Wall Street Journal - 10/06/98
By MICHAEL R. SESIT
Forget the Jack Dempsey-Gene Tunney title fight of 1926, or the 1975 Ali-Frazier "Thrilla in Manila." The real heavyweight title bout
of the century is about to take place in global financial markets.
In one corner is the reigning champion, the world's foremost transaction currency, its most respected store of value and the reserve
currency most widely held by central banks: the mighty U.S. dollar.
In the other corner is the contender, the new common currency of 11 European countries: the euro.
The winner, if there is one, will walk away with more than just bragging rights, economists say. The nation or nations whose
currency prevails will enjoy lower interest rates on government debt, cheaper financing and transaction costs for businesses,
competitive advantages for banks and other financial institutions, a spur for economic growth and enhanced political power.
European economic and monetary union, along with the birth of the euro on Jan. 1, 1999, "is the most important event to occur in
the international financial system since the collapse of the fixed-exchange-rate Bretton Woods regime in the early 1970s," says
David D. Hale, chief economist at Zurich Kemper Investments Inc. in Chicago. "It could open the door to exchange-rate realignments
on a global basis with important consequences for both trade and capital flows." And if financial markets accept the euro as a viable
currency, he adds, "it will almost certainly reduce the role of the dollar as the world's dominant reserve currency."
Symbolically, it would mean that Europe, after 54 years, has emancipated itself from the American financial hegemony under which
it fell at the end of World War II. Indeed, Norbert Walter, chief economist at Deutsche Bank AG in Frankfurt, contends the euro will
become to international finance what the Airbus Industrie consortium has to global aviation: a serious rival to a well-entrenched
American mainstay.
Can It Be No. 1?
But does the euro have a chance to unseat the dollar as the international currency and eventually become dominant? That's a
subject of heated debate among academics, traders, investment managers, market economists, chief financial officers and
government officials. Some are confident that the dollar can hold its own, because of the size of the U.S. economy and the safety
and liquidity of the U.S. government-bond market. But others see European nations' vigorous trade and combined economic bulk
catapulting the euro to the top. Still others see the two currencies sharing the crown, with each holding control of particular sectors
of the international financial system, but neither one dominant overall.
Since the Second World War, the title has belonged to the dollar alone, by virtue of its stability and the backing of the world's
largest economy. "If people want a perfectly liquid asset, then they hold dollars," says Richard Portes, professor of economics at
the London Business School and president of the Center for Economic Policy Research in London.
There are many advantages to issuing the world's currency of choice, one of the biggest being seigniorage, or the effective
interest-free loan foreigners give a country when they hold its currency. Think of each dollar bill as representing a debt owed by the
U.S. Treasury to the holder. When foreigners sell their assets or products -- or exchange their own currencies -- for dollars and hold
those dollars, they are in effect buying a U.S. debt, and financing the U.S. government free of charge. Their only reward is the
security of the dollar itself as protection against economic and political upheaval.
"If other people will hold my money, it's cheap funding for my country," explains Kit Juckes, a currency strategist at NatWest Global
Financial Markets in London.
Most Russians, for example, hold their savings not in marks, yen, French francs or lire, but in the form of $100 bills. Moreover, they
keep the cash stashed in their mattresses, not banks. "At the moment, the Russians can hardly finance themselves at any interest
rate," says Mr. Juckes, "while Russian citizens are falling all over themselves to effectively finance the U.S. at zero."
The Federal Reserve estimates that of the $443.6 billion in U.S. currency in circulation, roughly two-thirds is held offshore. By not
having to borrow and pay interest on that money, the U.S. Treasury saves $15 billion to $18 billion a year.
As the printer of the international currency, the U.S. also receives a so-called liquidity premium. Because of the disproportionate
demand for dollars and dollar-denominated securities, "the U.S. has to pay less [interest] on its government bonds," says Prof.
Portes. Global demand for dollars also allows the U.S. to finance its balance-of-payments deficit in its own currency, cushioning the
impact of its yawning trade imbalance.
U.S. financial institutions, too, benefit from the depth and liquidity of America's financial markets made possible by the dollar's
international role, with easy access to a large pool of cash at comparatively low interest rates. So do U.S. companies: The more
they can bill for their exports in dollars, the less they have to worry about currency fluctuations.
