EMU and the International Monetary System

Comments on Bergsten and on Alogoskoufis and Portes

Thomas Krueger, Paul Masson, and Bart Turtelboom
Published Date:
September 1997
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Masahiro Kawai

This discussion has two objectives. One is to make comments on the papers by Alogoskoufis and Portes and by Bergsten, which examine the prospective implications of the creation of the EMU and the introduction of a single currency, the euro, for the international monetary system. Another objective is to reexamine this issue from Asian perspectives.

General Comments on the Papers

The creation of EMU and the introduction of the euro will fundamentally alter the international monetary system. Both papers argue that economic and monetary unification of some of the EU countries will produce a euro capable of challenging the U.S. dollar dominance and converting the international monetary system into a bipolar regime centered on both the U.S. dollar and the euro. The Japanese yen, while still important, would play a far less significant role.

Lingering Questions

There are, however, some questions to be answered before we can conclude that the euro will indeed become a real competitor currency for the dollar.

  • Is the Bundesbank anti-inflationary credibility easily transferrable to the newly established ECB? Any central bank would have to deliver price stability before it can convince the public that it is indeed pursuing an anti-inflationary policy. It usually takes a long time to build such credibility.

  • How many countries will join EMU? If the de facto deutsche mark—area countries—Austria, Belgium, France, Luxembourg, the Netherlands, and Germany—become the only members of EMU, the Bundesbank credibility would be easily transmitted to the ECB. However, if a wider array of countries, particularly the so-called Club Med (Italy, Spain, and Portugal), were to be included in EMU, it would be harder for the ECB to establish its reputation as an anti-inflation central bank.

  • If the ECB is successful in pursuing a credible anti-inflationary policy, will countries in Central and Eastern Europe, the Mediterranean, and North Africa be able to peg (or stabilize) their exchange rates to the euro? To the extent that exchange rate pegging (or stabilization) is considered too costly because the ECB’s restrictive monetary policy is detrimental to their growth and employment, these countries will choose not to join the euro area and the role of the euro will be limited.

  • Is the ECB willing to promote the euro as an international currency, while the Bundesbank has not promoted the deutsche mark for fear of losing the ability to conduct an effective monetary policy? If the ECB wishes to retain effective monetary control mechanisms for price stability, it may not want to promote the euro as an international currency, thereby limiting the global role of the euro.

  • Will EMU countries maintain tight fiscal policy in accordance with the Stability and Growth Pact? If fiscal policy is too tight, adhering to a strict interpretation of the Pact, it may continue to depress the European economy. If fiscal policy is too expansionary, assuming a more flexible interpretation of the Pact, monetary policy credibility may be adversely affected and a weak euro may emerge.

  • Can Europe establish a full-fledged money and capital market that is comparable to that of the United States in terms of breadth, depth, and liquidity? The euro is unlikely to evolve into a currency capable of rivaling the U.S. dollar without such a market.

  • Fundamentally, can a unified Europe exhibit dynamic economic performance, despite the well-known rigidities in the labor market that have kept the rates of unemployment high? EMU would simply become another huge welfare state with an unattractive currency, if major structural reform were not undertaken.

These are some of the important questions to consider before predicting a bright future for EMU and the euro during the transition period.

Fundamentals Versus Inertia (or History)

Both the Alogoskoufis and Portes paper and the one by Bergsten discuss the presence of two opposing forces—changes in fundamentals versus inertia or history—affecting the global roles of the euro and the dollar. Bergsten reports that the trade flow of the EU’s Core-Six members (Austria, Belgium, France, Germany, Netherlands, and Luxembourg) is already larger than that of the United States. The relative weight, measured by GDP, of the EU-15 is greater than that of the United States. In addition, Central and Eastern European countries have increasingly been integrated with the EU and are expected to be EU members in the twenty-first century. Given the contention that large relative size is an important criterion for a key currency, the creation of EMU itself constitutes a fundamental change, pointing to the eventual emergence of the euro as a competitor for the U.S. dollar. However, the force of inertia and history of the U.S. dollar as the world’s only key currency, enjoying incumbency advantages, will continue to work in the opposing direction. The U.S. economy’s relative weight in the world has declined over time and the United States has run persistent current account deficits since the first half of the 1980s, with a consequent, long-term decline in the value of the U.S. dollar relative to the deutsche mark and the yen since 1985. Despite all this, the U.S. dollar continues to play a dominant international currency role for reasons of economies of scale, network externalities, hysteresis, and its public goods nature. Many traders and investors still rely heavily on the U.S. dollar, despite the less favorable conditions that have generated the strength of the dollar.1 The incumbency advantage suggests that it requires a great deal for a newly emerging currency to seriously challenge the dominant one. This includes, for example, a dynamic, sustained economic growth of the EU relative to the United States, an issue I would like to come back to below; critical, discontinuous disruptions in the world economy; and a set of fundamental economic difficulties in the United States such as rampant inflation, large-scale dollar depreciation, and severe capital controls. Without such fundamental breaks, it would be hard for the euro to seriously challenge the dollar’s global key-currency role.

