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International Role of the Euro

Poul M. Thomsen Director, European Department International Monetary Fund

Brussels, September 19, 2019

September 19, 2019

Introduction

Ladies and gentlemen, thank you for coming today. I would also like to thank Jean Hilgers, the Belgian Financial Forum, and the National Bank of Belgium for organizing this conference and inviting me.

 

I have been asked to talk about what can be done to strengthen the euro’s role as a reserve currency. This is a timely question, for at least two reasons:

 

First, this being the 20th anniversary of the euro, it is a good time to take stock of the use of the euro as a global currency.

 

Second, many European policymakers have been calling for strengthening the international role of the euro, including President Juncker in his State of the Union address last year. With a new Commission assuming office, it is an opportune time to ask what more policymakers can do.

 

The desire to boost the international role of the euro is motivated by a number of factors. One is the sense among European policymakers—rightly or wrongly—that the US benefits from an “exorbitant privilege,” and that an increased role for the euro could reduce what is perceived by some as European vulnerabilities stemming from the dominance of the dollar.

 

In a speech at the Fed’s recent Jackson Hole Symposium, Bank of England Governor Mark Carney discussed the imbalances in the international monetary and financial system created by the dominance of the US dollar. [1] He argued that the high share of trade invoicing and financial activities denominated in dollars increases spillovers from US policies and weakens the effectiveness of monetary policy in other countries, undermining their ability to focus on domestic objectives. He noted that growth in dollar-denominated borrowing by nonfinancial firms globally has increased vulnerabilities to fluctuations in the dollar exchange rate and caused central banks to continue building up costly dollar reserves. This is especially true in emerging markets, which represent a growing share of the global economy. This dynamic reinforces the strong network effects of trade invoicing in dollars and continued dominance of the dollar as an international reserve currency.

 

Governor Carney concluded that “ultimately a multi-polar global economy requires a new international monetary and financial system to realize its full potential.” This includes a diversification of international reserve currencies and reduced reliance on the dollar. [2]

 

Governor Carney focused in particular on the Chinese renminbi’s potential. I will focus on the potential for the euro.

 

As a starting point, we should remind ourselves that the euro already is an important reserve currency. In fact, it is the second most utilized international reserve currency—a role it inherited in large measure from the deutsche mark yet subsequently expanded on. [3]

 

My remarks today will be from the perspective of what can be done to further strengthen the role of the euro as an international reserve currency. But, you will see that the policy conclusions are to a considerable degree similar to what we have been arguing will be needed to strengthen the resilience of the euro area in any event: namely, to reduce the zone’s vulnerability to country-specific shocks and to foster convergence within the monetary union. You could say that—in my view—strengthening the role of the euro as a reserve currency would be a byproduct of much-needed reforms to make the euro area work better for all its citizens.

What makes a good international reserve currency and how does the euro stack up?

Let us start by reminding ourselves of some of the main findings from the large body of economic research on the key features that an international reserve currency should possess.

First, the currency should have a large transaction area. This is important for providing a sufficient underlying demand for its use, both in trade and in finance. The British Empire provided such a basis for the use of sterling up to WWII, and the US has been the world’s largest economy since the late 19th century.

The euro area clearly qualifies here. At current exchange rates, the eurozone accounted for 16 percent of global GDP in 2018, making it the second largest single currency zone in the world in terms of output.

The second feature is good institutions. This includes things like a stable monetary policy and respect for the rule of law. Users of an international reserve currency need to be confident that they will not be arbitrarily expropriated, whether through violent swings in inflation and the exchange rate or through outright seizure of assets. Having a stable monetary policy also helps to generate lower interest rates, which makes it attractive to foreigners to borrow in the currency.

On institutions, the euro area and its member states measure up pretty well. According to the World Governance Indicators, euro area countries rank in the top 20 percent of all countries on the rule of law, with just a few exceptions. Moreover, the EU has been a strong defender of multilateralism and dispute resolution through global institutions such as the WTO. And the experience of the last 20 years has shown the ECB’s strong commitment to its inflation objective and strong independence even in the face of considerable criticism, at times from powerful member states.