But claiming the title of the world's currency also means defending that title. The dollar's status as a safe haven depends on how
well the U.S. keeps control of inflation and maintains the confidence of foreign central banks holding dollar reserves, as well as of
the private sector. If sentiment turns against the dollar, the stakes escalate; with so much of the currency in foreign hands, the U.S.
can find itself no longer in control of its monetary policy.
The euro will have many of the attributes the greenback now enjoys. By some calculations, the combined economies of the 11
Euroland countries -- Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain
-- account for nearly a quarter of the world economy and amount to 75% of the U.S. economy, says Greg Jensen, an associate at
Bridgewater Associates, a Wilton, Conn., money-management firm. "The sheer force of having almost 25% of global economic
activity occurring in a single bloc could easily propel the euro toward being an important reserve currency," he says.
Euroland is also the world's largest trading bloc, accounting for roughly 40% of global trade, including trade within the bloc.
Commerce between the 11 euro-zone nations and all others accounts for 19% of global trade, slightly more than the U.S.'s 17%
share. Mr. Jensen notes that 17 major economies -- Brazil, Britain, Bulgaria, Chile, the Czech Republic, Denmark, Greece,
Hungary, India, Norway, Peru, Poland, Russia, South Africa, Switzerland, Sweden and Turkey -- will have Euroland as their major
trading partner.
More Convenient
Many of these countries will stop using the dollar for trade purposes and switch to the euro for convenience, Deutsche Bank's Mr.
Walter predicts. Also, Asian companies that currently bill for their European trade in dollars to avoid having to deal with many
different currencies might find the euro an attractive alternative.
The euro, too, will offer investors a high degree of liquidity. Euroland will represent a bond market that at the end of 1996 equaled
$6.1 trillion, or 63% of the size of the $9.6 trillion world-wide market for dollar-denominated bonds.
Mr. Hale of Zurich Kemper and others point out that the euro's status as an investment vehicle should be enhanced by the European
Central Bank, which will be at least as independent of politics as Germany's Bundesbank and, like the Bundesbank, run by people
with strong inflation-fighting credentials. He also estimates that the euro's share of official global central-bank reserves could grow to
"at least" between 20% and 30%.
C. Fred Bergsten, director of the Institute for International Economics in Washington, D.C., predicted in a 1997 Foreign Affairs
article that the European monetary union would give rise to a bipolar global currency system dominated by the U.S. and Europe,
supplanting the dollar-based regime that has prevailed for most of the 20th century. In the process, he foresees a massive
reallocation of international investment portfolios, with $500 billion to $1 trillion of assets shifting to euros, mostly from dollars.
Prof. Portes of the Center for Economic Policy Research thinks the euro will make a bolder advance. A confirmed euro bull, he
argues that the answer to whether the euro will successfully challenge the dollar's global status depends not on the behavior of
central banks, not on how many goods and services are invoiced in euros and not on whether non-Euroland countries choose to peg
their currencies to the euro -- but rather on the integration and expansion of European government-bond markets.
Currently the costs of trading in the U.S. government-bond market are much lower than in the German, British or French bond
markets. That is, the spreads, or the difference between the bid and offered prices, on European bonds are wider than on Treasurys.
That's because the trading volume of U.S. Treasurys is much larger.
But "the more Euroland integrates its government-bond markets, the cheaper it will be to operate in those markets; and so more
people will want to do it," says Prof. Portes. "And the relative attraction of New York as opposed to Euroland will diminish."
That whole process, he argues, won't take very long. Much depends on Euroland policy makers taking the necessary steps to
deregulate and harmonize their government-bond markets to enhance their liquidity, breadth and depth. But market forces will also
play a role. For instance, Germany initially resisted converting its mark-denominated government bonds into euros. But after France
and others said they would redenominate their bonds, the Germans recognized they would be at a competitive disadvantage,
because investors would prefer a more liquid euro market to a smaller mark-based one.
Financial markets change and adjust "much faster than they used to," says Prof. Portes. "This change isn't going to be a glacially
slow process."
He predicts that if Britain joins the EMU, as he expects it will, "we can see a major challenge to the U.S. dollar's role as the
international currency within five years."