Structural Rigidities

I would like to close this part of my discussion by pointing out that both papers significantly underestimate the implications of structural rigidities in Europe’s labor market for the external value of the euro. It is quite possible that such structural rigidities will be a severe impediment to the rapid emergence of the euro as the world’s major international currency, and as a serious competitor currency for the U.S. dollar. This is because the euro, which must challenge the incumbency advantage of the U.S. dollar, will be severely handicapped as a serious contender if structural rigidities are not addressed. Without structural reform, the EU’s dynamic growth prospect would be limited. The euro would not be as attractive an international currency as the incumbent U.S. dollar, and relative parity between the euro and the dollar would never be achieved. Bergsten’s claim that markets prize stability more than growth may apply to the incumbent, but not necessarily to a newly emerging challenger, which would place a higher weight on growth.

Nominal Anchor Currency Role of the Dollar, Euro, and Yen

Although Bergsten uses the term key currency, he does not clearly define what it is. He appears to be using the term interchangeably with “dominant international currency,” particularly for transactions and reserve purposes. The term key currency was used 50 years ago by John Williams (1947) more narrowly to mean a target or nominal-anchor currency to which other countries attempt to peg their exchange rates. In this part of my discussion, I would like to focus on the nominal anchor currency role of the U.S. dollar, the prospective euro, and the Japanese yen and to report the measured size of the respective currency areas.2

First of all, we identify what currency or currency basket each country has so far chosen as a nominal anchor, that is, as a target currency or currency basket for exchange rate stabilization. To do this, we extend work by Jeffrey Frankel and his coauthor (Frankel and Wei, 1993 and 1994) and attempt to find whether each country’s exchange rate is affected by the currencies of major industrialized countries, such as the U.S. dollar, deutsche mark, French franc, pound sterling, Japanese yen, and SDR, and several other regional currencies depending on colonial, historical, geographical, and other relevant considerations.3 Specifically, we regress the log first difference in a country’s exchange rate (measured in terms of the Swiss franc) on a constant term and the log first differences in the exchange rates of the major and other relevant minor currencies (all measured vis-à-vis the Swiss franc).4 The coefficients that are estimated to be statistically significant are interpreted as the weights assigned by the authorities to the corresponding currencies in their exchange rate stabilization policies.

Next, GDP is used to measure the economic size of the currency areas for the euro, the U.S. dollar, and the yen. For a country pegging its exchange rate to a particular currency, its entire GDP is classified as belonging to the currency area formed by this particular currency. If a country does not peg the exchange rate to a single currency but instead assigns several different weights to a basket of major or regional currencies, its GDP is divided according to these weights and distributed to the corresponding currency areas. See Table 1 for a summary.

Bergsten’s Table 1 considers the case of the Core-Six forming EMU, the case of the EU-12, which includes all countries currently in the ERM, forming EMU, and the case of the EU-15 forming EMU. The last scenario, while highly unlikely in the near future, is presented for reference purposes. The intermediate case indicates that about 45 percent of the world economy is covered by the U.S. dollar area, 30 percent by the euro area, and less than 20 percent by the Japanese yen area. The dollar area is large because many developing countries regard the dollar as the most important global anchor. The Japanese yen area occupies 19.4 percent, which is slightly larger than the weight of the Japanese economy in the world. The yen area outside Japan is less than 0.3 percent of the world economy and, hence, the yen cannot be said to be a full-fledged, global nominal anchor currency.

