The Euro: A New Currency for the World?
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The Euro: A New Currency for the World?
The Euro: A New Currency
for the World?
NORBERT WALTER
Chief Economist
Deutsche Bank Research
E
uropean economic and monetary union (EMU) became reality on Janu-
ary 1, 1999. Since its inception, the “Eurosystem,” consisting of the Euro
pean Central Bank (ECB) and the national central banks of the partici-
pating countries, assumed responsibility for monetary policy in the euro-currency
area. The national central banks have transferred their sovereignty in monetary
policy to the European level. Thus we now have a monetary regime of joint deci-
sion-making in Europe. This contrasts with the “old” system, under which the
German mark was the anchor currency within the European Monetary System
and German partner countries had to follow the pace set by the monetary policy
of the Bundesbank. The national central banks of the eleven EMU member states
(Germany, France, Italy, Spain, the Benelux, Austria, Finland, Ireland, and Portu-
gal) continue to exist, playing a major role in the implementation of the mon-
etary policy of the Eurosystem and in the new European landscape of payment
systems.
Technically, the changeover from national currencies to the euro went off
smoothly. Since the beginning of EMU, monetary policy operations and finan-
cial market transactions have been carried out in euros only. Within a couple of
days euro-denominated transactions in the forex, money, bond, equity, and de-
rivative markets were regarded as “business as usual.” The euro, no longer the
national currencies, dominates media reports on financial market prices. Yet many
still find it difficult to understand that there is no cash available in euros. Euro
Summer/Fall 1999 – Volume VI, Issue 2 113Norbert Walter
notes and coins will only be introduced in the first half of 2002, when the neces-
sary quantity of euro cash has been produced and distributed in exchange for
national notes and coins.
Economic and monetary union has proved to be a well-designed and man-
ageable project. The Eurosystem is an independent institution that is establishing
credibility in its own right. By cutting the key interest rate for the first time in
early April 1999, the ECB demonstrated that it is able to take decisive and timely
action. The ECB was in a convenient position because EMU had started in an
environment of price stability. Financial market participants and international
investors have confidence in the euro and in the ECB’s ability to maintain price
stability for Euroland in the future. This is reflected in historically low long-term
bond yields. On the other hand, the relatively weak performance of the euro vis-
à-vis the dollar during the first months of EMU ran counter to the expectations
of several market participants. Many of whom, in light of the emerging large and
liquid financial markets in the euro area, had anticipated a reallocation of inter-
national institutional investors’ funds to the benefit of the euro. The relatively
weak development of the euro should not be viewed too negatively. It primarily
reflects the much better growth performance of the U.S. economy compared to
the sluggish economic development in the euro area during the winter half-year,
as well as the related interest rate prospects on both sides of the Atlantic. The euro
has a good chance to recover once the European economy starts to pick up again.
The successful introduction of the euro has increased the acceptance of the
new currency among the population. This is especially the case in Germany where,
for the first time, a majority was in favor of EMU at the beginning of 1999. The
long-lasting skepticism should not surprise anyone who is familiar with Germany’s
twentieth-century monetary past: two hyperinflations in the first half of the cen-
tury, followed by a currency reform that wiped out financial wealth almost alto-
gether, and thereafter the Germans’ deep attachment to the strong German mark.
The skepticism was to a large extent due to a lack of information about monetary
union. Not only the German government, but most European governments within
EMU sadly neglected the need to explain this historical undertaking to the public
at large. The “man in the street” reacted passionately when told by the mass me-
dia that the bank notes and coins in his pocket were to be exchanged for some-
thing unknown, initially called “ECU” and then later “euro.” Banks played a
major role in informing the general public about the benefits of the European
currency in the creation of wealth and to the competitiveness of Europe in global
markets.
Why EMU?
Otherwise, though, the German government and business community have al-
114 The Brown Journal of World AffairsThe Euro: A New Currency for the World?
ways been staunch supporters of European integration. The opening of markets
and the political decision-making in common institutions has always been of
great advantage to the countries involved, and has helped Germany find its place
in the European post-war political arena. In the Maastricht Treaty the EU mem-
ber states committed themselves to creating an economic and monetary union.
