Internationalisation of the euro

Fecha: marzo 2020

Iain Begg, European Institute, London School of Economics and Political Science¹

Despite the evident problems of the protracted sovereign debt crisis, the euro is, by any reasonable measure, comfortably the second most important global currency after the US dollar. Yet there has long been ambivalence about what international role the euro should aspire to fulfil, with the European Central Bank (ECB) especially doubtful about a more extensive internationalisation.

In the last two years, this has started to change, although the impetus for change appears to have come more from the European Commission than the ECB or, indeed, the European Council. The Commission (2018) published a communication in which it sets out both the rationale and the conditions for a step-change in the global reach of the euro. It enumerates a range of potential benefits of an enhanced international role, including the overtly political aim of being a ‘tool to strengthen Europe’s influence in the world’. The Euro Summit in December 2018 then asked for work on the issue to be taken forward, usually a signal that there is now political momentum behind a proposal. The ECB approach can be summed up as ensuring the euro is as attractive as possible by further governance reforms, then letting markets decide whether to boost their use of the currency.

This policy note first assesses why it would be in Europe’s interest to have an enhanced international role for the euro, then examines what is required for a currency to achieve this ambition and looks at the evidence on the euro today. After considering the conditions needing to be met, the note considers how to push forward on the global role of the euro.

The rationale for seeking an enhanced international role for the euro
The underlying reasons are not hard to discern. On the one hand, the euro is close to its 21st birthday, the traditional age of transition from youth to adulthood, and could reasonably be expected to broaden its ‘grown-up’ roles and responsibilities. On the other, confidence in multi-lateral institutions has eroded and there is increasing concern that US hegemony is not only fading, but also drifting from being comparatively benevolent vis-à-vis Europe to more overtly hostile. Europe, in other words, has to face up to a range of global challenges, and the future of international monetary arrangement is plainly a key dimension.

For Montoya Acedo and Buti, it is partly a matter of strengthening Eurozone sovereignty, but they also argue that it is ‘time to revisit the policy of “benign neglect” towards the international role of the euro’ because the balance of costs and benefits has changed. However, the stance of the ECB will be crucial. As explained by Benôit Coeuré, former ECB Executive Board member, in a February 2019 speech in New York, the euro’s international role decreased after a high-point reach just prior to the financial crisis. As a result, there is

‘a perception that the EU is more exposed to the risk that the monetary power of others is not used in its best interest or has been used against it. And I guess that’s the starting point for the discussion in Europe’.

Another perspective is offered by Gräb and Mehl in an assessment of the costs and benefits of internationalisation, published in the latest ECB paper on the International Role of the Euro. They recall that, since 1999 and the first speeches on the matter by the ECB President, Wim Duisenberg, ‘the Eurosystem has advocated a policy of neutrality vis-à-vis the international role of the euro’. They explain this position as reflecting an assessment of the trade-off between costs and benefits.

Advantages of a stronger euro role include greater choice for economic agents across the world, against the backdrop of concerns about the US global role, as well as benefits for the Eurozone in a number of respects:

Scope for improved financial stability;
Lower exchange rate risk and costs for European businesses;
Reduced interest rates as a result of greater monetary autonomy by diminishing the spillover of interest changes in, above all, the US. However, while this phenomenon is a real concern for the currencies of small open economies, its impact is likely to be more marginal for the euro;
The prospect of less exchange rate pass-through into inflation and greater monetary policy autonomy: a higher share of imports invoiced in euros would, assuming some short-term stickiness in prices, mean less volatility in prices because of exchange rate movements;
Reduced exposure to external influence, such as extra-territorial sanctions which the US (especially) is able to impose because European banks or companies want to use the dollar. According to the Commission, the exposure would be reduced if transactions were only in euros.

Since the phrase was coined by former French President Valéry Giscard d’Estaing, Europeans have complained of the ‘exorbitant privilege’ enjoyed by the US $. The reason is the advantages for the US economy of being able to capitalise on having the safe asset of the US Treasury bond, thereby being able to finance borrowing by the US government on very favourable terms, while also having its liabilities in the same currency as it issues.