Limits to the Yen’s International Currency Role

The weight of the Japanese yen as an international currency has been limited both in comparison to the U.S. dollar and the deutsche mark and relative to the size of the Japanese economy. The yen has not been playing a major role as international money or as a nominal anchor to which other countries may peg, or stabilize the value of, their own currencies. Several explanations can be given for the limited use of the yen as an international currency.

First, use of the Japanese yen in invoicing Japan’s trade has been limited due to the country’s specific trade structure. Japan has been dependent on the United States as its major export market and on imports of large quantities of minerals, fuels, raw materials, and basic commodities for its industrial production. Trade with the United States and trade in primary commodities tend to be dollar denominated, further reducing the use of the yen.

Second, Japanese money and capital markets, particularly for treasury bills and other private short-term instruments, have not been as well developed as markets in New York or London. Functional and institutional limitations, the lack of a market infrastructure with a global standard, and overregulation in Tokyo money and capital markets have been pointed to as severe impediments to an expanded use of the yen by many authors (see Hamada and Horiuchi, 1987; Kawai, 1996; and Garber, 1996). As a result of these impediments in the Tokyo markets, foreign monetary authorities and private investors have been reluctant to use yen instruments to carry out international trade and capital transactions.

The third explanation concerns the historical context of Japan’s postwar economic development. The post-World War II reconstruction and growth of the Japanese economy were made possible by financial aid and trade opportunities provided by the United States. Japan received U.S. aid during the reconstruction period, depended on the open U.S. market for its subsequent exports, and relied on the U.S. dollar money markets to finance its trade and balance of payments. Essentially, Japan commenced its postwar growth as a dollar-area country, just as many other East Asian economies and, to some extent, Western European countries did. Western European countries were at a similar stage of economic development, and their economic interdependence, particularly through foreign direct investment and intra-industry trade, deepened naturally and rapidly after the postwar reconstruction. Therefore, given the high degree of regional trade and investment interdependence, it is not surprising to see a high proportion of intra-European trade being invoiced in these countries’ own national currencies. In contrast, Japan’s postwar development far outpaced other East Asian economies and its trade with developing East Asia tended to be an interindustry, rather than intra-industry, type. Most of Japan’s trade with other East Asian economies, which were basically dollar-area economies, was invoiced primarily in the U.S. dollar. This is the historical context of Japan’s rapid economic growth and trade expansion, which has not been matched by a commensurate increase in the use of the yen as an international currency.

Fourth and finally, the developing East Asian economies have had little incentive to stabilize their currencies against the Japanese yen. The rapid economic development and growth in East Asia in the last 10 years have been made possible partly by the steep appreciation of the Japanese yen vis-à-vis the U.S. dollar that started in 1985. The steep yen appreciation has forced Japanese manufacturing firms to cope with the reduced international price competitiveness and generated foreign direct investment in the manufacturing sectors in the developing East Asian economies, particularly Asian newly industrializing economies and ASEAN, which have been transformed into a cost-competitive industrial base. (Since the late 1980s, ASEAN countries have received foreign direct investment inflows from the Asian newly industrializing economics, which have experienced currency appreciation and wage-cost increases.) The foreign direct investment inflow into East Asia has expanded exports of industrial products and contributed to dynamic economic growth. To summarize, the East Asian economies would not have enjoyed an explosive economic performance if they had stabilized their exchange rates against the Japanese yen. They have maintained stable exchange rates vis-à-vis the U.S. dollar, thereby importing monetary discipline from the United States and taking advantage of the yen rate appreciation to accomplish substantial restructuring of the economy.

Possibilities for an Increased Role of the Yen

Bergsten argues that the international role of the yen will continue to be limited owing to Japan’s continued failure to deregulate and modernize its money and capital markets, the continued fragility of its financial sector, and a prolonged period of stagnation. One of the possible implications of the limited role of the yen would be a larger role of the euro in East Asia. However, one can make a case for a growing role of the yen, since the above-mentioned factors limiting the international use of the yen are gradually disappearing.

