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The ongoing reforms in the European Economic and Monetary Union can support the common currency on the international scene, and further policies at the European level can strengthen a wider use of the euro on international capital markets.
Changing Landscape
The
international monetary and financial system may be slowly moving
towards a ‘multipolar’ structure. The US dollar remains the dominant
global currency, and serves as a point of reference for international
borrowers and investors. The euro is a distant second behind the dollar
on global financial markets, but it is on par with the dollar for
international trade invoicing and global payments (Figure 1).
Furthermore, the international use of the renminbi is also rising with
the opening up of Chinese financial markets and with the authorities’
active policy support.
European policymakers have recognised the importance of the issue
and the international role of the euro featured high on the agenda at
the latest Euro summit on 25 March 2021.2 The European Commission has highlighted the need for more geopolitical financial sovereignty,3 and a recent ESM discussion paper focused on the main drivers of the euro’s global role and the policies to support it.4
A more prominent international role for the euro would benefit Europe
by ensuring more stable financing conditions and it would lend greater
stability to the international financial system as a whole. A wider use
of the euro for financial transactions and investments can also promote
diversification across the international monetary and financial system.
An
excessive reliance on the US dollar entails certain drawbacks. For
instance, US monetary policy can induce shocks to global financial
markets,5 while dominant-currency pricing and financing can hinder external adjustment through exchange rate flexibility.6
A more diversified mix of global currencies would allow borrowers and
investors to diversify their assets and liabilities, enable effective
risk sharing and hedge volatilities induced by capital flow
fluctuations.7
The Euro‘s Strengths and Weaknesses
Different functions of an international currency strengthen one another.8 Countries
with euro-denominated export receipts have economic incentives to
manage their financial assets and liabilities in euros. This logic works
in two ways. It can increase demand for euro-denominated safe assets if
other central banks wish to invest their foreign reserves in the
currency in which the countries’ export receipts are denominated. And it
can foster more diverse euro-denominated debt markets if other
countries decide to issue a larger share of their sovereign debt in
euros.
Figure 1 The euro is the world’s second most important currency
(Global share of the US dollar and the euro in %)
Notes: *Bank loans include cross-border loans denominated in a
foreign currency (i.e. currencies foreign to bank location country);
**Debt securities include securities that are issued in a currency other
than that of the borrower’s residency.
Sources: Invoicing
based on Boz et al. (2020); Payments based on Swift via Bloomberg
Finance L.P.; FX trading, bank loans, and international debt securities
based on BIS; Reserves based on the International Monetary Fund’s (IMF)
Cofer, latest available data”
The euro has many strengths that can support a stronger role
globally. Its large economic area, well-advanced financial markets, and
relatively low currency volatility support an international euro status,
underpinned by an independent central bank with a clear price stability
mandate and a prohibition against monetising government deficits. The
euro area demonstrates its strong external position with a persistent
current account surplus since 2012. Its broadly balanced international
investment position shows that the monetary union can attract foreign
investors, including those seeking a safe haven,9 and it can support investment in the rest of the world as a capital exporter.
However, diversification away from the US dollar has benefitted the euro only to a limited extent so far.10
Economic fundamentals vary greatly across member states. Without an
overarching risk-sharing mechanism, idiosyncratic economic and political
risks bring about varying impacts across European financial markets. In
particular, on sovereign debt markets some government bonds exhibit the
characteristics of safe assets, while others trade like risky assets.11
A scarcity of euro-denominated safe assets is an obstacle to
establishing the euro as a safe-haven currency. Safe assets accounted
for about 25% of euro area GDP at the end of 2019,12
while the US Treasury market accounted for 90% of GDP – and the volume
of all euro area sovereign debt combined is still smaller than that of
the US Treasury market. This means that a large part of euro area assets
may lose value during increased global risk aversion, and such
sentiment generates capital outflows seeking to preserve value.13
The
euro area’s heavy reliance on bank financing also limits the depth and
liquidity of European financial markets. A large share of outstanding
corporate debt registers as unmarketable assets on bank balance sheets
and as unavailable assets for foreign investors. European capital
markets remain small and fragmented, with a relatively small share of
corporate liabilities securitised and a large share of European
investors’ assets concentrated in their national markets.14
What can be done to support the international role of the euro?
The
bedrock of a currency’s international status is the strength and
resilience of its underlying economy. Thus, reforms to strengthen growth
potential in euro area member states will be crucial. Markets will look
at the ability of European countries to deal with impediments to growth
and address the scars left by the pandemic crisis. Supporting growth
will enhance market perception of the euro and demonstrate an ability to
address longer-term euro area economic challenges. It will also help
mitigate the risk of social and political conflict undermining euro area
cohesion. Measures taken during the pandemic crisis go a long way to
supporting the international role of the euro. The EU recovery fund
addresses macroeconomic instability with intra-regional transfers and
promotes structural reforms. The fund, together with substantial ECB
purchases of government debt, helps mitigate sovereign credit risk in
high-debt countries, which should encourage inflows from foreign
investors and support the currency.
Safe assets.
