EMU and the International Monetary System

INTERNATIONAL MONETARY FUND

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1997
• ISBN:
  9781557756640

NONE

1 Introduction

Paul R. Masson. Thomas H. Krueger. and Bart G. Turtelboom

Economic and monetary union in Europe (EMU) will produce profound changes in exchange and financial markets, and these are likely to affect in a fundamental way the activities of a broad range of market participants and private and official institutions. As part of an ongoing effort at the International Monetary Fund to understand the broader, systemic implications of EMU, a conference was held in Washington, D.C., on March 17–18, 1997, which brought together a distinguished group of several hundred academics, officials, and policymakers. The conference, cosponsored by the Fondation Camille Gutt and the International Monetary Fund, was on the subject of EMU and the international monetary system, and it generated many insights into the effects of the introduction of the euro.

Given the widespread interest in this topic, it was felt useful to disseminate this work to a wider audience, and the present book, reporting on the papers and proceedings of the conference, is the result. This introduction gives a short summary of the papers, three speeches, and two roundtable discussions, organized along five main themes: the characteristics of the euro and its potential role as an international currency; EMU and international policy coordination; EMU and the relationship between the Fund and its EMU members; lessons of European monetary integration for the international monetary system; and the transition to EMU. The papers, which appear in the chapters that follow in the order in which they were presented at the conference, are accompanied by discussants’ comments, and in some cases by a summary of the general discussion. Written versions of the presentations at the roundtables and of the speeches are also included in the book.

Characteristics of the Euro and Its Potential Role as an International Currency

The attractiveness of the euro is likely to be determined mainly by the macroeconomic policy stance in Europe, and, in particular, by the success of the European Central Bank (ECB) in achieving low inflation. On the latter issue, there was general agreement that the ECB would follow in the steps of the Bundesbank in its dedication to price stability, and be independent of political interference as provided in its statutes. Other factors are also likely to be important in affecting the international use of the euro, including the development of integrated, liquid, and efficient European financial markets. Reserve currency use is likely to evolve slowly, but the euro would start as the second most important reserve currency and could, over time, rival the dollar.

Will the Euro Be a Strong Currency?

Several chapters in this book deal with the potential strength of the euro, focusing in some cases on portfolio diversification as the primary factor influencing the initial strength or weakness of the euro.

Fred Bergsten, in Chapter 2, addresses the issue of the potential strength of the euro by first reviewing the criteria determining the global role of a currency. The euro zone will be bigger than the United States, both in terms of the size of the underlying economy and the extent of its external trade. In the absence of exchange controls, European capital markets, presently small by U.S. standards, should expand strongly in the medium term. Given the strong anti-inflationary mandate of the ECB, the European economy should be stable and perform well, though Bergsten acknowledges the resistance in Europe to much-needed structural reforms. Taken together, he posits, the euro has all characteristics to become a strong currency in the international monetary system. He takes a more nuanced view of the prospects for an immediate appreciation of the euro, though in his view European currencies are now overdepreciated (perhaps deliberately) against the dollar, making an appreciation appropriate. Bergsten also stresses that despite his general preference for target zones for the major currencies to facilitate policy coordination, uncertainty surrounding the implementation of EMU would make target zones undesirable initially.

Chapter 3, by George Alogoskoufis and Richard Portes, analyzes the impact of EMU on the euro-dollar exchange rate and the external position of the European Union (EU). They argue that there will be excess demand for the euro, which will lead it to appreciate. Their argument for the enhanced international prominence of the euro compared with the deutsche mark is based on the existence of network externalities for a currency: when more people use a particular currency as a means of payment, transaction costs decrease, which induces even more people to use that currency. The need to use the U.S. dollar for intervention purposes within the euro region will disappear with the arrival of the euro, and in foreign exchange markets the position of the euro will be enhanced and the currency will be cheaper to use. Many foreign exchange transactions are now intermediated through the dollar because a “dollar round-trip” is often cheaper than directly trading two other currencies, but this will tend to change with the introduction of the euro.

With regard to the unit of account function, the euro is also likely to hasten the decline of the dollar as the denomination of international trade. All intra-European trade will be invoiced in euros and those countries pegging their currency to the euro are likely to see a growing fraction of their trade invoiced in euros rather than dollars. Finally, the euro will reinforce the declining trend of the dollar for the denomination of financial assets.

Paul De Grauwe, in Chapter 4, is more agnostic about the potential strength of the euro. His analysis of the “ins” and “outs” of EMU underscores that the early behavior of the euro could be affected by the specific countries participating in EMU. Notably, some of the candidates like Italy and Spain have currencies that, he argues, are presently undervalued; should these countries not participate in EMU from the outset, the euro might initially depreciate.