First, Japan’s trade structure has been changing in the last 10 years. With diversified trade partners and increased intra-industry trade, Japan has been importing increasing amounts of manufactured products, particularly from East Asia. These changes are expected to increase the international use of the Japanese yen as a trade-invoicing currency.

Second, serious deregulation and liberalization of Japanese money and capital markets may proceed over time. This can be brought about partly by the U.S. pressure (gaiatsu, or external pressure) to further liberalize and to open the Japanese financial markets, and partly by the Japanese government's reaction to the “hollowing out” of the Tokyo money and capital markets. The latter example includes Prime Minister Ryutaro Hashimoto's November 1996 announcement of Japanese-style “big bang,” overhauling and liberalizing the Japanese financial sector by the year 2001.

Third, Japan's economic interdependence with East Asia will increase over time, aided by previous substantial yen appreciation and the rising trends of intra-industry trade in machinery and equipment, direct investments, and various types of financial flows.5 This points to a possibility of a rising international role of the yen in East Asia. This process will be hastened as the East Asian economies grow further, raise their per capita income, and become similar to Japan in their economic and industrial structure and in the composition of output and trade. In addition, there is evidence that the yen is being used widely to denominate long-term debts in East Asia; the East Asian economies have shifted the currency composition of external debts away from the dollar toward the yen since the 1980s (Tavlas and Ozeki, 1992, and Kawai, 1996).

Fourth, Japan’s low, stable inflation together with the continuous current account surpluses will enhance the attractiveness of the Japanese yen as an international currency6 In contrast, the continuous current account deficits posted by the United States and the precipitous decline in the value of the dollar may reduce its international role. If the international use of the dollar declines relatively in East Asia, it is likely to be accompanied by a rise in the use of the yen in East Asia.

Thus, one cannot deny a distinct possibility that the East Asian economies will start regarding the yen as one of the important nominal-anchor currencies, while the role of the U. S. dollar will continue to be significant because of the effects of inertia and history. The yen may come to share the nominal anchor-currency role with the dollar in East Asia, in the sense of receiving greater weights assigned by the East Asian authorities in their currency basket policies.7

Broader East Asian Perspectives

How will the developing East Asian economies be affected by the creation of EMU? What benefits and costs will it bring to East Asia? Will the euro become an important key currency in the region? It is important to examine the impact that the creation of EMU and the introduction of the euro might have on East Asia, because East Asia is relatively large in economic size, it is a dynamically growing part of the world economy, and it holds large quantities of foreign exchange reserves.

There are three positive effects on East Asia. First, the emergence of the euro will give private traders and investors a wider menu of dominant international currencies to choose from. They will be able to reduce exchange risks by diversifying the currencies used in international transactions. Second, investors will have greater access to a larger, and more efficient, financial market in a unified Europe, which does a great service to everyone in the world. East Asian investors will be able to diversify their portfolios across international financial instruments in a broad, deep, liquid market. Third, as Fred Bergsten suggests, the emergence of the euro will place considerable limits on the policy autonomy of the United States. The United States will be forced to pursue macroeconomic policies conducive to maintaining sustainable current accounts and avoiding rapid dollar depreciation. This is a welcome consequence because it ensures a stable purchasing power and increased attractiveness of the U.S. dollar, the dominant international currency in East Asia.

Despite its predicted increased role in East Asia, the euro is unlikely to rise to the status of a major key currency, because this region is less integrated in trade and foreign direct investment with Europe than with Japan and the United States. The continued structural rigidity of the EU economy is another reason why the euro may not serve as an important key currency in East Asia where economic growth will be much higher than in Europe. The EU is expected to continue to face aggressive trade behavior by East Asian firms, and this trend would be strengthened if East Asia chose to stabilize its exchange rates to the euro. The Asian economies in the euro area, therefore, would be forced to realign exchange rates frequently. This suggests that, while its international role may rise in East Asia, the euro is not a realistic candidate for East Asia’s nominal anchor currency.

