International role of the euro
04/02/2003 - Speeches
International role of the euro
Address by Nicholas C. Garganas
Governor of the Bank of Greece
4 February 2003
at the Conference of the European Commission
“Europe, The Mediterranean and the euro”
Athens, 3-4 February 2003
Ladies and gentlemen it is a pleasure to participate in an event
organised by the European Commission. I would like to thank the Commission for inviting me
to address some of the basic considerations that confront the euro in its emergence as an
Let me begin by asking the question: “How does a currency acquire the
status of an international currency?” This question is being asked more and more often
as the euro takes on increasing importance in the global financial system.
The interwar period was dominated by two currencies - - the U.S. dollar
and the pound sterling - - while the postwar world has been dominated by the U.S. dollar.
Unlike the situation in national economies or monetary unions, where the currency used is
determined by government decree, currencies are used internationally because of neither an
Act of Parliament nor an Act of God. Rather the choice of currencies used for
international transactions is mainly the result of invisible hand processes. Currencies
attain international status because they meet the various needs of foreign official
institutions and foreign private parties more effectively than do other financial assets.
What factors contribute to the use of a specific money as an
international currency? Why was the Dutch guilder the dominant international currency in
the 17th and 18th centuries, the British pound in the 19th and early 20th centuries, and
the dollar since the end of the second world war? Several factors are essential if a
currency is to be used internationally.
First and foremost, an international currency must be perceived as
sound. To be acceptable, market participants must be willing to hold it as a store of
value. This circumstance means that inflation in the country or monetary union issuing the
currency must be low and stable relative to those of other currencies. Inflation reduces
the purchasing power of a currency, discouraging its use internationally. It also leads to
exchange-rate depreciation and uncertainty. A necessary condition for the international
use of a currency, therefore, is that a currency’s future value in terms of goods and
services has to be perceived as predictable and stable.
Clearly, many currencies meet this test; yet few emerge as
international currencies. Therefore, there must be - - and there are - - additional
factors that help determine the internationalisation of a currency. One such factor has to
do with size. The size factor relates to the relative economic and demographic area for
which the currency serves as legal tender - - in other words the “habitat” of the
currency. A strong, competitive economy, open to, and active in, international trade and
finance will naturally generate a large quantity of foreign exchange transactions with at
least one leg in the home economy to support its wide-ranging business activity.
Another factor underlying the international use of a currency is the
presence of an open, well-developed financial system. This factor is a necessary part of a
strong, competitive, and open economy. Just as relatively low levels of inflation and
inflation variability contribute to the international demand for a currency,
well-developed financial markets supply assets appropriate for international use, and
strengthen the demand for additional assets as well. Well-developed financial markets in
the currency’s issuing jurisdiction contribute to the international use of that
currency. Central banks and other investors have preferences for safe, liquid financial
instruments; deep and liquid financial markets that offer a full array of instruments and
services will attract business from abroad that might otherwise have stayed at home.
Money as a conveyer of information
History has shown that the forgoing three factors - - a stable
currency, a strong, competitive economy, and deep, broad and liquid financial markets - -
are necessary for the international use of a currency. History has also shown, however,
that only a single currency, or at most a few currencies, emerge as major international
currencies at any one time. To understand why this is so, we need to consider a key
function of money. Money conveys information about prices. When you are in Greece, for
example, and you want to compare the prices of two hotel rooms, you compare them in euros.
The euro, in other words, conveys essential information which allows you to make price
comparisons so that you can reach a decision.
Money, in its capacity as a transmitter of information, performs a
function similar to that of an international language. The greater the number of people
who speak a language, the more it can facilitate communication. The same is true with
money. A currency would hardly do you any good if you are the only person who uses it. The
utility of money depends, in part, on how many others use it. When a Saudi Arabian
exporter, who does not speak Italian, sells crude oil to an Italian importer who does not
speak Arabic, the transaction may well be conducted using the English language and it may
will be denominated and settled in U.S. dollars. The U.S. dollar, in this case, is used as
a “vehicle” currency, that is, it is used to denominate and execute foreign trade
transactions that do not involve direct transactions with the issuing economy. This use
leads, as does the use of English, to easier communication in transmitting information. As
is the case with a language, the more popular is a currency the more useful it is to those
who use it. Because the attractiveness of any international currency grows as its use
increases, an international currency has a tendency to become a natural monopoly. This
circumstance explains why only a single money, or a few moneys, are used as international
currencies at a particular time.