Less Influence
The consequences of such a dramatic shift would be felt broadly across the globe. If the euro replaces the dollar as the international
currency most used for financial- asset and foreign-exchange transactions, all the advantages enjoyed by the U.S. government,
corporations and financial institutions will shift to Europe. The result, Prof. Portes predicts, would be an annual economic boost
equal to about 0.5% of Euroland's gross domestic product, matched by a similar loss for the U.S.
There would be geopolitical consequences as well. Prof. Portes contends that America's influence in international organizations,
such as the International Monetary Fund, and its sway in managing financial crises -- such as Asia's recently and Mexico's in 1994
and 1995 -- is "disproportionate to the size of the American economy due to the fact that the dollar is the international currency."
Indeed, Diane Kunz, a professor of history at Columbia University in New York, argues that financial and geopolitical power feed off
each other, and that a shift away from the dollar would expose the U.S.'s financial vulnerabilities -- its status as the biggest debtor
nation, for instance -- and therefore undermine its political clout. The U.S. would have to compete more against other countries for
funds, because the euro would offer an alternative safe haven for investments. U.S. companies and financial institutions would face
similar hurdles. As a result, Americans would have to pay more for their import-driven lifestyle.
"The death of the dollar order will drastically increase the price of the American dream, while simultaneously shattering American
global influence," Prof. Kunz wrote in a 1995 Foreign Affairs article.
The Die-Hard Dollar
But some economists think such warnings are premature. Dethroning the greenback, they argue, won't be easy.
Despite the automatic creation of a more than $6 trillion euro-denominated bond market, half of which will represent government
bonds, there won't be "a tradable financial asset denominated in the euro that will have the liquidity that comes anywhere close to
that which exists in U.S. Treasurys," says Larry Neal, an economics professor at the University of Illinois in Urbana-Champaign.
And that means "the euro isn't going to challenge the dollar as a reserve currency."
Even though Germany, France, Italy and eight other countries will be issuing debt in a common currency, Prof. Neal points out,
Euroland will lack the crowning feature of the U.S. fixed-income market: a single federal government that sells large amounts of bills,
notes and bonds. Instead, the Euroland government-bond market will consist of 11 sovereign nations, each selling smaller quantities
than the U.S. and competing with one another for investors.
"Each country's debt will have to be serviced with its own individual taxes," says Prof. Neal. "So it becomes equivalent to state debt
in the U.S." Although all 50 states issue debt denominated in dollars, "the state bonds aren't used as reserve assets by [foreign]
central banks or by multinationals," he notes. For a safe reserve asset, he says, "it's U.S. Treasurys."
Although no American state has defaulted in this century, there were numerous defaults in the 19th century. Mr. Hale of Zurich
Kemper points out that Florida, Alabama, North Carolina, South Carolina, Georgia, Arkansas, Tennessee, Minnesota, Michigan and
Virginia all had defaults.
One key long-term rationale for holding a reserve asset is to have the ability to respond quickly to economic or political shocks.
"That means you have to convert your asset quickly and without loss, which means you want a financial asset that has the most
liquid market," says Prof. Neal.
Suppose that Japan suddenly has to sell both U.S. Treasurys and euro-denominated German government bonds it holds as reserve
assets. The price decline of German bonds will be much larger than the fall in Treasurys, Prof. Neal says, "because the outstanding
stock of German bonds is so much smaller."
Thank Alexander Hamilton
The highly liquid U.S. bond market owes its origins to Alexander Hamilton, the nation's first Treasury secretary. In 1790, Mr.
Hamilton created a large, broad market for U.S. debt by having the federal government assume the debts of individual states,
including those from the Revolutionary War.
No such refinancing is planned for the euro-zone; each country will back its own bonds, but no longer retain the power to print
money, as the U.S. does. Because of that, some EMU member states are expected to pose a higher default risk on their securities
than the U.S.
Other factors that might damp enthusiasm for the euro include the risk that popular support for low-inflation policies will erode if
unemployment remains high; possible policy disputes between EMU member countries; and the danger that the EMU could
ultimately break apart if those policy differences become irreconcilable.
At one point during the Russian ruble devaluation and default crisis in August, the gap between Italian and German 10-year
government bond yields widened to 0.6 percentage point from about 0.25 point. "A lot of that [increased] spread was related to the
fear that EMU could break up or that Italy would drop out or be excluded," says Phyllis Reed, a bond strategist at Barclays Capital
in London.