An ample supply of safe assets can act as a ballast to dampen euro area
sovereign debt price fluctuations during times of stress.15
The EU is on course to become one of the largest issuers in the euro
area and to expand the supply of euro-denominated safe assets.15 By
2026, a total of €850 billion new EU bonds could be issued. This could
expand the pool of highly rated bonds to about 40% of GDP over the
coming years,16
which would offer a new alternative for low-risk euro-denominated
investments. EU bonds appear to exhibit better performance when it comes
to risk-off or systemic euro risk correlations,17 and
common liabilities have a more powerful effect on semi-core markets
than core markets, so they can contribute to convergence between euro
area issuers.18
This should, in turn, facilitate the diversification of official
reserves into euros. Supranational issuance is already fairly
well-subscribed relative to national bonds, with a large share absorbed
by central banks.19
However, the additional EU bond supply will only lead to a permanent
increase in the euro’s share of official reserve allocation if reserve
managers are confident such instruments will remain available over an
extended period, possibly beyond the envisaged expiry of the debt issued
under the Recovery and Resiliency Facility in 2058. Otherwise, there is
a risk that EU bonds would merely substitute other euro-denominated
reserve holdings and dampen demand for member states’ sovereign debt.
The
ECB’s Pandemic Emergency Purchase Programme also supports market
confidence in the euro, as it reaffirms the ECB’s ability and commitment
to act as the euro area lender of last resort. The programme’s
flexibility helps to tame divergences across euro area government bond
markets and to reduce sovereign credit risk in high-debt member states.
However, the ECB’s purchases reduce the volume of government debt
securities available to investors. To address this issue, some observers
suggested the ECB could offset this decline in sovereign securities
with the issuance of its own certificates of deposit to expand and
stabilise the supply of euro safe assets.20
Policy coordination. Euro internationalisation may require further efforts, such as enhancing European policy coordination. A well-coordinated economic, fiscal, and monetary policy mix can strengthen confidence that euro area countries can avoid a protracted debt overhang after economic shocks, such as the pandemic. Simple effective rules and procedures would help guide market views, and bolster investor trust. Clear communication and guidance about fiscal and monetary policy outlooks could steer market expectations and underpin confidence in the euro.
Risk sharing. In the long run, a more explicit and permanent public risk mechanism would reinforce confidence in the euro and help mitigate asymmetric shocks. Financing under the Next Generation EU plan will support the recovery from the pandemic shock, but a permanent mechanism for risk-sharing among euro area countries hit by asymmetric shocks is missing. Establishing such a fiscal capacity to stabilise economies beyond the current crisis would reinforce global investor confidence in the euro area’s capacity to respond to economic and financial shocks.
Banking union. Completing banking union and
improving private sector risk sharing would make euro-denominated
financial markets more attractive. More cross-border banking in Europe
is one way to increase risk sharing in the private sector. The
completion of banking union is a precondition for a more integrated
European banking market, including the common backstop to the Single
Resolution Fund and European Deposit Insurance Scheme. Implementing
these projects would strengthen market trust in the ability to secure
financial stability.
Capital markets union. In
the wake of Brexit, European capital markets need to increase their
openness to, and attractiveness for, international capital. Advancing
towards financial union would support an international euro. Financial
market depth and liquidity are key determinants for any currency’s
global status, so progress towards a capital markets union21
– along with completing banking union – would better connect European
capital markets and deepen the euro-denominated markets, making the euro
more attractive and enhancing its use internationally. Connections
established by capital markets integration could also promote private
sector risk-sharing and shock absorption. A more harmonised and
centralised European supervisory authority – mirroring the supervisory
model implemented for banking union – would considerably ease market
access for international investors.22
Green finance. The growing demand for green bonds could be a promising development. A Bank for International Settlements report23
found two thirds of central banks have not included sustainability
considerations in their list of objectives, yet 68% identify scope to
adopt one. The euro would reap advantage from progress on this front,
because almost half the world’s green bond issues are euro-denominated.24 EU residents are now the largest green bond issuers and the Taxonomy regulation25 will likely establish the EU as the largest pool of certified investors for green finance.
Market infrastructure.
Improvements in financial market infrastructures facilitate access by
global investors to euro-denominated markets. Since the euro’s launch,
the Eurosystem has helped reshape and consolidate the infrastructure for
large-value payments, post-trading services, and instant retail
payments, aiming to establish a truly single financial market across
Europe where payments, securities, and collateral can shift safely and
efficiently between participants without friction or restrictions.26
Central bank digital currencies, and in particular a digital euro,
could bring additional payment efficiency gains. Furthermore, there is
room to develop an infrastructure for euro-denominated debt issuance.
One potential change would be to develop a European platform for debt
distribution, where a secure, stable, and transparent market within a
common regulatory environment would nurture euro-denominated debt
issuance.
Reaching beyond the euro area.
Policies could aim to increase the use of the euro in specific markets,
such as the emerging market sovereign debt market or in the energy
sector, based on existing trade and financial links. For countries with
extensive exports to the euro area, scope may exist to use the euro more
widely as an invoicing unit, buttressing the economic rationale to
increase euro-denominated debt issues to mitigate currency mismatches.
Euro-denominated funding and bond issuance by partner countries could
reduce their reliance on the US dollar and expand euro usage in emerging
markets. This development could be augmented by measures to support
euro liquidity on foreign exchange markets, helping the direct
conversion of emerging market currencies into euros. Promoting
euro-based financial instruments to hedge against exchange rate
movements would also help, because even when instruments like
cross-currency swaps are available for emerging market currencies, they
are usually not liquid enough to appeal to investors. Trading through
the US dollar, called triangulation, remains common practice.
Conclusion
A
stronger international role of the euro would benefit both Europe and
the global financial system. It would ensure more stable financing
conditions in the euro area, attract more investors, and help finance
the post-pandemic recovery. A wider global use of the euro would also
allow international borrowers and investors to diversify their exposures
and hedge currency volatilities in the system as a whole. The ongoing
reforms in the European Economic and Monetary Union can support the
common currency on the international scene.
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