the international role of the euro

Journal of Policy Modeling24 (2002) 315–345

The international role of the euro

Philipp Hartmann∗, Otmar IssingEuropean Central Bank, Kaiserstraße 29, 60311 Frankfurt, Germany

Received 4 January 2002; received in revised form 5 February 2002; accepted 5 March 2002

Abstract

This paper discusses the factors determining the international use of the euro, the relationof it with the ECB monetary policy and the overall use of the euro in the internationalmonetary system since its introduction. The euro has become the second most importantinternational currency after the dollar and in advance of the yen. Changes in this role couldhave an impact on the monetary policy strategy of the ECB, notably the interpretation ofmonetary aggregates and the behaviour of other indicators such as the exchange rate. TheECB strategy is well designed to deal with these effects.© 2002 Society for Policy Modeling. Published by Elsevier Science Inc. All rights reserved.

JEL classification:G15; F02; F33; E52; E58

Keywords:International currencies; Euro; Dollar; Yen; Monetary policy; Monetary aggregates;Exchange rate; International monetary system; EMU; European Central Bank

1. Introduction

The euro has just become 3 years old and on 1 January 2002 euro notes andcoins have started to circulate for the first time in the 12 countries of the euro area.Since the successful technical introduction of the currency in January 1999 theEuropean Central Bank conducted monetary policy in a way to fulfil its primaryobjective to maintain price stability. Apart from the consequences of Economicand Monetary Union (EMU) in Europe for the domestic, i.e. euro area, economythe euro’s international implications have always attracted special attention (see,e.g.,ECU Institute, 1995; Emerson et al., 1991; Henning, 1997; Issing, 1998;

∗ Corresponding author.

0161-8938/02/$ – see front matter © 2002 Society for Policy Modeling.PII: S0161-8938(02)00111-4

316 P. Hartmann, O. Issing / Journal of Policy Modeling 24 (2002) 315–345

Kenen, 1995; Masson et al., 1997). Various observers asked, even before the startof stage 3 of EMU, how international policy co-operation would be affected and inwhich direction exchange rates would move. Another question raised was whetherEMU could change the relative use of the main currencies outside of their homecountries. The present article discusses this issue, by analysing how the euro’s roledeveloped since its introduction relative to dollar and yen, what are the drivingfactors behind and what are the implications for the ECB’s monetary policy andthe structure of the international monetary system.

Of course, daring an assessment after only 3 years faces at least two importantcaveats. First, overall currency uses traditionally change very slowly in the inter-national sphere. As the euro exists now only for 3 years, and considering that notesand coins were just introduced, it is still too early to have confidence that currentlyobserved changes reflect the start of structural changes and long-term trends in-stead of being just short-lived phenomena. Second, discussing the internationalrole of the euro to understand its implications for the structure of the internationalmonetary system and for the monetary policy of the ECB should not be misunder-stood as meaning that the ECB has a deliberate policy to influence that role. As amatter of fact, the ECB adopted a neutral stance towards the international role ofthe euro, neither trying to hinder nor trying to foster its international use (ECB,1999b).

The paper is organised as follows. In theSection 2, the economic and financialfactors that determine the international role of a currency will be addressed. Thenit will be outlined how the international role of the euro relates to the ECB’smonetary policy. Thereafter it will be described where the euro stands at present inthe international monetary system and asked about the international implicationsof a further development of this role. ThenSection 5concludes.

2. Factors determining the euro’s international role

An international currency can be defined as a currency that is not only used byresidents of the country (or group of countries) issuing this currency but also bynon-residents. The extent with which non-residents use a currency as comparedto other currencies defines its international role. Following a standard typology,a currency can be used as medium of exchange, as unit of account and as storeof value. In the international sphere one can further distinguish official use (in-tervention currencies, anchor or pegging currencies and reserve currencies) fromprivate use (vehicle and invoicing currencies, quotation currencies, investment andfinancing currencies).1 There is also another notion of international role for a cur-rency, namely to which extent interest rate and exchange rate developments of thiscurrency cause interest rate and exchange rate developments in the same direction

1 SeeCohen (1971), ECB (1999b), Hartmann (1998)andKenen (1983)for detailed discussions ofthe dimensions of international currency uses.

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for other currencies. These two notions for the international role of a currency areobviously related, in that a currency that is more used abroad will often also implygreater interest rate and exchange rate “leadership.” However, for the purpose ofthe present article the focus will mainly be on the first notion of international role.

2.1. A list of important factors

At least until the Middle Ages one can trace back examples of dominant inter-national currencies. The first relatively well documented case being the Byzantinegold nomisma (Lopez, 1951). It followed the eras of the Florentine fiorino, theVenetian ducato, the Amsterdam bank guilder, the pound sterling and the US dol-lar. In most times one currency dominated the international scene, whereas a fewothers also played an important international role and most others had only negli-gible roles. Moreover, in practically all documented cases the transition from oneleading international currency to another took a very long time, witness the caseof sterling and dollar (Cohen, 1971). This sluggishness in important changes inthe use of currencies leads us to the factors determining their international role.

There is now a quite extensive body of literature addressing the factors thatdetermine the international use of currencies. While historical analyses have oftenemphasised the role of goods trade and the real economy, the more recent literaturehas increasingly pointed to the role of financial markets, international portfolioinvestment and international financing. One can synthesise the arguments broughtforward in four main factors.