'It's a Huge Experiment'
Moreover, some economists contend that the dollar's dominance as a trusted financial vehicle also reflects the U.S.'s status as a
political and military superpower, which Europe cannot claim. Says Mr. Juckes of NatWest, "For the euro to compete with the dollar
as a global medium of exchange, Euroland has to graduate into a unified political heavyweight after centuries of just being lots of
little and medium-size countries."
Prof. Neal concedes that the euro will benefit travelers and companies doing business in Europe by reducing transaction costs and
making life simpler. But as for other perceived advantages of the monetary union, he's skeptical. "It's a huge experiment, and
Europeans think it's going to give them a lot of clout on the seigniorage point," he says. "But I'm quite sure they will be
disappointed."
Indeed, many economists say, the dollar's dominance has survived similar threats in the past half-century, and won't be quick to
yield this time. For example, says Jean-Francois Mercier, an international economist at Salomon Smith Barney in London, even
though the Japanese economy grew substantially from the 1960s to the late 1980s, studies show the use of the yen as a
transaction or reserve currency didn't increase commensurately. The dollar remained dominant.
One reason is that many Asian nations pegged their currencies to the dollar. Another is sheer inertia. Once in the habit of using
dollars, people and institutions tend to stay with the reserve currency of the day. Mr. Jensen of Bridgewater Associates says 50% of
world trade flows are invoiced in dollars, nearly three times the U.S.'s share of world trade. And about 64% of central-bank reserves
are held in dollars, a figure that has been relatively stable over the past dozen years.
Nor does Mr. Mercier foresee a massive reallocation of foreign central banks' currency reserves to the euro in the near term. Many
non-European Union central banks will want to wait to see whether the grand experiment works before committing their reserves to
the new currency. Also, some of these countries, especially in Asia, don't have overly strong trade ties to Europe. Asks Mr.
Mercier: "Why would the Singapore Monetary Authority want to hold a bigger proportion of euros if Singapore's international trade
structure -- which is dominated by the U.S. and Asia -- doesn't change overnight?"
As for individual investors, pension funds, mutual funds and insurance companies, it all comes down to the performance of
euro-denominated assets. "Unless the euro creates a dramatic shift in the relative performance of European assets, you wouldn't
expect an immediate change in the exposure of private investors to a particular area," Mr. Mercier says.
Take a hypothetical securities portfolio that is currently 50% denominated in dollars, 20% in marks, 10% in French francs, 10% in
lire and 10% in other currencies. At the inception of the euro on Jan. 1, that portfolio's composition becomes 50% dollars, 40%
euros and 10% other currencies. "I don't think it would justify an overweighing of the euro [beyond that 40%], unless the euro is
perceived as an overperforming currency," says Mr. Mercier.
To be sure, some experts think the whole question of currency dominance is overstated. John Llewellyn, chief global economist at
Lehman Brothers International in London, says that a nation's ability to finance its current-account deficits in its own currency is
less important under today's free-floating exchange-rate system than it was under the fixed-rate regime, which collapsed in the early
1970s.
Holding Value
"What matters to your mother is that her money will retain its value in world terms and that she can earn a reasonable rate of return
if her assets are denominated in that currency -- in short, that her savings will be safe," says Mr. Llewellyn. "In that sense, she
cares, if she lives in Europe, that the euro is strong. Strong doesn't have to mean dominant, just that it retain its value."
Indeed, while the world's base currency must above all else be regarded as stable, it doesn't necessarily have to be the strongest
currency. Actually, the dollar has been the strongest currency -- the one with the steadiest growth in purchasing power -- for only
about five out of the past 27 years, yet during that period, it has remained unchallenged as the world's reserve asset.
NatWest's Mr. Juckes says that America's persistently large current-account deficit -- which many economists estimate will widen
to about $200 billion this year from $155 billion last year -- actually contributes to the dollar's status as the pre-eminent reserve
currency. As Americans keep buying more goods than they sell to foreigners, the world becomes flooded with greenbacks. Central
banks, says Mr. Juckes, "get the reserves they're handed, not what they necessarily choose to hold."
Euroland's current-account surplus places it in the reverse situation, as Europeans export more than they import. As the demand for
euros grows, Mr. Juckes predicts, "we are likely to get a more expensive euro rather than much larger reserve holdings." Whether
that rise in value will increase the euro's appeal as a store of value remains uncertain.
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