Benefits and costs
An international currency provides several major benefits to the
issuing economy. First, the economy derives seigniorage, because the non interest-bearing
claims on it are denominated in its own currency. When Argentina, for example, imports
autos from Japan, it must pay for them with foreign exchange it earned through its
exports; it is highly unlikely that the Japanese importer would be willing to accept the
Argentina currency, the peso. When the U.S., however, imports Japanese autos, it can pay
for them with Federal Reserve notes, which are just a paper claim on the U.S. government.
The Board of Governors of the U.S. Federal Reserve System estimates that seigniorage
revenue for the United States amounts to between $ 11 billion and $ 15 billion per year.
Second, as the international use of a currency expands, loans,
investments, and purchases of goods and services --both foreign and domestic-- will
increasingly be executed through the financial institutions of the issuing economy. Thus,
the earnings of its financial sector are likely to increase.
Third, the tendency of world trade to be denominated in the
international currency means that the issuing economy will be less vulnerable to changes
in the value of its currency than are other economies. If the U.S. dollar, for example,
depreciates sharply against other currencies, this will have a smaller effect on U.S.
inflation than is the case in other economies. This is because most U.S. imports are
denominated in dollars. Therefore, when the dollar declines on the foreign exchange
market, the price of U.S. imports - - in dollars - - need not change.
The main cost of having an international currency is that it can
complicate the conduct of monetary policy. Because foreigners hold a substantial share of
the currency, a portfolio shift away from the currency, for example, can lead to large
capital outflows and/or large declines in the exchange rate. Concerns about the effects of
changes in portfolio preferences caused both the German and the Japanese governments to
take measures to restrict the international uses of the deutsche mark and yen,
respectively, during the 1970s and early 1980s. Concerns that the imbalances in the U.S.
economy, including the large current account deficit, could lead to a massive sell-off by
foreigners of their holdings of U.S. dollar balances have underpinned concerns of a
possible hard landing for the U.S. currency.
The international role of the euro
Let me now turn to the specific focus of this session - - the
international role of the euro. It is important to note that the ECB has adopted a neutral
stance concerning the internationalization of its currency, implying that it neither
fosters nor hinders the process. It accepts the view that the international role of the
euro is primarily determined by the decisions of market participants. How, then, does the
euro stack up in terms of the conditions that determine an international currency?
The first factor I mentioned that determines international currency use
is a stable currency. The mandate of the ECB is to maintain the purchasing power of its
currency. Since its inception, therefore, the ECB has sought, and it has attained,
stability of its currency. This stability is proof that the institution is performing
Yet, in the quest for stability, monetary policy cannot go it alone. It
needs to be complimented by a consistent fiscal-policy stance. Indeed, the academic
literature has coined a name for the connection between monetary and fiscal policies,
calling it “fiscal dominance”. The implication of this connection for the
international role of the euro is that, to ensure the future stability of the euro, member
states will need to adhere to the Stability and Growth Pact.
The second factor determining international currency-status is size.
Measured in terms of population, the euro area is one of the largest economies in the
world, with more than 300 million inhabitants. By comparison, the populations of the
United States and Japan are about 270 million and 125 million, respectively. The euro area
is the largest trading partner of the world economy, accounting for almost 20 per cent of
world exports, compared with about 15 per cent for the United States and 9 per cent for
Japan. The GDP of the euro area is equivalent to some 16 per cent of world GDP, about 6
percentage points less than the share of the United States but more than twice the share
of Japan. 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, Sweden and the United Kingdom) join the
Eurosystem. The entry of these countries would result in a monetary union of some 376
million inhabitants, about 40 per cent larger than the United States and almost triple the
size of Japan, with a GDP only slightly less than that of the United States and 2Ό times
that of Japan. All these facts and figures, which demonstrate the demographic and economic
importance of the European Union, will be further strengthened by EU enlargement.