It is not all one way, because the extent of exorbitant privilege comes under challenge in periods of crisis, such as the decade from the onset of the financial crisis in the latter half of the 2000s. As Gourinchas, Rey and Govillot demonstrate, there is a countervailing ‘exorbitant duty’ arising from the responsibility of the leading currency to provide insurance to the rest of the world. They calculate that the US provided a net transfer of wealth, in the form of a reduction in its net foreign assets, in two episodes: the financial crisis (19% of GDP) and the euro crisis (a further 17% of GDP). The resulting open question for the Eurozone is whether the balance of privilege and duty, so defined, is one it is ready to accept.

Attributes of an international currency
In April 2008, as the financial crisis was intensifying, Menzie Chinn and Jacob Frenkel published an article in which they concluded ‘that the euro may surpass the dollar as leading international reserve currency as early as 2015’. Their principal argument was that the persistent depreciation of the dollar would weaken its appeal for, and hold on, global investors. Their analysis was careful, cautious and historically grounded, bearing in mind how rapidly the pound had been supplanted by the dollar in the mid-20^th Century. But with the benefit of hindsight, it was also mistaken.

Earlier, in 2003, Jerry Cohen had predicted the euro was ‘fated to remain a distant second’ to the dollar, a theme to which he has repeatedly returned. Among his key arguments were the flaws in the institutional design and governance of the euro. In subsequent work, published in 2015, Cohen has also turned his gaze to the renminbi, but reached broadly the same conclusion: in the Darwinian flight for supremacy ‘only the dollar embodies the full list of attributes that make a currency internationally competitive’. As he also put it:

“Dollar pessimists, it turns out, are like members of one of those religious cults that predict the end of the world at noon tomorrow. How do we explain, the day after, why we are all still here?”

A hegemonic currency does not necessarily require the most powerful economy, though it plainly helps. Nor need there be only one dominant currency; indeed, as Barry Eichengreen explains in his magisterial volume on exorbitant privilege having a multi-polar system is far from unusual, and he recalls how the pound and the dollar co-existed in the inter-war years. Even so, it would take egregious policy mistakes by the US for the dollar’s status to be compromised.

To be credible, any aspiring global currency has to command widespread support in financial markets and the confidence of prospective users. Liquidity is unavoidably part of the story and here the Eurozone lags behind the US, but is well ahead of China. Moreover, rivals would need to establish the necessary pre-conditions. The two most likely ones, China and the Eurozone, continue to exhibit major shortcomings. As Eichengreen rather tartly puts it, the ‘Euro is a currency without a state’, while the renminbi ‘is a currency with too much state’. The necessary attributes for an international currency, can be linked to the three basic functions of money: unit of account, store of value and medium of exchange. Elements of these functions, together with governance provisions suggest five requirements for an international currency:

1. A large market, rich in transactions
2. Robust, stable and transparent institutions
3. Deep and liquid financial markets.
4. Having an internationally accepted and safe asset: in a turbulent world, investors are arguably more likely to want the currency that is the safest of havens, even if this means accepting lower returns on assets.
5. The backing of a powerful state

Whereas the US can reasonably point to all five being fulfilled, the euro is deficient in the last two and would need to bolster the second and third. The EU also has to ponder how ambitious to be and what time-scale is realistic. Although, as the ECB repeatedly asserts, markets will ultimately determine usage of the euro for transactions, the EU can try to accelerate the process, for instance by using its market power to develop a strategy to reduce the share of dollar invoicing in key sectors, such as energy.

The evidence
The international role of the euro can be measured on a number of different criteria, starting with its share of global holdings of international reserves. As figure 1 shows, throughout its first decade the euro accounted for around a fifth of the total, less than a third of the US$ share, with a smattering of other currencies sharing the rest. In its latest report annual report on the international role of the euro, the ECB notes some evidence of diversification away from the dollar, not least because of the hostile approach to sanctions by the US authorities. Nevertheless, the gap in shares remains striking.

