As an international currency, the euro has always been a distant second to the dollar. The idea of a greater international role for the euro has been floated, but without major institutional reform, the euro will not become a dominant currency.
When created two decades ago, the euro
immediately became the world’s second most important currency. But it
has remained a distant second to the US dollar. Its internationalisation
peaked in 2005 and went into reverse with the euro crisis, never fully
recovering since. Although some predict the demise of the dollar, its global hegemony persists.
The European Union is now
considering promoting a greater international role for the euro, in
particular in the context of an ambition for the EU to play a more
strategic geopolitical role
Faced with a United States administration
less inclined towards multilateral solutions and willing to use its
currency to extend its domestic policies beyond its borders (for
instance by forcing European firms to cut ties with Crimea, Cuba or
Iran), the European Union is considering promoting
a greater international role for the euro. Regular attention is now
paid to it in policy speeches, in particular in the context of the
European Commission’s stated desire for the EU to play a more strategic
geopolitical role. The European Central Bank, meanwhile, has abandoned
its traditional neutral stance on this question.
Pros and cons of a dominant currency
Despite being an international currency,
the euro is not a dominant one. Does this matter and would it be
beneficial for the EU if the euro had a greater international role? As a
dominant currency, the dollar enjoys certain advantages: seigniorage
revenues from the significant holdings of cash abroad (as long as rates
are positive); lower yields for the government from a safety and
liquidity premium; an aggregate return on foreign assets superior to the
cost of foreign liabilities; lower transaction costs for its citizens
and companies; a competitive advantage for domestic banks which issue
international currency; a lower dependence on the US driven global
financial cycle; and an additional geopolitical instrument to ensure
financial and economic autonomy.
However, a dominant currency also entails
costs. In times of global uncertainty, the dominant currency needs to
provide some form of insurance to the rest of the world in two ways.
First, the appreciation of the dominant currency, caused by an increase
in demand for a ‘safe’ currency during times of uncertainty, can lead to
negative wealth effects for the country if its debt is denominated in
the dominant currency but its assets are invested abroad in local
currencies. Second, to avoid the collapse of the global financial
system, the central bank issuing the dominant currency needs to play the
role of international ‘lender of last resort’ (e.g. via currency swap
lines with other central banks), which could interfere with its domestic
policy objectives. Finally, to achieve the status of globally dominant
currency, a global safe asset needs to be provided, which results in
periods of significant capital inflows that combine with current account
deficits.
The euro area does not provide a large and elastic supply of a safe asset
These cons explain why some countries,
such as Germany, were reluctant to promote the internationalisation of
their currencies in the past. They feared it could weaken control over
monetary policy, generate undesirable exchange rate volatility and
result in excessive appreciation of the currency, thus undermining their
export-dependent growth model. The euro area and the ECB inherited this
pre-euro German position and left the role of the euro to be determined
by market forces and other central banks. This is now changing in
official communications, but are the steps taken sufficient?
Determinants of global currency status
Historically, countries issuing dominant
currencies have been characterised by a large and growing economy, free
movement of capital, an explicit willingness to play an international
role, stability (monetary, financial, fiscal, institutional, political
and judicial), an ability to provide a large and elastic supply of safe
assets, developed financial markets, and significant geopolitical and/or
military power. How does the euro area measure up?
Thanks to a large economic base, the euro
area partially fulfils the first criterion. Though not the foremost
global economic power, the monetary union represents one of the largest
economic blocs in the world even if it lacks economic dynamism. It also
fulfils the second criterion, as free movement of capital is solidly
entrenched in European Treaties. The willingness to play an
international role was previously not there, but this has changed.
The stability criterion is only partly met
in the euro area. Despite missing its inflation target in recent years,
the ECB has ensured a stable value of the currency in the last two
decades. Financial stability risks, after being at the root of the euro
crisis, have been reduced. And most euro-area countries fare pretty well
in terms of judicial and political stability, despite some setbacks in
some countries in recent years.
Nevertheless, flaws in the architecture of
the monetary union have sometimes led investors to doubt its long-term
durability, or the irreversible participation of some countries. These
doubts came to the fore during the euro crisis and redenomination risks
have periodically resurfaced since then, notably in Greece in 2015 and
in Italy in 2018. Finally, fiscal stability is a more complex issue in
the euro area than in other jurisdictions due to decentralised fiscal
and centralised monetary policy. The European Stability Mechanism (ESM)
and the ECB’s Outright Monetary Transactions (OMT) programme have
addressed this issue to some extent.
However, the euro area does not provide a
large and elastic supply of a safe asset. Safe assets are liquid assets
that credibly store value at all times, in particular during systemic
crises, and there is a high demand for them. Sovereign debt securities
from advanced countries play this role, as long as public finances are
considered sound by the markets.