Their efforts to achieve even closer economic integration over the last decades
culminated in the creation of a single-currency area.
The common currency represents the completion of the European Single
Market. With the creation of EMU, the remaining exchange rate risks between
the participating currencies were eliminated. Exchange rate volatility, which re-
peatedly distorted competitiveness in the corporate sector, is now a thing of the
past for EMU countries. The exchange of goods, services, and capital has become
easier. The elimination of exchange rate risks provides greater certainty for trade
and long-term investment, and also reduces companies’ hedging costs. Fierce com-
petition will also benefit consumers by dampening prices.
EMU gave birth to a large and liquid financial market offering much broader
investment activities and financing opportunities than the various national mar-
kets. Competition among financial markets, between financial centers, and among
banks and insurance companies will increase, all of which represents both a chal-
lenge to the financial institutions affected and an opportunity for investors and
borrowers.
A stable euro will play a considerably more important role in the interna-
tional currency system as a trade, investment, and reserve currency than the Ger-
man mark or French franc ever did. From the German perspective, this has the
advantage of spreading the burden formerly borne by the mark to the much broader
shoulders of the common euro financial market. The latter will be sufficiently
large to cushion the adverse effects that massive capital outflows could have on
economic activity in the EMU countries, as well as on the development of inter-
est rates and inflation.
Concerns about EMU
A key concern as perceived by (mainly academic) opponents was the lack of fiscal
discipline of member states that could undermine the stability of the common
currency. This potential problem cannot be ignored—witness the U.S. Congress’s
strenuous efforts to get its own spending under control. EMU countries therefore
agreed on a stability and growth pact in order to secure fiscal discipline. But there
are strong reasons to believe that, in addition to the sanctions being imposed on
budgetary offenders, discipline can and will be imposed in Europe by competi-
tion in the financial markets. An over-spending country would face a downgrad-
ing of its creditworthiness by rating agencies and financial markets. As a result,
Summer/Fall 1999 – Volume VI, Issue 2 115Norbert Walter
governments would have to pay higher interest rates on public debt. Finance
ministers, party leaders, and all politicians in charge would quickly wish to disas-
sociate themselves from such policies. Italy and Sweden have proven so in the
past.
A second concern is that EMU might lead to increased transfer payments
in the form of regional, structural, and cohesion funds that have been an integral
part of the EU budget for years. The funds aim to support underdeveloped re-
gions in the process of catching up, and thus
The euro “eye-opener” to ensure balanced and sustained progress
for customers is a chal- within the EU. In 1997, the volume of these
funds amounted to 32 billion euros. This
lenge to companies. corresponds to 35.7 percent of the total EU
budget, but only 0.54 percent of the EU’s GDP. There is little room for maneu-
vering to increase transfer payments since any change in the structure of funds
requires a unanimous decision by the EU Council. Given the results of the Berlin
summit in March 1999 on the Agenda 2000, there is evidently little political
willingness to further expand transfers. EMU is therefore unlikely to develop into
a transfer union.
A third concern, especially of observers from non–EMU countries, is whether
a country can leave or be excluded from the currency union. There is no clause in
the Maastricht Treaty allowing a member state to withdraw from EMU, nor does
the Treaty contain any arrangements for the exclusion of a member. Nonetheless,
it is impossible to say definitively that no member will ever want to leave EMU.
However, such a case would only be conceivable in extreme conditions, such as in
the wake of a severe economic shock. No doubt, the economic and political cost
of withdrawal from EMU would be immense. Switching an economy from the
euro to a new national currency would cause much greater problems than the
initial changeover from a national currency to the euro. The reintroduction of a
national currency would raise many questions and cause great uncertainty: At
what rate, for example, should the euro be converted into the national currency?
Which bonds and financial instruments would be redenominated? What would
be done with foreign claims and liabilities of the government, companies, and
banks of the country leaving EMU? In which currency should they be serviced: in
euros or in the new (i.e., the national) currency? The risk that foreign lenders
would drastically reduce credit facilities and that foreign investors would pull out
of the country concerned would be high. Downward pressure on the new cur-
rency, rising interest rates, and a shortage of credit—all with repercussions on the
country’s economy—would probably be the unavoidable consequence.
