Abstract
Why the German currency is being used increasingly worldwide
How does a national currency acquire the status of an international or key currency? This question is being asked anew as the deutsche mark takes on increasing importance on the global scene. The postwar world was dominated by two currencies, the US dollar and the pound sterling. But, as explained by Robert Aliber, they “became international currencies neither by Act of Congress (Parliament) nor by Act of God, but rather because they met various needs of foreign official institutions and foreign private parties more effectively than other financial assets could” (The Future of the Dollar as an International Currency, New York, 1966).
One of the factors underlying the adoption of a managed floating exchange rate system in 1973 was the desire to move away from the dollar standard that characterized the Bretton Woods fixed rate system. Although the international monetary order continues to be dominated by the dollar, in recent years we have seen the gradual move toward a multicurrency system. Other currencies—including the deutsche mark and the yen—are being increasingly used internationally. This article explains the characteristics of an international currency and the factors that affect them, before discussing the extent of the internationalization of the deutsche mark in recent years.
An international currency
An international currency fulfills three basic functions in the global monetary system: it serves as a medium of exchange, unit of account, and store of value. As a medium of exchange, an international currency is used by private agents in foreign trade and international capital transactions. Official agents use international currencies to intervene in foreign exchange markets and for balance of payments financing. As a unit of account, an international currency is used for invoicing merchandise trade and for denominating financial transactions. International currencies are also used by official agents in defining exchange rate parities. As a store of value, international currencies are held by private agents as financial assets (e. g., in the form of bonds held by nonresidents). Similarly, official agents (such as central banks) hold international currencies and financial assets denominated in such currencies as reserve assets.
Two sets of factors are essential if a currency is to be used internationally. First, there needs to be confidence in the value of the currency and in the political stability of the issuing country. Second, a country should possess financial markets that are substantially free of controls, broad (i.e., contain a large assortment of financial instruments), and deep (i.e., there exist well-developed secondary markets). It should also possess financial institutions that are sophisticated and competitive in offshore financial centers.
Regarding the first factor, high and variable inflation rates—relative to those of other countries—generate nominal exchange rate depreciation and uncertainty. This increases the costs of obtaining information and performing efficient calculations about the prices of tradable goods and capital assets, thereby undermining the use of a currency as an international unit of account, store of value, and medium of exchange. Further, inflation increases the costs of holding a currency by eroding its purchasing power, thereby debasing the currency as an international store of value and medium of exchange. While holding a relatively high inflation currency in an interest yielding form can offset some of the inflation cost, such holdings still entail increased costs of calculations and are associated with higher risk.
The achievement of relatively low levels of inflation and of inflation variability depends importantly on stable and consistent government policies. In this connection, a track record of sustained current account deficits in excess of normal private capital inflows (i.e., those capital inflows that exist in the absence of undue restrictions on trade or special incentives to incoming or outgoing capital) can lead to continuous exchange rate depreciation, eroding confidence in the currency.
On the need for well-developed and free financial markets, in general, just as relatively low levels of inflation and inflation variability contribute to the demand for international currencies, well-developed financial markets facilitate the supply (as well as the demand) of such currencies. Thus, the large and free financial markets of New York and London contribute to the use of the dollar and the pound sterling, respectively, as international currencies.
The absence of financial market controls contributes to lower costs of transacting in a currency than would otherwise be the case. Correspondingly, a country that possesses financial markets that are broad and deep is in a position to serve as an international banking center. Specifically, such a country can be expected to provide a high degree of efficiency in international liquidity transformation by accepting short-term, liquid, liabilities denominated in its own currency, while making long-term, less liquid, loans abroad.
While the foregoing conditions are important determinants of international currency use, they do not fully explain why a currency emerges as a dominant international currency. In this regard, studies of invoicing practices between exporters and importers have shown that the international dominance of a nation’s currency appears to be directly related to the country’s share of world exports, the proportion of specialized manufactured products in its exports, and the extent of its trade with developing countries.