One must point out some possible costs of EMU to East Asia. First, to the extent that the emergence of the euro increases currency substitution, greater fluctuations of the exchange rates among the euro, the U.S. dollar, and the Japanese yen are expected. Given that the East Asian economies trade with the United States, Japan, and to a lesser extent Europe, exchange rate fluctuations among the three major currencies can pose a large strain on many economies, Second, a unified, larger Europe tends to exert a greater financial and macro-economic influence on the East Asian economies, which have so far been affected largely by U.S. and Japanese economic conditions. They increasingly will have to take into account shocks emanating from Europe in their macroeconomic management. In addition, greater financial interdependence with Europe implies that there will be a greater risk of sudden capital inflows and outflows, increased pressure on the exchange rate, and undesirable effects on financial institutions in East Asia.

The East Asian economies have developed several forums for financial co-operation by finance ministers and central bankers, such as EMEAP (Executives Meeting of East Asia and Pacific Central Banks), the Six Markets Meeting, and the APEC Finance Ministers Meeting. One of their objectives is to establish a cooperative framework to cope with possible currency and financial crisis of a Mexican type through frequent exchanges of information and bilateral repurchase agreements involving U.S. dollar-denominated foreign exchange reserves. There is even a talk of establishing an Asian BIS. A possible rise in the international use of the euro in East Asia would eventually require closer coordination of financial and exchange rate policies between East Asia and Europe. In addition to the existing arrangements, a framework for geographically wider cooperative mechanisms would have to be developed to ensure exchange rate, financial, and macroeconomic stability.

International Policy Coordination in a Tripolar World Economy

The creation of the euro is highly desirable from a global perspective. It is important, however, to emphasize that the transition process should be orderly, without causing large disturbances to the rest of the world. Both Alogoskoufis and Portes and Bergsten correctly point out that the emergence of the euro as a major international currency is likely to be a cause of instability in the international monetary system and, therefore, requires effective monetary cooperation between the EU and the United States. Regardless whether the forthcoming international monetary system is bipolar or tripolar, Japan must be part of such cooperative arrangements given its large economic size and influence over East Asian economies. In the steady state, avoiding wild exchange rate fluctuations among the major currencies will continue to be an important policy objective not only for Europe, the United States, and Japan, but also for the rest of the world, particularly developing economies that need stable exchange rates among the major currencies. Greater effort is needed to develop a framework for international monetary coordination to maintain stable exchange rates among the euro, the dollar, and the yen.

The U.S. share in world output, though declining over rime, remains larger than the share of the EU-12, so a noticeable decline in the international role of the U.S. dollar is not to be expected, at least in the foreseeable future. The output level of the United Kingdom was overtaken by the United States in the 1880s and the gap continued to widen after that. Despite this, the pound sterling remained the most dominant international currency until the 1930s, when the role of the U.S. dollar became equally important. The dollar became the most dominant currency only in the 1950s and 1960s. Bergsten, however, argues that trade flows would be a more appropriate measure of economic size.

Statistics cited here draw on Kawai and Akiyama (1997).

Since some countries are known to stabilize their exchange rates against currencies other than major industrialized countries’ currencies (i.e., the South African rand in Africa, and the Australian dollar, the Singapore dollar, and the Indian rupee in Asia), we include in the regression equation the exchange rates of such relatively minor or regional currencies for certain groups of countries.

ln carrying out econometric exercises, we have deleted data observations with values of log first differences greater than 0.1 to eliminate the effects of discrete currency revaluations or devaluations.

See Kawai (1997) for the interactions between Japan's trade and foreign direct investment particularly vis-à-vis developing East Asia. One must note that, even though new foreign direct investment flows have been declining in volume, reinvestment of retained profits has been rising and is now an important part of Japan's foreign direct investment in East Asia.

Current account surpluses, other things being equal, are expected to increase the use of the yen in Japan’s international trade and finance for two reasons (see Kawai, 1994). Since exports exceed imports, the weight of the yen used to denominate trade becomes higher than otherwise, given that the proportion of exports denominated in yen is generally bigger than that of imports. Japanese investors, to the extent they care about exchange risk, are likely to demand increasingly that their foreign investments be denominated in yen.

Hence, the yen’s role will not be as distinct as the one played by the deutsche mark in the EMS. Even in Western Europe, however, the nominal anchor-currency role of the deutsche mark appears to have been shared by the French franc in recent years (see Kawai and Akiyama, 1997).


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