European financial intermediaries have paid large fines to US authorities which they have had to tolerate for fear of losing market access. While there is a wider agenda about the relative lack of presence of Europe on the global stage, going beyond internationalisation of the currency, these fines clearly cause resentment in Europe. A recently compiled infographic by Refinitiv shows just how substantial some of these fines have been, running to hundreds of millions of dollars for breaching US Treasury Office of Foreign Assets sanctions.

Figure 1 Currency composition of official foreign exchanges reserves (% share of allocated reserves)

Source IMF:

On other indicators, the story is more mixed. Measures of the use of the euro for transactions, such as invoicing, generally show the great pre-eminence of the dollar. Thus, according to the ECB’s 2019 analysis:

The share of the euro in international debt issuance was stable between 2017 and 2018 at 23%, down from around 30% in the mid-2000s, but the dollar share has increased by twenty percentage points over the same period to 63%;
However, euro debt is concentrated in developed Europe and Canada, with the dollar dominant in the Middle East and elsewhere;
The share of the euro in invoicing for exports outside the euro area has been stable at around 50-60% over the last decade and is very high for exports to non-euro EU countries, but is very low for exports to the US;
In contrast to the dollar, the euro is little used for invoicing not involving the euro area, although Member States in central and Eastern Europe, as well as Turkey do use the euro to trade with one another;
Differentiated goods are more likely to be invoiced in the exporter’s currency, whereas homogeneous good (such as oil) are more likely to be invoiced in the dominant currency;
Euro use for cash purposes is quite extensive in the non-euro area countries of central, eastern and south-eastern Europe.

In addition, the 2018 Commission communication cites data from Swift showing global payments in euros were very close to those in dollars in 2017, at 36% and 40% respectively. In earlier years, the euro share exceeded the dollar share significantly, but fell back in the period 2014-16. But these data only really reflect the size of two advanced economies with broadly similar numbers of transactions, most internal.

Preconditions
Several pre-conditions will have to be met for the euro to make advances. Completing economic and monetary union by further governance reforms is vital, bearing in mind it is only a few years since the very survival of the euro was in doubt. Although, by the EU’s normal standards, the extent of reform in recent years is impressive, there are continuing gaps resulting from the tendency to ‘kick the can down the road’ when politically awkward issues arise. These include:

An incomplete banking union, still without a coherent fiscal backstop and with unresolved disputes over the scale and scope of common deposit insurance;
Less progress on advancing the project to create a capital markets union than would be required to ensure deep and liquid financial markets;
The continuing inability, despite a plethora of proposals, to establish a European safe asset, regarded by Benoit Coeuré as ‘a dominant factor keeping the euro from having a stronger international role’;
A confusion of voices representing the euro, whether in international bodies (such as the IMF) or when communication is needed, for example to reassure economic actors in time of crisis;
Sometimes too easily neglected is the need for political momentum behind a project that can elicit weighty opposition.

Because a European safe asset is widely regarded as an essential development without which internationalisation of the euro will remain stalled, the options for creating one deserve attention. Continuing resistance from net creditor members of the Eurozone to fully-fledged Eurobonds – jointly and severally guaranteed – rules out an asset with the same depth of appeal as the US Treasury bond. But there is no shortage of creative thinking on new financial instruments with attributes sufficiently ‘safe’ to fulfil the criteria markets seek.

Leandro and Zettlemeyer assess four distinct approaches, all of which they adjudge to be capable of generating sufficient assets to substitute for national sovereign debt, yet without requiring the national guarantees likely to foment resistance. In a subsequent paper they revisit the question focusing on avoiding mutualisation of risk. Giudice, de Manuel, Kontolemis and Monteiro look specifically at E-bonds, a form of safe asset that involves a supranational agency borrowing from the market, then issuing bilateral loans to member states. The table below summarises these authors’ assessments of the implications in key respects.