Let me now turn to financial markets in the euro area. The introduction
of the euro and the successful implementation of the TARGET payment system have
contributed to the potential for highly integrated financial markets within the euro area.
With regard to capital markets, the euro has seen a strong development
in the bond market. The launch of the euro seems to have acted as a catalyst for the
development of a bond market in which corporations can issue debt securities of
unprecedented size. As a result, the introduction of the euro has created the second
largest bond market in the world. This circumstance has led to declining transactions
costs, as bid-ask spreads have narrowed, and increased diversity, as new types of issuers
participated in the market.
The integration of the euro area bond market, and the associated
reduction of borrowing costs in euro, have meant that the euro has been playing an
increasingly significant role as a financing currency. in the international debt
securities market, recent data indicate that the share in outstanding amounts of
euro-denominated instruments issued by non-residents totals 29 per cent, compared with 44
per cent for the U.S. dollar and 13 per cent for the Japanese yen.
In contrast to borrowers, investors are interested in income prospects
and they demand high efficiency and liquidity of the financial markets in which they
invest. These market characteristics exist only if the financial markets are deep and
wide. Such is not yet the case in euro-area equity markets. These markets tend to be
smaller, on average, than their counterparts in many other industrialised countries and
they account for a commensurately smaller share of trading activity. This situation is
very much a result of the segmentation of national markets, which have been built around
national securities depositories and settlement systems intimately connected to the
national payment infrastructures
The challenge is to remove institutional and economic factors that
raise the cost of cross-border operations. In particular, further integration will require
harmonization of accounting rules, tax regimes, and legal frameworks, and the acquisition
of the necessary technical infrastructure for handling cross-border holdings and settling
securities. The costs of these regulatory obstacles are identified in the Financial
Services Action Plan, issued by the European Commission. The Action Plan lists priorities
and time-scales for legislative and other measure to tackle three strategic objectives:
(1) completing a single wholesale market; (2) developing open and secure markets for
retail services; and (3) ensuring the continued stability of EU financial markets. It also
addresses the importance of eliminating tax obstacles and distortions for the creation of
an optimal single financial market. To date, 30 of 42 measures contained in the Action
Plan have been completed. I hope the remaining obstacles identified in the Action Plan
will be removed within the scheduled deadlines.
As I mentioned, the relatively narrow euro-area financial markets have
meant that the euro area has not approached its full potential as an international asset.
As of the end of 2001, 13 per cent of the identified official holdings foreign reserves
were in euro, compared with about 68 per cent for the US dollar and about 5 per cent for
the Japanese yen. As a medium-of-exchange and asset vehicle in the foreign exchange
markets, the U.S. dollar remains the dominant global vehicle; the euro’s share in global
spot trading amounts to about 20 per cent.
The other speakers on this panel will provide specific information
about the current state of play of the euro as an international currency. The evidence
they will present will confirm that the euro has emerged as the world’s second most
important international currency. Yet, the evidence will also confirm that the dollar is
still far ahead of the euro. Before I turn the lectern over, let me make a few remarks
about future prospects.
Two essential, inter-related elements will help the euro attain equal
status with the U.S dollar. First, improved productivity and competitiveness of the euro
area will raise the rate of return on euro area assets, boosting the role of the euro as
in investment currency. This prediction is predicated on profound changes in areas such as
product and labour market regulations, public debt and fiscal deficits, and social
security systems. Second, continued financial market integration, a necessary condition
for further investments in euro assets, will require changes in, and harmonisation of,
legislations, regulations, market practices, and infrastructures.
The euro has made an impressive debut on the global stage. To a
significant extent, this situation reflects the credibility credentials earned by the ECB
in its first several years of existence. It also reflects the perceptions of market
participants of the euro area as an economy with strong growth potential. Determined
efforts in the remaining areas I have discussed would fulfil these perce3ptions and add to
the attractiveness of the euro in the international arena, allowing it to seriously
challenge the hegemonic role now played by the U.S. dollar.
Ladies and gentlemen, thank you for your attention.