A longer study “On the International Use of Currencies: The Case of the Deutsche Mark,” IMF Working Paper (WP19013), is available from the author. A revised version of the Working Paper will be published in the Princeton University series Essays in International Finance.
These observed behavioral patterns reflect the tendency for trade between developed countries to typically be denominated in the currency of the exporter. Importers often refrain from currency hedging because forward markets are typically thinner than spot markets and therefore entail larger bid-ask spreads. Importers often guard against currency fluctuations by passing through the consequences of exchange rate changes to their customers in the domestic market in the form of higher prices. This course of action is most practical in small, open economies in which a large domestic import-competing industry does not exist and helps explain why trade between developed and developing countries is usually denominated in the currency of the developed countries. Exporters are also more likely to have an incentive to invoice in their own currency to guard against unforeseeable exchange rates. They cannot easily cut factor payments that had been previously set via contracts, particularly in the case of manufactured exports involving long production lags. Exporters can use the forward market to cover their risk but this increases their costs. It is more expedient to pass the risk off to the importer.
The combination of all these factors—relatively low inflation, broad and deep financial markets, and pertinent trade patterns—fosters the use of a currency for international transactions. Against this background, we can examine the use of the deutsche mark as an international currency since the 1970s.
Inflation and monetary policy
Keeping the value of money stable has been the aim of the Deutsche Bundesbank ever since its establishment. Since 1975 that aim has been pursued by formulating and announcing monetary growth targets. A similar anti-inflationary orientation for monetary policy was also adopted in the 1970s by a number of other large industrial countries, including France, Italy, Japan, Switzerland, the United Kingdom, and the United States. Underlying this medium-term approach was the view that in the short run, monetary growth is an important determinant of nominal income growth and the balance of payments, and that over the medium term, its primary impact is on inflation and the nominal exchange rate.
In comparison with these other major industrial countries, the medium-term orientation of Germany’s monetary policy has been quite successful in maintaining a stable internal value of the deutsche mark. In fact, over 1970-89 Germany experienced the lowest average annual inflation rate (3.9 percent) among these countries. The Bundesbank’s success in controlling inflation established credibility for Germany’s monetary policy and led eventually to the deutsche mark being used, in effect, as the nominal anchor for the other currencies participating in the Exchange Rate Mechanism (ERM) of the European Monetary System. In turn, this situation has allowed Germany to retain a fair degree of domestic monetary independence and decreased the volatility of its nominal exchange rate against the currencies of its EMS partners.
German financial markets
But the Bundesbank did not favor a broad international role for its currency until the mid-1980s, when it acknowledged the difficulty of inhibiting market forces underlying the demand for deutsche mark-denominated assets. During the period encompassing the late 1960s through the early 1980s, the Bundesbank attempted to moderate the international use of the deutsche mark. Underlying this approach—which emerged under the Bretton Woods fixed exchange rate regime—was the view that substantial swings in capital flows could impede domestic stabilization objectives. While the move to a floating exchange rate system increased the Bundesbank’s control over domestic monetary conditions, the gain in control may have been less for Germany than for other large developed countries in view of the relative openness of the German economy. In particular, the Bundesbank’s view was that the relative openness of the German economy in terms of foreign trade made that economy particularly susceptible to the consequences—including on inflation—of exchange rate changes.
Consequently, to tighten its grip on domestic monetary conditions, the Bundesbank extended relatively firm control over capital inflows. In this context, a “gentleman’s agreement” entered into by the Bundesbank and the German banks in 1968 stipulated that only German banks could lead syndicates for deutsche mark-denominated bonds. The rationale underlying the agreement was that German banks would be more apt to follow the advice of the Bundesbank than would foreign banks and therefore could be more effectively controlled. A second important restriction concerned the kind of bonds that could be issued. Only the standard fixed rate bond was permitted. Innovative financial instruments—including floating rate notes, zero coupon bonds, and bonds linked to currency and interest rate swaps—were strictly prohibited. Finally, in the 1970s, there were also restrictions against the holding of German securities by foreign official institutions, thereby limiting the use of the deutsche mark as a reserve currency.