The third feature a reserve currency needs is deep, liquid, and open financial markets. Financial markets need to be deep to provide enough assets denominated in the currency to satisfy the demand of foreign investors and central banks. And markets need to be liquid and open—meaning few controls on the currency—so that foreign holders of assets denominated in the reserve currency feel confident that they can move in and out of their positions easily and without excessively moving prices and exchange rates. For example, research on the history of reserve currencies shows that the development of deep and liquid financial markets was critical to the US dollar gaining parity with sterling as an international currency before WWII. [4]

While euro area financial markets are open—with strong safeguards against capital controls— they are not nearly as deep and liquid as US financial markets. For example, in 2018, euro area bond and equity markets were worth about 20 trillion dollars compared to over 50 trillion dollars in the US. Moreover, the choice of euro-denominated assets is more limited than dollar-denominated assets. For instance, less than 30 percent of euro area nonfinancial corporations’ financing comes from tradable debt and listed equity versus about 70 percent for US firms. One issue here is clearly the much higher reliance on relationship-based lending than on arm’s-length capital markets in the euro area.

Overall, euro area financial markets are also much more fragmented than in the US, including for sovereign debt. The market for US Treasury bonds is one of the deepest and most liquid in the world. There is no single comparable market in the euro area.

The fourth important feature of an international reserve currency, according to some literature, is the backing of a strong central state, in part to give the currency true permanence. As Robert Mundell put it 20 years ago, and I quote: “You have to have a belief that the euro is going to be there not just tomorrow and 10 years from now, or 30 years from now, but 100 years from now.” [5]

Obviously, there is no strong central state for the euro area as whole. It is an economic and monetary union, but it is not a political union. I want to emphasize this, because this is of course the defining feature of the euro area—the feature that makes this area fundamentally different from other major currency areas, which all are political unions with a strong center. This, I will argue—the fact that it is not a political union—is clearly the limiting feature when it comes to the ability of the euro to seriously challenge the dollar.

The global financial crisis and the euro area debt crisis that followed exposed the fact that national policies in some euro area member states were not always consistent with membership in a monetary union. It also highlighted a number of weaknesses in the architecture of the monetary union itself. It is therefore not surprising—as Johannes Graeb noted earlier—that after climbing considerably in its first decade, international use of the euro declined sharply as the euro area debt crisis caused investors to question the sustainability of the zone in its current form.

Of course, much has been done since the crisis to address the architectural shortcomings of the monetary union. The establishment of the ESM and the creation of the banking union were important steps. As we all know, however, the architecture remains incomplete.

And, perhaps even more importantly, national policies in important areas still fall well short of what is needed for countries to thrive within the euro area. In particular, several countries with high public debt levels have done too little to put their debt burdens on a downward path and reduce their vulnerability to country-specific shocks and attendant shifts in market sentiment. Most of these high-debt countries also have low productivity and competitiveness gaps and have failed to implement many of the structural reforms they need to overcome these problems.

At the same time, euro area countries running large and persistent external and fiscal surpluses have done too little to boost domestic investment and demand, which would of course also contribute to a healthy rebalancing within the region.

……..

In light of this, let me now turn to what I see as the prospects for improving the functioning of the euro area and increasing the international role of the euro.

Prospects for improving the functioning of the euro area and increasing the international role of the euro

In line with what I just said, I see three important issues critical to increasing the international role of the euro. The first is the balance between the network effects of using a single currency in trade and finance and the desire for greater diversification in international reserve currencies. I will only briefly comment on this. The second is the depth and liquidity of euro area financial markets. The third, and most important, is how well the euro area functions for its members and the attendant impact on its attractiveness as a reserve currency.

As mentioned, there are often strong network effects and efficiency gains from transacting in one currency. [6] But, history shows that there is nothing inevitable about having a single dominant global currency. The growth in the international use of the euro in its first decade—when it was essentially taking market share from the dollar—is evidence of the appetite for more than one major international currency. This desire for diversification in reserve currencies and for reducing the vulnerabilities and spillovers created by the dominance of just one serves as a counterweight to the network benefits of transacting in a single currency.

European policymakers are of course interested in increasing the invoicing of international trade in euros, as Marco discussed earlier. How to do this is still not entirely clear to me though—this is usually a decision taken by individual actors, and depends on various factors, including the strength of the network effects already discussed.

European policymakers have argued for pricing more commodities in euros. I remain to be convinced about the success of such efforts. For commodities with a truly global market, such as oil, the efficiency gains from everyone pricing in a single currency seem to be quite strong. In those markets it is hard to see the euro making significant inroads into the dollar’s dominance anytime soon.

Let me turn now to the second point: enhancing the role of the euro by developing deeper and more liquid euro area financial markets looks more promising. Here prospects are better.

For the banking union, the biggest element still missing is a common deposit insurance scheme for banks. At the same time, further work is also needed to strengthen the bank resolution and bank supervision frameworks. This includes reducing the still-excessive fragmentation of rules and regulations along national lines.