From the creation of the euro to the euro
crisis, sovereign bonds from euro-area countries enjoyed this status –
but several lost it during the euro crisis. The stock of AAA-rated debt
securities from the euro area declined from around 40% of its GDP in
2008 to 20% in 2018 (Figure 1), while the supply of AAA-rated US Federal
debt securities increased from 65% of GDP to more than 100%.
Figure 1: Supply of safe assets from the euro-area (€ billions)
Source: Bruegel based on Bloomberg for
bonds issued by EFSF, EU, ESM and EIB, S&P for credit ratings and
Eurostat for government debt securities. Note: includes bonds issued by
the 19 euro-area countries, the European Financial Stability Facility,
the European Union, the European Stability Mechanism and the European
Investment Bank.
As far as the development of financial
markets is concerned, the euro area’s capital markets are much less
developed, less liquid and less deep than in the US. They are still
heavily fragmented along national lines, despite the Capital Markets
Union initiative. Finally, even though Ursula von der Leyen’s European
Commission considers itself a “geopolitical Commission”, the EU is far from being a dominant military power.
No shortcut to dominant status
Overall, the monetary
union does not meet all the criteria for the euro to become a dominant
currency. The only solution is to improve the institutional setup of the
monetary union. Besides completion of the banking union and the
deepening of capital markets, the supply of safe assets is essential. It
is also crucial to boost growth in order to make the euro area an
attractive destination for investment, but also to improve the prospects
of individual countries so that their debt is considered safe. Finally,
a more determined attitude on the part of the ECB (by offering more
easily currency swaps to countries in which euro liquidity is important)
would help, as would progress on an EU external/defence policy and a
more visible geopolitical role.
Overall, the monetary union does not meet all the criteria for the euro to become a dominant currency
Current minor initiatives put forward by
the European Commission – promoting the labelling of energy contracts
and derivative clearings in euro, or encouraging the systematic use of
the euro by institutions such as the European Investment Bank (EIB) and
the European Bank for Reconstruction and Development, or by third
countries through diplomacy – are useful, but insufficient.
Two issues should now be prioritised.
The increase in the supply of safe assets during the COVID-19 crisis
Significant steps have been taken to
ensure that the supply of euro-denominated safe assets is increased.
First, the ECB’s Pandemic Emergency Purchase Programme has ensured the
stability of the monetary union by allowing governments to issue debt
easily, thereby also increasing the supply of safe assets. Second, the
Eurogroup agreed
on 9 April 2020 to increase joint borrowing by up to €540 billion: €200
billion through the EIB, €100 billion through the new EU ‘SURE’ credit
line to help countries finance temporary lay-off benefits and up to €240
billion through the ESM. Third, the European Council reached
an agreement on 21 July 2020 to issue up to €750 billion-worth of EU
debt to finance its recovery plan, using the EU budget as a mechanism
for borrowing.
As the fall in sovereign spreads shows,
markets have interpreted these decisions as a commitment by EU countries
to stick together, and as an improvement in the institutional set-up of
the Economic and Monetary Union. This should increase its stability and
reinforce the international role of the euro. The euro indeed
appreciated when the €750 billion package was agreed, and when France
and Germany made the initial proposal in May (Figure 2).
Figure 2: US dollar – euro exchange rate
Source: Bruegel based on Board of Governors of the Federal Reserve System.
It is now of central importance that the agreed package clears its final legislative hurdles. Strong governance mechanisms will also bolster the credibility of the package. An important discussion is about the issuance of green bonds (as well as social bonds),
and whether they represent an opportunity to create a new market with
Europe in the lead, or rather a disruption that would fragment the
market for EU bonds. Finally, the EU should reconsider whether it is
sensible to pay back the debt as originally planned or if it is
preferable to roll it over when it matures. Repaying the debt would not
only be a major economic burden without benefit but would also
counteract the strategy to boost the international role of the euro.
Promoting the euro by boosting growth
An ambitious and strategic growth agenda
for the next decade is also needed. Policymakers must ensure that funds
from the recovery plan are used wisely to reboot the European economy
once the coronavirus is defeated. This will provide a double dividend
for the euro as an international currency by increasing the euro-area’s
attractiveness and by boosting ratings of weaker countries, thus
increasing the overall supply of safe assets.
The EU recovery fund will be particularly
crucial in that regard. It should complement national stimulus measures
to prevent a slow recovery, but given the usual sluggishness
in the disbursement of EU funds, its macro effect will only start to
materialise in a couple of years. That’s why the recovery fund should
mainly aim at establishing a new growth model in Europe and focusing on
the necessary reforms.
Overall, the euro is not yet set to
dominate as a global currency as long as no major further
institutional steps are taken. There is no shortcut to becoming a
dominant currency.
© Bruegel
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