The probability of any exit scenario is considered by most analysts to be
low. Europe, particularly EMU countries, have too much to lose. Not only would
the withdrawal of a member, not to mention the collapse of the whole project, be
116 The Brown Journal of World AffairsThe Euro: A New Currency for the World?
a severe setback to the political cohesion of Europe, it would also threaten the
hard-earned achievements of the past four decades of European integration. The
economic consequences would also be difficult to cope with and would deprive
Europe of many future opportunities in global competition. If EMU did experi-
ence difficulties in the future as a result of unforeseeable economic shocks, it
would be necessary—just as it is today—to find appropriate economic-policy
solutions to deal with specific problems. A return to national currencies would
not be an option.
Impact on Foreign Corporations
Since January 1, 1999, companies have been able to start the changeover to the
euro on a voluntary basis, based on the principle “no prohibition—no compul-
sion” (i.e., nobody may be compelled to use or be prohibited from using the
euro). Many large companies have announced that they will be converting to the
euro in 1999 and that they expect their customers and suppliers to be equally
“eurofit.” This situation will probably accelerate the changeover process in the
corporate sector.
The introduction of the single currency implies strategic challenges, not
only for European companies but also for foreign corporations exporting to and/
or operating in Euroland. The euro will enhance price transparency and boost
competition within EMU. With just one currency, pricing is more transparent.
In the new currency area it will be much more difficult to price a product differ-
ently in various countries, which has been a common practice. For example, cer-
tain painkillers cost twice as much in Germany as in France. And furthermore,
according to a recent study by the EU Commission, pre-tax prices for the same
car model differ by up to 40 percent between several nations. The single currency
will put pressure on prices to converge towards the lowest level; a McKinsey study
indicates that profits may be slashed by up to 10 percent.
The euro “eye-opener” for customers is a challenge to companies. It opens
up new opportunities, but also gives new competitors easier market-access. Intra-
European competition may thus require companies to review their product de-
sign, sourcing, and production locations. Moreover, companies from other coun-
tries will have to adjust their strategies to this new environment.
Quite apart from the strategic consequences of EMU, companies will have
to cope with technical and organizational problems caused by the euro changeover.
All companies will be affected by specific problems in areas such as production,
accounting, organization, and personnel. A key task, and the one which will give
rise to the highest costs, will be the changeover of IT systems. In order to reap the
benefits of monetary union, foreign companies operating in Euroland need to
identify their degree of exposure. The cost of the technical changeover and the
Summer/Fall 1999 – Volume VI, Issue 2 117Norbert Walter
effects on core business areas and staff functions, as well as strategic questions,
differ widely from sector to sector. For all foreign companies, though, it is impor-
tant to make preparations as early as possible and to be thoroughly informed on
the implications of monetary union so as to ensure a successful changeover.
EMU will most likely bring about an increase of M&A activities in Europe,
as companies seek to position themselves to serve the single European market
rather than organizing themselves on national lines. The current wave of mergers
has a lot to do with the introduction of the euro—the new currency is reinforcing
the existing global trend towards mergers. The single-currency area also provides
greater certainty for foreign companies planning direct investment in the euro
area. The world’s second-largest capital market will offer attractive investment
opportunities and cheaper financing.
Monetary union has improved the basis for trade with Europe substantially
and can therefore help to tighten trade ties between Euroland and the rest of the
world by stimulating competition and growth. Stronger growth in EMU will
create openings for companies in other countries to increase their exports to the
euro area. The single currency will continue to make trade with and investment
in the euro area less expensive, since treasury operations, currency management,
and pricing will be in one currency rather than ten. With EMU, the maintenance
of different foreign currency accounts as well as hedging against currency risks are
a thing of the past.
Economic Policies in Euroland: Cooperation versus Competition
EMU definitely does not mean that economic and fiscal policy decisions should
be made at the European level. On the contrary, EMU creates the opportunity
for competition between the policies of member states with beneficial effects on
the development of their own economies.
