, may be in for a surprise. -
Financial Times. |