Robert McCauley and William White, in Chapter 12, point to the possibility that the supply of assets in euros might eventually increase more than the demand for those assets, leading to depreciation, not appreciation, of the euro. This view contrasts with both the analysis in Alogoskoufis and Portes, and Bergsten’s expectation. Indeed, because of relatively underdeveloped European financial markets, the share of the world supply of assets in EU currencies falls at present well short of Europe’s economic importance. This might well change with EMU, when in addition to the redenomination of existing liabilities in EU currencies into euros, foreign issuers might want to do a larger share of their borrowing in euros than in existing EU currencies, provided integrated European financial markets meant efficiency gains and hence lower borrowing costs.

Volatility

Even a strong euro might be subject to considerable volatility—a subject discussed in several chapters.

Chapter 7, by Agnès Bénassy-Quéré, Benoît Mojon, and Jean Pisani-Ferry, sets out to address the question of how economic and monetary union will affect exchange rate volatility between the euro and the dollar. In answering this question, the paper focuses on the preferences of the ECB in the steady state and does not address credibility issues during the transition.

To study the volatility issue, these authors develop a small three-country model with short-run nominal rigidity but long-run flexibility. Their results suggest that monetary union of two countries (“EMU”) increases the volatility of the real effective exchange rate of the currency of the third country (“United States”) to U.S. shocks or symmetric European shocks. This is so because the ECB can internalize the externality coming from macroeconomic interdependence; the ECB would adjust interest rates more than individual European countries and the dollar exchange rate would move more. Asymmetric shocks in Europe do not affect the dollar exchange rate since they are automatically offset in Europe. The authors use this model to present quantitative evidence on the question of euro-dollar rate volatility and conclude that EMU is likely to lead to moderately higher volatility of the real effective exchange rate if the central bank targets the exchange rate in addition to inflation.

Daniel Cohen shares the conclusion that exchange rate volatility is likely to increase. Indeed, he presents a numerical example in Chapter 13 that suggests that the increase in volatility could be substantial relative to the present monetary and exchange rate regime. His model allows for both price and demand shocks. The policymaker’s objective function takes into account inflation and aggregate demand, as well as a fiscal variable, while allowing for different degrees of policy coordination. While the author’s overall assessment is that EMU would raise exchange rate volatility, his analysis also indicates that the result depends critically on the dominance of price shocks. By contrast, if demand shocks dominate, Cohen’s model suggests that exchange rate volatility might even decline under monetary union.

Paul Masson and Bart Turtelboom (Chapter 8) argue that, given the paucity of reliable EMU-wide economic indicators at the start of EMU and the practical challenges involved in devising new monetary policy operating procedures, the ECB may have little choice but to place considerable weight on the exchange rate in the early stages of EMU. This may indeed result in a relatively stable euro exchange rate.

De Grauwe identifies another potential aspect of exchange rate volatility: the relationship between the countries adopting the euro and those EU countries that do not join EMU. A successor to the exchange rate arrangements under the ERM has been designed to link the “ins” and the “outs”—termed the ERM II. This mechanism would involve wide bands and the proviso that exchange market intervention should not endanger the price stability objective of the ECB. It is envisaged that realignments be jointly decided, done in time to prevent “one-way bets” from developing, and small enough so that new central rates would be within the old bands of fluctuation.

De Grauwe argues that though the above features, and the achievement of a considerable amount of economic convergence, would deter speculation and make less likely the type of crisis that occurred within the ERM in 1992–93, other features might make the ERM II vulnerable. In particular, the crucial nature of the Maastricht fiscal criteria might make countries vulnerable to shifts in market sentiment, especially if they have high debt levels. For instance, a country whose commitment to entering EMU was thought to be flagging might pay higher interest rates on its debt, widening the budget deficit and setting in motion a self-fulfilling spiral. De Grauwe presents a model of self-fulfilling speculative attacks that illustrates these potential risks—risks that rise as the level of government debt increases. Another problem facing the ERM II, as De Grauwe argues, is the present overvaluation of the core currencies relative to the peripheral ones, so that the latter might therefore need to appreciate over time.

Use of the Euro as Official Reserve Currency

Several chapters discuss the potentially attractive features of the euro as a reserve currency, though its use for that purpose may only develop gradually. In Chapter 8, Masson and Turtelboom use stochastic simulations to analyze the effects of replacing European currencies by the euro, including the impact on official reserve holdings. The simulations are performed for two monetary policy scenarios, allowing for the ECB to be guided by either a monetary or an inflation target; the authors also analyze a variant of inflation targeting whereby the ECB places some weight on output conditions. The simulation results suggest, for given structural relationships, that macroeconomic variables for the EU should be at least as stable after EMU as at present.