These and other restrictions, including a withholding tax on interest income, which was announced in late 1987, weakened the competitive position of German banks vis-à-vis foreign banks, while the surge and increased variability in inflation during the 1970s rendered fixed rate bonds less attractive than other, more flexible instruments. These developments led to innovations aimed at eroding the regulations, an effort facilitated by technological improvements (e. g., in data processing) that lowered transaction costs. For example, in 1983 a foreign deutsche mark bond issue had been used to arrange a currency swap, allowing foreign access to the deutsche mark bond market. Subsequently, to maintain the competitive position of the deutsche mark relative to other currencies, the Bundesbank has lifted most financial market restrictions in recent years, with the withholding tax abolished as of July 1989.
Nevertheless, partly because of Germany’s relatively late move to ease restrictions, the breadth and depth of German financial markets have lagged behind some other large financial centers, most notably London and New York. Further, a turnover tax on all secondary market dealings in bonds and equities has prevented the establishment of a market in short-term commercial instruments and encouraged the switching of secondary trading in deutsche mark-denominated instruments to foreign financial centers. Also, the equity market is not as developed as the New York and London equity markets, and futures trading has only recently been allowed. While measures have recently been taken to enhance Germany’s competitiveness in these areas, the relatively late shift to more open financial markets has restricted Germany’s relative efficiency in competing for international funds.
Trade patterns
Developments in Germany’s trade patterns in recent years have generally been conducive to the international use of the deutsche mark on several accounts. First, in 1986, Germany became the world’s largest exporter, surpassing the United States, thus enhancing the potential role of the deutsche mark in global invoicing. Germany remained the world’s largest exporter until 1989, when the United States regained the position of the world’s largest exporter. Second, over 1980-88 the share of specialized manufactured goods (primarily machinery and transport goods) in relation to total German exports rose from 45 to 48 percent.
On the other hand, Germany’s trade with developing countries has decreased in recent years. Exports to developing countries as a share of total German exports declined from about 26 percent in 1980 to 19 percent in 1988, and imports from developing countries as a percentage of total German imports declined from 29 percent to 21 percent. These declines, however, have been more than offset by a rising proportion of German trade with other European countries. For example, German imports from EC countries rose from 62 percent in 1980 to 70 percent in 1988. Given that EC countries have in recent years invoiced a growing proportion of their exports in deutsche marks, the decline in Germany’s trade with developing countries need not imply an overall decline in the share of world trade denominated in deutsche marks. Moreover, corresponding declines in trade shares with developing countries were experienced by most other large developed countries—including Japan and the United States—during the 1980s.
The preceding discussion suggests that, in general, the determinants of international currency use presage an expanding international role for the deutsche mark. Recent data trends confirm this expectation. There has been an increase in the use of the deutsche mark as an international unit of account, with a growing share in the deutsche mark-denomination of world exports. Taking into account the invoicing practices of the six largest industrial countries and of the Organization for Petroleum Exporting Countries, as well as these countries’ share of world trade, the following trends emerge: in 1980, at least 34.5 percent of world exports were denominated in dollars while 10.2 percent were denominated in deutsche marks; by 1987, the respective numbers were: 24.8 percent in dollars and 12.4 percent in deutsche marks.
Other uses
As mentioned earlier, one measure of a currency’s role as an international medium of exchange is its use in exchange market intervention by central banks. In this connection, the deutsche mark is one of two currencies used for intervention by the US Federal Reserve and the US Treasury, the other currency being the Japanese yen. In fact, the deutsche mark has accounted for more than half of US intervention throughout the 1980s, although its share vis-à-vis the yen has declined (see Table 1). Further, the share of deutsche mark intervention within the European Monetary System has risen from about 24 percent in the early 1980s to almost 60 percent in recent years, with most of the increase coming at the expense of the dollar. Again, the data reflect the increased use of the deutsche mark by European countries.