As to capital market union, I believe that there is a growing sense among member states that capital market integration offers an opportunity for EMU deepening that could be politically easier than some other reforms. By this I mean that many of the necessary steps do not run into the concerns about risk-sharing versus risk-reduction that have stalled other parts of the architectural reform agenda.

Thus, while completing the banking union and building a capital market union are undoubtedly still long-term projects, I do sense an encouraging political willingness to reinvigorate some of these efforts. A caveat though: realistically, euro area financial markets will never be as integrated as those in the US. This reflects in part that some of the necessary measures—like harmonization of bankruptcy procedures—are highly political and will run into the familiar obstacles to EMU deepening. But it also reflects the prevalence of SMEs in Europe compared to the US, which suggest that relationship banking will always be more important in Europe. Thus, while the prospects for making progress on BU and CMU suggest to me that it is realistic to envisage an expanded role for the euro as an international reserve currency, these considerations also suggest the limitations for such an expansion.

But, the main limitation—and this brings me to the third point—remains the inconsistencies of policies at the national level with being member of a currency union and limitation in the euro area’s architecture.

Of course, the architectural reforms needed to improve how the euro area serves its members entail more than just developing a deeper financial union. The fiscal rules need to be overhauled and a central fiscal capacity needs to be created to provide insurance against country-specific risks.

Even more important than architectural reforms—in my view—is the need for member states to have policies that are consistent with membership in a monetary union. As I mentioned before, this means reducing fiscal vulnerabilities where they are high and seeing countries with low productivity growth and competitiveness gaps implement structural reforms to improve the resilience and efficiency of their domestic economies. And again: countries with sizable external surpluses need to do their part by investing more at home and supporting faster wage growth, including to help engineer a healthy rebalancing within the euro area.

Here, in my view, we have the main limitation when we discussed the prospect for a stronger role for the euro. Without much stronger coherence in policies at the national level with the limitations of belonging to a currency union, and without architectural changes to help weather country-specific shocks, the euro area will remain more vulnerable to shocks. I don’t see how one can seriously dream about the euro seriously rivalling the dollar without making much more progress in ensuring policy-consistency and completing the architecture.

The problems the Commission is having in enforcing the fiscal rules is on open display every day. So is the failure to seriously advance the architectural reforms in the face of this inability to enforce the rules as key architectural reforms appear stuck over concerns that increased risk sharing creates serious moral hazard problems and therefore should be contingent on first making progress on risk reduction. These issues lie outside of what we are discussing today. But again: I don’t see how we can imagine the euro seriously rivaling the dollar without first solving these fundamental problems inside the euro area.

Before I conclude, let me briefly comment on one special issue: the supply of euro-denominated safe assets. As I mentioned, the euro area does not have a single safe asset comparable to US Treasuries.

I agree that it would be desirable to have an increased supply for safe assets and that this would help enhance the euro’s global role.

But what are the prospects for this? Some observers have called on Germany and other AAA-rated countries to issue more debt. While there are good reasons for Germany and other countries with fiscal space to issue more debt in order to finance infrastructure and other reforms to boost their long-term growth potential, the notion that fiscal objectives should factor-in the need to feed more safe assets into world financial markets is tough to sell even under the most ambitious notions about giving greater weight to area-wide objectives in national fiscal policy.

The fact is that the discussion of safe assets quickly runs into the familiar conflict between risk-sharing and risk-reduction. On the one hand, we have the proposal to create a common euro area safe asset, perhaps some sort of debt instrument jointly backed by all euro area member states. On the other hand, we have the concerns that such “mutualization” will cause moral hazard problems. Here the counter-argument is that poor policies at the national level have caused some countries to lose their high credit ratings and that the logical conclusion is to create more safe assets by making lower-rated assets safer. From this perspective, the solution is for countries that are currently considered less safe to pursue better policies—more prudent fiscal policies and more ambitious structural reforms.

Thus, a safe asset is not a silver bullet that will somehow allow the euro area to bypass the fundamental challenges regarding risk-sharing versus risk-reduction that are hampering the development of a more resilient euro area—there and no easy shortcuts to creating a stronger role for the euro as a reserve currency.

….

It is time for me to conclude. I believe that further progress on banking, and in particular capital market union, could help strengthen the euro’s global role. But I also believe that this role will be limited as long as we have not overcome the fundamental problems in policies at the national level and the shortcomings in the architecture that have been evident since the GFC. Enhancing the global role of the euro is a welcome bi-product of changes needed to make the euro work better for Europe.

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