Masson and Turtelboom then analyze the potential demand for reserves after EMU in the light of the results from the stochastic simulations. Simulation results suggest that the incentives to hold foreign exchange reserves in euros for store of value purposes should be somewhat greater than for the deutsche mark at present, and hence that there should be incentives to diversify away from the dollar. However, they argue that holdings of dollar reserves by EU central banks, though they appear to be too large in the light of EMU, are unlikely to be a major influence on the exchange rate between the euro and the dollar. Masson and Turtelboom argue that more important than these factors will be the relative stance of monetary policies and economic conditions. They also point out that the bulk of reserves outside the EU are held by East Asian countries, which are unlikely to want to use the euro as an exchange rate anchor, so substitution of dollars by euros would likely result from gradual portfolio diversification.

Bergsten and Alogoskoufis and Portes concur with the view that the euro will have attractive features and that, after some transition period, the euro should constitute a rival to the dollar as a reserve currency: it would be based on a wide economic area and would develop as a vehicle for invoicing trade and for effecting foreign exchange transactions. Nevertheless, the potential for a shift out of dollar reserves is generally not viewed as a major issue for exchange rates.

The Euro and Financial Markets

Two chapters—Chapter 11 by Alessandro Prati and Garry Schinasi and Chapter 12 by McCauley and White—see the introduction of the euro as a catalyst for the development of integrated money and bond markets in Europe. Even without EMU, technological progress and regulatory changes are already forcing a rationalization of European banking systems. The arrival of the euro will further increase competition among banks and between banks and alternative sources of funds. While this should eventually lead to a further consolidation of the sector, McCauley and White suggest that slow regulatory progress and the value of local expertise will retard this process.

Prati and Schinasi focus on prospective developments for European and international capital markets, including the impact of EMU on banking institutions and capital flows. They argue that the introduction of the euro will likely reinforce existing trends toward more liquid and integrated capital markets, which could rival U.S. markets in size. The paper sees scope for further securitization of European finance, the development of more precise measures of credit and liquidity risk, regulatory initiatives to reduce or eliminate existing cross-border restrictions on investment, and increased opportunities for portfolio diversification. All these trends will be reinforced by technological advances in derivatives and securities markets. Over time, they argue, this will lead to a harmonization of trading practices and, ultimately, fully integrated markets.

The development of EMU-wide repo and interbank markets will depend importantly on the legal and tax system and on the instruments employed by the monetary authorities, including the extent to which reserve requirements will be imposed on repo operations. The disappearance of foreign exchange risk will refocus the pricing of government bonds on credit risk and the related ratings; in this regard, they expect a narrowing of yields but remain agnostic as to its effect on market liquidity. Prati and Schinasi also argue that further disintermediation and increased competition for investable funds will lead to mergers and acquisitions among banks and between banks and specialized firms and institutional investors. At the retail level, it is argued that the introduction of the euro would further stimulate cross-border mergers and alliances but regulatory reform would be essential to support the needed, and more far-reaching, consolidation in this sector.

The chapter by McCauley and White addresses similar issues, though focusing more narrowly on bond markets and banking developments. The paper first sets out the background for the banking system in which the introduction of the euro will take place. Many banks in continental Europe, though experiencing rising profitability, are still substantially less profitable than their Anglo-Saxon and Scandinavian counterparts. Hence, even in the absence of the euro, restructuring will likely be the order of the day. As for the competition from nonbank sources of capital, the paper puts the advantage squarely on the side of direct market access. Although inertia on the part of market participants, legal, regulatory, and supervisory differences, and continuing political sensitivities to takeovers and mergers, especially with foreign firms, are likely to check the pace of increasing competition, it will still be important to ensure that banks and their personnel face the right incentives to avoid excessive risk-taking when coping with the additional competition. It is thus not unlikely that national regulators will increasingly have to cooperate or at least make sure that the home rule principle is working effectively. For world financial markets, it seems likely in the longer term that supervisory and regulatory structures will become more harmonized.

In bond markets, McCauley and White see the arrival of the euro as a potential driving force toward an integrated market, although some of the changes may take time to manifest themselves given very different market structures. In government bond markets, the disappearance of national currencies will likely increase the focus of market makers on creditworthiness and its measurement, leading to very small pricing differences between high-quality borrowers but larger ones among countries with different debt-to-GDP ratios. Overall, the euro bond market is likely to b...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Content Page
• Preface v
• List of Abbreviations xi
• 1. Introduction
• Session I Policy Coordination and a Tripolar International Monetary System
• Session II Exchange Arrangements of Other Countries Vis-À-Vis the Emu
• Session III The Euro As A Reserve Currency and Exchange Rate Volatility
• Session IV Euro Financial Markets and the International Financial System
• Session V the external dimension Of The european Policy mix
• Session VI Relations Among the Imf, the Ecb, and Fund/Emu Members
• Footnotes