With the introduction of the euro, the participating countries lost certain
instruments of economic policy. Responsibility for monetary and exchange rate
policy was transferred to the European Central Bank at the inception of mon-
etary union. The member countries are restricted in their fiscal policies under the
Stability and Growth Pact, but only insofar as prescribed by the upper limit on
budget deficits. A complete standardization of economic policy is neither neces-
sary nor helpful from a competive point of view. Member states can continue to
make their own decisions over the level of state activity, reflected in the public
spending ratio and the tax ratio—namely the purposes for which government
revenues are to be employed, the types and rates of taxes, and the regulatory
framework in which the markets operate. What will change under EMU is the
nature of competition between national economic policies. There will be a shift
from macro-policy (exchange rate, monetary, and fiscal policies) towards greater
118 The Brown Journal of World AffairsThe Euro: A New Currency for the World?
emphasis on micro-policy—that is, a shift towards structural reforms to create,
for example, attractive tax systems, modern and financially sustainable social se-
curity systems, and greater flexibility in the labor market.
To delegate responsibility for bringing down unemployment to the Euro-
pean Union would be the wrong approach. EU employment pacts are no substi-
tute for structural reforms by the individual member states.
Too much harmonization can have a damaging effect, even including the
harmonization of taxes. Generally, competition among tax systems is in fact to be
welcomed because it encourages efficient measures to enhance investment loca-
tions and helps to contain the power exerted by the state via taxation. But tax
competition must be fair. This means in particular that foreign investors should
not receive preferential treatment. There are plans for a minimum taxation of
cross-border interest income in the EU.
A single currency does not mean the end of economic policymaking, which
will continue to play a role in helping to maintain competitiveness. It should not
follow in the wake of the markets, but act as their lodestar. And the demands on
economic policy are rising. It can, and must, mold future developments through,
for example, structural reforms and giving the markets greater flexibility. Other-
wise, governments may be penalized even more quickly by companies responding
to the new dimensions in competition than by voters.
Impact on Financial Centers in Europe
The advent of the euro has intensified competition among Europe’s financial
centers. EMU provides the continental European financial centers with a good
chance of narrowing London’s acknowledged lead as first in Europe. Well before
EMU began, these cities had already made enormous efforts to become more
attractive. Frankfurt, in particular, made great strides and, despite having lost the
advantage of the home currency, the German mark, is now in a good position.
Besides being the location of the ECB, it has benefited from both a raft of impor-
tant new legislation in recent years and from steps by the Bundesbank that—in
its capacity as fiscal agent for the German government—improved the proce-
dures and instruments for public debt issuance. Deutsche Börse AG, in close
cooperation with the banks, created a modern technical infrastructure for the
stock exchange by installing efficient electronic trading as well as settlement and
clearing systems. Nevertheless, it is important that more be done, such as the
modernization of stock market law, the admission of attractive pension funds to
strengthen occupational and private pension provision, an investor-friendly tax
reform, labor legislation allowing for greater flexibility, and better research and
education in financial matters. EMU is expected to be a catalyst in these fields.
At the same time it has been very interesting to watch how the “pre-in”
Summer/Fall 1999 – Volume VI, Issue 2 119Norbert Walter
status of the United Kingdom affected the attractiveness of the London financial
markets. The euro will not be introduced in the U.K. before 2002, but it already
plays an important role in London, which consequently also carefully prepared
for the launch of the new currency. The city will no doubt remain the leading
center in Europe thanks to the advantages of its size, excellently qualified person-
nel, attractive tax and legal environment, and draw of institutional investors from
around the world. Compared with London in particular, Frankfurt is handicapped
by the poorer quality of its “soft” factors and by excessively high rates of income
and corporation tax.