Currency distribution of foreign exchange intervention in the EMS and by the US Federal Reserve and Treasury1
(In percent)
Total intervention includes both purchases and sales.
From March 1979.
Up to June 1987.
From 1985 onward, the figures include intervention in private European Currency Units.
Currency distribution of foreign exchange intervention in the EMS and by the US Federal Reserve and Treasury1
(In percent)
| EMS | |||||
|---|---|---|---|---|---|
| 1979-82 2 | 1983-85 | 1986-87 3 | |||
| US dollars | 71.5 | 53.7 | 26.3 | ||
| EMS currencies | 27.2 | 43.5 | 71.7 | ||
| Of which: | |||||
| Deutsche mark | (23.7) | (39.4) | (59.0) | ||
| Others4 | 1.3 | 2.8 | 2.0 | ||
| United States | |||||
| Deutsche mark | 89.7 | 67.9 | 57.5 | ||
| Japanese yen | 12.3 | 22.1 | 42.5 | ||
Total intervention includes both purchases and sales.
From March 1979.
Up to June 1987.
From 1985 onward, the figures include intervention in private European Currency Units.
Currency distribution of foreign exchange intervention in the EMS and by the US Federal Reserve and Treasury1
(In percent)
| EMS | |||||
|---|---|---|---|---|---|
| 1979-82 2 | 1983-85 | 1986-87 3 | |||
| US dollars | 71.5 | 53.7 | 26.3 | ||
| EMS currencies | 27.2 | 43.5 | 71.7 | ||
| Of which: | |||||
| Deutsche mark | (23.7) | (39.4) | (59.0) | ||
| Others4 | 1.3 | 2.8 | 2.0 | ||
| United States | |||||
| Deutsche mark | 89.7 | 67.9 | 57.5 | ||
| Japanese yen | 12.3 | 22.1 | 42.5 | ||
Total intervention includes both purchases and sales.
From March 1979.
Up to June 1987.
From 1985 onward, the figures include intervention in private European Currency Units.
The use of the deutsche mark as an international store of value has also increased. Deutsche mark-denominated claims in Germany held by nonresidents more than doubled between 1980 and 1986, reflecting measures taken to deregulate the financial system in those years. However, the announcement in 1987 of the withholding tax decreased the demand for deutsche mark-denominated instruments. Consequently, deutsche mark-denominated claims held in Germany by nonresidents showed little overall increase in 1987 and 1988. The subsequent abolition of the withholding tax in 1989 led to a sharp increase in foreign deutsche mark claims held in Germany in that year. Taking the entire period 1980 through the first half of 1989, such claims almost tripled, rising to DM 585 billion. Likewise, deutsche mark-denominated claims outside Germany in the form of eurodeutsche mark deposits and external deutsche mark bonds, more than doubled, reaching DM 730 billion at the end of the period. In terms of the performance of the deutsche mark relative to other currencies, the deutsche mark’s share of eurobond issues rose from about 6.5 percent in the early 1980s to about 9 percent in the late 1980s; during this period, the share of the Japanese yen rose from about 5.5 percent to 10.5 percent, while the share of the US dollar declined from 63 percent to 47 percent. Likewise, the share of deutsche mark eurocurrency deposits rose from 11 percent to 13 percent. The yen’s share rose from 2 percent to 5 percent while the US dollar’s share declined from 74 percent to 62 percent.
It is noteworthy, however, that most of the increase in the deutsche mark claims in Germany held by nonresidents was in long-term claims. The share of long-term claims rose from roughly 60 percent at the beginning of the 1980s to over 70 percent in the late 1980s. This reflects Germany’s comparative disadvantage with regard to short-term financial instruments; as noted, the turnover tax on all secondary market dealings in bonds and equities has prevented the establishment of a market in short-term commercial instruments. In turn, this has restricted the efficiency of the German financial market in exercising one of the central functions of a key-currency country—notably in providing a high degree of efficiency in international liquidity transformation by being able to accept short-term liquid liabilities denominated in its own currency, while making long-term, less liquid loans abroad.
