EMU and the International Monetary System

Comments on Masson and Turtelboom

Thomas Krueger, Paul Masson, and Bart Turtelboom
Published Date:
September 1997
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Bandid Nijathaworn

Let me begin first by thanking the Fund for inviting me to be a discussant in this session. Today I have been asked to comment on the paper by Masson and Turtelboom. Also, I have been asked to go beyond the scope of the paper and to speculate on the attractiveness of the euro from the perspectives of Asian countries. Because time is limited, I will focus my comments on these two topics.

First, the paper. I find it to be a major undertaking that tries systematically to come up with initial answers to the two important questions that are now on the mind of most market participants regarding the euro. First, will the euro facilitate greater macroeconomic stability in Europe? And second, what would be the prospect of the euro as a reserve currency?

In spite of the limitations posed by simplified assumptions and model calibration, the paper has come up with two important tentative findings. The first finding is that a more symmetric European monetary policy would have the result of reducing the variability of European macroeconomic indicators, with inflation targeting providing the largest gains in macroeconomic stability, as well as lower variability of short-term interest rates and the exchange rate of the euro against the dollar. The second finding is that, drawing on the above results and assuming away credibility problems, the paper concludes that holding of euro reserves should be about as attractive as the deutsche mark from a portfolio balance perspective.

These findings are very positive for the EMU and they sound very plausible. However, they must be carefully interpreted in light of a number of important limitations and uncertainties that cannot be adequately captured by a modeling exercise, as well as in light of the recent developments in financial markets. It is on this basis that I would like to offer specific comments.

First, if we look at the recent macroeconomic data, say, from 1986–95, it is clear that the EU data aggregates already give the picture of a relatively more stable European economy than do the national numbers. For example, the standard deviations of output, inflation, and short- and long-term rates do exhibit reduced volatility compared to the national variables, and compare quite well with the United States and Japan. There is, however, a trade-off between volatility and level. While the aggregate EU data on GDP growth from 1986 to 1995 has been approximately equal to that of the United States and Japan, EU inflation and interest rates have been higher than those in either the United States or Japan.

Against this background, the main uncertainty in moving to a single monetary policy is that there is no guarantee that the stability of the money demand function would continue after EMU. If the relationship was more unstable, the gains in macroeconomic stability might not be as large as postulated by the model. The point I would like to stress is that EMU is, by all accounts, an important “institutional” change. And we have seen that for a number of countries over the last decade, institutional change has been an important explanation of at least some changes that have taken place in the demand for money behavior. This is also likely to occur in the case of EMU because the shock of the conversion process will induce the private sector to shift their currency holdings in the early stage of EMU. This effect, therefore, is an important qualification in interpreting the model results, especially on the expectation of reduced volatility in interest rates. My view is that reduced volatility in short- and long-term interest rates might not be as great as those depicted by the model despite lower inflation expectations and the removal of foreign exchange risk. The trade-off on the level could also be slightly higher because of the added uncertainty on the fiscal outlook.

Second, another important qualification that may weigh on the model results is the transmission mechanism of monetary policy itself. Under one monetary policy–one interest rate setting, the effect of an interest rate change on price and output would be even more limited compared with the situations under individual monetary policies. As we know, the effect depends on how efficiently the product and factor markets respond to changes in interest rate. On this very point, many observers have raised the issues of productivity differentials and limited labor market flexibility and mobility as being possible limiting factors that could hinder the effectiveness of a European-wide monetary policy. On this note, interpretation regarding the effectiveness of monetary policy, especially on output, would have to be made very carefully. These points on the structural changes have also been noted in the paper, and they are quite important.

Let me now turn to the second part of my remarks, on the attractiveness of the euro from the perspective of Asian countries. As noted in the paper, Asia’s combined holding of global foreign exchange reserves was about 41 percent in 1995. The figure could be slightly higher at end-1996 on account of continued capital flows to Asia. The primary purpose of holding reserves is for foreign exchange intervention. Given that the U. S. dollar is an important anchor currency for a large number of exchange regimes in Asia, a large proportion of reserves tends to be held in U.S. dollars.

With the introduction of the euro, a key question is how the relative proportion of reserve holdings will change. This is a very difficult question to answer because it depends on a number of factors. In my view, the attractiveness of the euro will depend on three important factors.

The first is the confidence in the external value of the euro. This will relate primarily to the economic fundamentals of EMU and the soundness of financial policies. As we all know, market preference is for currencies with relatively low inflation costs.

The second factor is the openness and the degree of financial markets development of the issuing country, in this case the EU-15. Such development will help support the liquidity function of the euro through a large assortment of financial instruments as well as a deep and well-developed secondary market.

The third factor is, of course, trade volume between EMU and Asia. This will be an important demand side factor for enhancing the demand for the euro as reserve asset.

Let me elaborate on each of these three points in turn. The ECB’s main mandate is to preserve price stability. I believe there will be a strong showing on the part of the ECB to demonstrate this commitment in its conduct of monetary policy, resulting in a low and stable rate of inflation in Europe. This will definitely provide support for the euro and build credibility for the ECB’s monetary policy. The main risk, as I see it, is how far fiscal commitment will go to support the configuration of financial policies that is necessary for sustaining macroeconomic stability within EMU in the medium term.

Although the Stability and Growth Pact has laid down a number of important procedures for fiscal consolidation within EMU, some observers have pointed to the problems of weakening competitiveness and the possible need to stimulate demand to lessen pressure on unemployment at the national level as being possible conditions for the fiscal deficits to remain stubborn. How such pressure will evolve over time remains to be seen. But a loose fiscal policy will not act to consolidate the strength of the euro in the medium term.

On the issue of financial markets development, I am quite positive that a market in euro-dominated financial instruments will be developed quickly to support the role of the euro as an international currency. The market is, and has been, preparing for this change for some time. As a result, the market for euro financial instruments is expected to be large and liquid, supported by the presence of and the competition between European financial institutions in the global market, as well as by the efficient clearing and settlement system. These facilities will increase the liquidity of the euro and hence the attractiveness of the euro as a reserve currency.

A more uncertain issue is the evolution of trade between EMU and Asia. At present roughly 14 percent of trade of the EU-15 is with Asia, while about 61 percent is intra-EU trade. After EMU, the intra-EU component will become domestic, thereby raising Asia’s share in EMU international trade to about 35 percent. A first key question is how the structure of European international trade will evolve after EMU. Because of the absence of foreign exchange risk, it is expected that initially intra-EU trade and investment will expand in response to the benefits of increased economies of scale, reduced transaction costs, and the benefits of more direct price comparisons, which tend to induce stronger competition. Thereafter, the scope for a further expansion of trade between Asia and EMU should be strengthened on account of Asiașs continued demand for specialized machinery and capital goods from Europe while supplying the lower-cost consumer products and basic commodities to the EMU. Trade relations should also be strengthened through bilateral government arrangements, for example, through the initiatives of the recent Asia-Europe summit. These developments should raise the relative importance of European trade in Asia, and enhance the demand for euros in the Asia-Pacific region.

On the whole, I see good prospects for the euro to emerge as an important reserve currency in Asia. The three factors cited above will be important especially in the medium term. The implications associated with the immediate transition period are, however, more difficult to gauge with a firm degree of confidence. On this note, the prevailing attitude is to wait and see. And in the process, the three developments I cited above will be closely monitored.

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