Yet despite all the competition among Europe’s financial centers, there is
also growing cooperation. This certainly applies to the stock exchanges. There is a
cooperative arrangement between Frankfurt and London to develop a joint tech-
nical platform for more efficient stock trading. If other centers join, this arrange-
ment might well become a pan-European alliance. There are three reasons for
increased cooperation. The first is that the equity market in Europe is extremely
fragmented, with thirty-two stock exchanges—compared with eight in the United
States, the world’s biggest equity market. Secondly, globalization raises the critical
size for stock markets as well as for companies. In competition for liquidity, the
capital markets in Frankfurt, London, and Paris are pitted against large centers
overseas such as New York, Tokyo, and Hong Kong. Finally, the increasing use of
electronic trading systems and remote membership means it is no longer neces-
sary to be physically present at every exchange. Cooperation makes it easier to
shoulder the immense costs of technological developments. The advantages this
would have for market participants are obvious: easy and user-friendly access from
all locations in addition to rapid and low-cost execution of orders.
The International Role of the Euro
The uncontested international predominance of the U.S. dollar is not only the
result of the United States top position in world trade and capital transactions
since World War II, but also of the dollar’s status as anchor currency in the old
Bretton Woods System of fixed exchange rates and as a “safe haven” for invest-
ment capital in times of political crisis. Despite the growing importance of the
mark and the yen in the 1970s and 1980s, these currencies played primarily re-
gional roles in Europe and Asia, respectively. The only truly global currency was
the dollar.
Now we are living in a different world. European monetary union will pose
a serious challenge to the dollar in its capacity as an international reserve and
investment currency. The European Single Market is the second largest economic
area—after the United States—and has a large share of world trade. EMU pro-
vides the world’s second-biggest financial market. Higher liquidity, larger trading
120 The Brown Journal of World AffairsThe Euro: A New Currency for the World?
volumes, and growing competition in the European finance industry will reduce
transaction and issuing costs for euro-denominated paper, thereby diminishing
one of the dollar’s most important competitive advantages. The ECB’s institu-
tional framework, with the priority it accords to price stability, is a good basis for
ensuring the new currency’s credibility and acceptance.
The euro is expected to acquire an important role in world trade. The pre-
dominant invoicing currency is the dollar, with a share of just under 50 percent of
world exports. The EU currencies’ combined-share recently amounted to 33 per-
cent. In monetary terms, however, trade between Euroland countries essentially
became domestic trade with the inception of EMU. The euro’s share in world
invoicing will thus initially amount to only about 20 percent, but it will soon
begin to grow markedly.
For many countries, Euroland will be by far the most important trade part-
ner. Of course this applies particularly to the EU countries that have not yet
joined EMU. In view of their close economic ties with Euroland, the euro will
become a kind of parallel currency, above all for large multinationals in those
countries.
In eastern Europe’s foreign trade the euro is expected to gain a larger mar-
ket share than the German mark did in the past, given the region’s substantial and
growing trade volumes with Euroland. It is also conceivable that the euro will
become the vehicle currency in intra–eastern European trade. Furthermore, there
is a lot to suggest that the euro will be used increasingly in neighboring regions
such as Northern Africa and the Middle East, which also conduct a large part of
their trade with the EU. Even though oil prices, at least for the time being, will
probably continue to be quoted in dollars by international commodity markets,
bilateral contracts for oil deliveries in euros are certainly conceivable. However,
the euro’s weight as a trade currency will not increase overnight, as there will be a
considerable lag in the adjustment of invoicing habits to the new market environ-
ment and a change in the real economic situation.
In Asia and Latin America, the dollar will likely remain predominant in the
foreseeable future because of its vehicle function and both regions’ close trade ties
with the United States. In bilateral trade with the EU, however, the euro will
become an important currency. This is due, not least, to economies of scale and
network effects. The more economic agents use an established currency in inter-
national transactions, the more attractive and cost efficient its use becomes for
other market participants. This will likely continue to work in the dollar’s favor
for some time to come. Despite this advantage, we expect the euro’s share in
international trade invoicing to rise to roughly 35 percent over the medium term.
In turning to the euro’s role as an international reserve currency, its growing
significance as an invoicing currency in world trade will likely have an impact on
the exchange rate policies of central banks and the composition of their reserve
Summer/Fall 1999 – Volume VI, Issue 2 121Norbert Walter
portfolios. For some countries with close trade links to the EMU area, the euro
will become the official exchange rate anchor. This applies to ERM II members
and also to some eastern European countries, irrespective of whether or not they
join the EU. They will hold a substantial part of their currency reserves in euros
to cushion undesirable exchange rate fluctuations by means of forex market inter-
vention.