Currency shares of official holdings of foreign exchange from 1980 through 1988 are another measure of a currency’s use as an international store of value (see Table 2). Comparing the average holdings in 1980-83 with the period 1985-88, the data show that the largest gains in shares were registered by the Japanese yen (2.9 percentage points) and the deutsche mark (2.3 percentage points). On the other hand, the shares of the dollar and Swiss franc fell by 5.4 percent and 1.0 percent, respectively.
Official holdings of foreign exchange, 1975-88 1
(In percent)
End-of-year data. Official holdings include monetary authorities’ claims on nonresidents in the form of bank deposits, treasury bills, short-term and long-term government securities, European Currency Units, and other claims usable in the event of balance of payments need, including nonmarketable claims arising from intercentral bank and intergovernmental arrangements, without regard as to whether the claim is denominated in the currency of the debtors or the creditors.
Official holdings of foreign exchange, 1975-88 1
(In percent)
| 1975 | 1980 | 1985 | 1988 | |
|---|---|---|---|---|
| US dollar | 79.4 | 68.6 | 64.2 | 63.3 |
| Pound sterling | 3.9 | 2.9 | 3.1 | 3.1 |
| Deutsche mark | 6.3 | 14.9 | 14.9 | 16.2 |
| French franc | 1.2 | 1.7 | 1.3 | 1.7 |
| Swiss franc | 1.6 | 3.2 | 2.3 | 1.5 |
| Netherlands guilder | 0.6 | 1.3 | 1.0 | 1.1 |
| Japanese yen | 0.5 | 4.3 | 7.3 | 7.2 |
| Unspecified currencies | 6.5 | 3.1 | 5.4 | 6.0 |
End-of-year data. Official holdings include monetary authorities’ claims on nonresidents in the form of bank deposits, treasury bills, short-term and long-term government securities, European Currency Units, and other claims usable in the event of balance of payments need, including nonmarketable claims arising from intercentral bank and intergovernmental arrangements, without regard as to whether the claim is denominated in the currency of the debtors or the creditors.
Official holdings of foreign exchange, 1975-88 1
(In percent)
| 1975 | 1980 | 1985 | 1988 | |
|---|---|---|---|---|
| US dollar | 79.4 | 68.6 | 64.2 | 63.3 |
| Pound sterling | 3.9 | 2.9 | 3.1 | 3.1 |
| Deutsche mark | 6.3 | 14.9 | 14.9 | 16.2 |
| French franc | 1.2 | 1.7 | 1.3 | 1.7 |
| Swiss franc | 1.6 | 3.2 | 2.3 | 1.5 |
| Netherlands guilder | 0.6 | 1.3 | 1.0 | 1.1 |
| Japanese yen | 0.5 | 4.3 | 7.3 | 7.2 |
| Unspecified currencies | 6.5 | 3.1 | 5.4 | 6.0 |
End-of-year data. Official holdings include monetary authorities’ claims on nonresidents in the form of bank deposits, treasury bills, short-term and long-term government securities, European Currency Units, and other claims usable in the event of balance of payments need, including nonmarketable claims arising from intercentral bank and intergovernmental arrangements, without regard as to whether the claim is denominated in the currency of the debtors or the creditors.
Conclusion
The deutsche mark has emerged as an essential component of the international monetary system, to a significant extent because of the deutsche mark’s increasing importance as a key currency within Europe. In this regard, recent actions taken to open trade and financial connections between Eastern and Western Europe should contribute to wider use of the deutsche mark as a transaction and reference currency within Europe. Indicative of the growing use of the deutsche mark within Europe was the decision, effective in January 1990, to peg the Yugoslav dinar to the deutsche mark. Another important move is the currency union between the two German republics, provided that it does not undermine the internal value of the deutsche mark. The essential requirements for the continued use of the deutsche mark as a key international currency are the maintenance of the Bundesbank’s firm anti-inflationary bent, the further deepening and widening of German financial markets, and the continuation of Germany’s role as a major world exporter.