Table Proposals for a European safe asset assessed

* A ‘senior’ bond will only be at risk of default once ‘junior’ bonds from the same issuer have been wiped-out. This makes them safer.

Source: derived from Leandro and Zettelmeyer, and Giudice et al.

Beyond the immediate proposals for a safe asset assessed in the table above, the longer-term goal of having Eurobonds as part of the EMU architecture deserves attention. The ‘purple bond transition’ proposal from Bini Smaghi and Marcussen would entail distinguishing between debt up to 60% of GDP – consistent with the Maastricht debt criterion and the revised Stability and Growth Pact – guaranteed by (for example) the European Stability Mechanism) and higher levels of debt which would not be guaranteed. By providing a twenty-year transition towards lower debt levels, the scheme would facilitate the introduction of true Eurobonds.

Conclusions on ways forward
Bridging the gap between the euro and the dollar will not be easy, if only because of the incumbency advantages of the latter, nor will it happen quickly. Yet there is manifestly a political will to try. Could all this change and, if so, how rapidly? There is obvious resentment at the direction of US policy, not least on secondary sanctions, alongside a recognition that China will, in future, be a rival in key domains. On the US side, ‘weaponization’ of the dollar in the pursuit of foreign and economic policy objectives, already visible under previous presidents, has become increasingly prominent under the Trump administration. It can be viewed as a form of bullying, manifesting itself in various forms. There have been demands on companies, such as not to trade with Iran or to help in the construction of the Nordstream II pipeline from Russia to Germany, on pain of being excluded from US markets, with use of the dollar as the instrument

The upshot has been to strengthen the sense inside Europe that more has to be done to emphasise European autonomy in international matters. Coeuré detects ‘the growing perception of a shift in global governance, from leadership built on trust and common identities – what the ancient Greeks called hegemonia – to leadership based on arkhe, hard power where policies and doctrines are imposed on others’.

What the Commission proposed in its 2018 communication is a credible mix, comprising four sets of measures:

Completion of monetary union, alongside a banking union and a capital markets union;
Deepening the European financial sector;
A range of measures to facilitate use of the euro in international financial transactions and as a reserve currency;
Promoting the use of the euro in sectors deemed to be instrumental in boosting euro use, notably energy, food, other raw materials and the transport sector.

Some of these measures aim to build on Europe’s aggregate weight in global sectors, but could face an uphill battle. In particular, the halting progress on completing EMU and ambivalence about an integrated financial sector continue to be problematic. Poul Thomsen, the IMF’s Director for Europe, highlights the incomplete EMU and the continuing reluctance of Eurozone members to commit fully to the rules and other processes of governance of the euro as fundamental obstacles. The inference he draws is that it may be better to look at enhancement of the euro’s global role as ‘a welcome bi-product of changes needed to make the euro work better for Europe’. He is also sceptical about the prospects for boosting euro use in pricing of global commodities. As he notes:

‘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.

While his reservations are well-founded, Thomsen may be unduly pessimistic. The Von der Leyen Commission has made enhancement of Europe’s global influence a priority and sees the euro as a relevant and crucial instrument. There is an evident desire to move on from the ‘benign neglect’ of the international role and the current circumstances for breaking the deadlock on completing EMU are propitious. It may be unrealistic to expect early resolution of all the shortcomings in governance, but breakthroughs on banking union and a safe asset could come relatively quickly.

Despite the magnitude of the challenge, if the EU/Eurozone can overcome its penchant to procrastinate, the opportunity is there to achieve real advances and to initiate the sort of virtuous cycle portrayed in figure 2. It will not occur quickly and it would be prudent to envisage a ten to twenty year time-scale, rather than a rapid leap forward, but a significantly enhanced international role for the euro is a credible objective.

Figure 2. Pathway to an enhanced global role for the Euro: a virtuous cycle

Source: own elaboration

¹ I am grateful to Raymond Torres, Director for Macroeconomic and International Analysis at Funcas, for very helpful suggestions