The euro’s significance as a reserve currency will depend partly on the poli-
cies pursued by Asian central banks, which hold just over 40 percent of the world’s
official currency reserves (mostly in U.S. dollars). This high level of dollar hold-
ings is due, not least, to the fact
The European Union has that many Asian currencies were
been compared to a bicycle— pegged closely to the dollar before
the outbreak of the currency tur-
if it does not keep moving, it moil in Asia during the summer
is bound to fall over. of 1997. But it also reflects the
lack of an attractive alternative.
Even though the future exchange rate policy in Asia is difficult to forecast today,
it is fairly clear that the end of the rigid dollar peg will open up a greater scope for
the use of the euro as a reserve currency. While many Asian central banks have
adopted a “wait-and-see” attitude towards EMU, they will likely accumulate sig-
nificant amounts of euro reserves for reasons of risk diversification, profit optimi-
zation, and exchange rate stabilization. Taking these factors into consideration,
we think it is possible that the euro’s share in world forex reserves will rise to one-
third over the medium term.
The euro will also play an important role as an international investment
currency and will have far-reaching implications for international investors, due
to both the sheer size of the Euroland financial markets and the structural adjust-
ments that are now underway. EMU has created the second-largest bond market
in the world, with German government bonds as an established benchmark. It
has a volume that is second only to its dollar-denominated counterpart. This euro
bond market offers a great variety of investment and financing opportunities for
private and public entities from all over the world. Growth of the overall market
may slow as the participating countries continue to reduce their budget deficits,
but it could be stimulated by the development of the market for corporate bonds.
In short, the euro bond market is set to become the first real alternative to the
dollar bond market. As far as international bond issuances are concerned, the
euro has caught up with the dollar because both currencies had a market share of
about 45 percent in the first quarter of 1999.
EMU has also given birth to the world’s second-largest equity market. In
terms of market capitalization, the United States is well ahead with a total volume
of approximately 10.9 trillion U.S. dollars, as compared to Euroland’s 2.7 trillion
122 The Brown Journal of World AffairsThe Euro: A New Currency for the World?
U.S. dollars. The ratio of market capitalization to GDP in the eleven member
states is still far below the corresponding figure in the United States—44 percent
on average compared with 139 percent at the end of 1997. Furthermore, the
number of listed companies in the EMU area is fairly low. But the focus of asset
allocation in the euro equity market has already shifted from a national orienta-
tion to the relative performance of individual stocks within their respective in-
dustry in the whole euro zone. Also, new European stock indices will guide inves-
tors through the new universe of opportunities. A further boost to the Euroland
equity market will likely be felt in a couple of years when the U.K. joins Euroland.
This is a distinct possibility after the general elections expected to be called in
2001. Owing to the size of Euroland’s financial markets and its economy, the
euro has been widely used in international financial markets since its inception.
EMU as a Catalyst for Political Integration
The European Union has been compared to a bicycle—if it does not keep mov-
ing, it is bound to fall over. A standstill in European integration would mean the
EU was really moving backwards. Monetary union is a big step forward for Eu-
rope. EMU offers a variety of opportunities, not only for economic and financial
integration but also for foreign corporations and with regard to the international
role of the euro. EMU will also have a political dimension, despite the fact that
the political will is influenced by a nationally oriented democratic public and the
continuing existence of linguistic and cultural barriers.
The successful introduction of the euro will be a catalyst to deeper political
integration in the years ahead. One important issue will be institutional reforms.
Streamlining the decision-making process within EU institutions—European
Council, Commission, and Parliament—must be at the top of the agenda in
order to improve the European Union’s ability to take decisive and timely action.
This is also essential with regard to the challenge of enlargement, that is, the
integration of the poorer and less developed countries in central and eastern Eu-
rope. WA
Summer/Fall 1999 – Volume VI, Issue 2 123You can also read