(1) The depth, breadth and openness of domestic financial markets.(2) The stability of the currency and confidence in its future stability.(3) The size, strength and international linkages of the domestic real economy.(4) The previous use of the currency (inertia).

(1), (3) and (4) relate to size and liquidity and (2) to risk and diversificationneeds. To the extent that the size factors lead to scale economies in the use ofcurrencies, they can explain why there was often a single dominant internationalcurrency in history. The risk factors causing diversification or hedging needs forinternationally active agents can explain why there was most often more than oneinternational currency. Since the state and future development of these factorshave a bearing on the current and future international role of the euro, they will bediscussed briefly for the euro area.

2.2. Depth, breadth and openness of euro area financial markets

In the more recent era of financial innovation, liberalisation of financial sys-tems and free capital flows, the sheer size of domestic and cross-border financialtransactions are much more likely to “carry” most of the international role of acurrency than real trade transactions. The argument is that the larger, more liquid


and developed the markets of a country are, the more likely it is that this country’scurrency will also be used in international financial transactions.2 Large and liquidmarkets imply low transaction costs, which make it attractive for foreign agents touse this country’s financial markets or financial instruments denominated in thiscurrency and not another currency with larger transaction costs. Developed finan-cial markets, offering a broad range of liquid instruments — such as derivativesfor hedging for example —, will make it easier to manage currency and interestrate exposures, unavoidable in international transactions.

Table 1shows the aggregate size of euro area (EU 12) domestic capital marketsin 2000, as compared to US and Japanese markets. It indicates that the aggregateof equity, debt and bank loan financing is the largest in the US, followed by theeuro area and Japan.3 When interpreting the figures inTable 1it should be kept inmind though that the euro area has been built only 3 years ago on the basis of 11independent countries.4 Although capital flows had already been liberalised in thecourse of the 1980s, the different financial and banking markets can after such ashort period not be as integrated as in the case of an area that defines a country fortwo or three centuries. So, althoughTable 1describes well the potential size andliquidity of euro area capital markets, the aggregated figures should not be taken“literally” so shortly after the start of the euro. In this context it is worthwhilesketching the evolution of euro area financial markets in the last years.

The single monetary policy and the introduction of TARGET have virtuallyimmediately consolidated and integrated a large part of the euro area money mar-ket. Notably the euro area interbank deposit trading is characterised by increasedcross-border trading volumes, reduced bid-ask spreads and active cross-borderarbitrage that eliminates small rate differentials across the area extremely fast(Galati & Tsatsaronis, 2001; Hartmann, Manna, & Manzanares, 2001; Santillàn,Bayle, & Thygesen, 2000; ECB, 2001a). So, from this angle it is not too surprisingthat the euro area experienced a continuous net inflow of short-term capital fromabroad through money market instruments during 1999 and 2000 (ECB, 2001e,Table 8.5). However, the euro market for repurchase agreements (repo market)could not develop as dynamically early in stage 3, because of different legal en-vironments and master agreements in different euro area countries, the limitedsubstitutability of public debt securities often used as collateral and the still highcosts of cross-border securities settlement.

The euro area bond market provides a mixed picture (see, e.g.,ECB, 2001b;Galati & Tsatsaronis, 2001; Santillàn et al., 2000). On the one hand, a remarkableboom of mainly corporate issues occurred in the first years of stage 3. On the

2 See for examplePortes and Rey (1998). However, from a purely scientific perspective it shouldalso be noted that despite ever broader agreement with this point, there does not seem to be a formaltheory that has formulated it within a consistent model.

3 However, the relatively low euro exchange rate in 2000 probably underestimates the relative sizeof euro area capital markets compared to the US and Japan.

4 Stage 3 of EMU started with 11 countries, which were joined by Greece in 2001.

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other hand, slow progress in the consolidation of the securities settlement industrysomewhat hampers cross-border trading and the existence of national budgets in-stead of EU-wide public debt management does not allow the full integration andliquidity consolidation of the secondary euro area public debt market. Whereas ofcourse other factors than EMU, such as corporate consolidation in Europe and theliberalisation of the telecommunication sector, played a large role in the develop-ment of the euro area corporate bond market and whereas the total market size isstill much smaller than the US corporate bond market,5 one can probably maintainthat after the unification of the money market, the catalytic role of the euro in thedevelopment and integration of euro area capital markets had its next strongestimpact on the primary corporate bond market. The main reason for this was thatthe euro basically unified the demand side of domestic investors, increasing theattractiveness of the market for primary issuers.

Despite some early hopes on plans for large equity market mergers, such asIX the one planned between Deutsche Börse and the London Stock Exchange,developments in equity market structures have perhaps been least dynamic sincethe introduction of the euro (see, e.g.,ECB, 2001c; Galati & Tsatsaronis, 2001).Still, a merger of the Amsterdam, Brussels and Paris bourses took place (creatingEuronext). Also various alliances have been struck, increasing remote access tostock trading. However, European stocks are traded on a much larger number ofexchanges than US stocks and the situation in securities settlement is equally detri-mental to cross-border equity trading and investment as it is for bond trading andinvestment. Whereas industry effects in euro area stock returns have become moreimportant than country effects over time, initially increased cross-country correla-tions of stock returns have recently come down again (Adjaouté & Danthine, 2001).

Table 1also illustrates well that the US financial system is mainly based onsecurities market financing, whereas the euro area financial system is still morebased on bank loan financing. The relative virtues and drawbacks of these twotypes of systems have been discussed at length in the academic literature (see,e.g.,Allen & Gale, 2000). Whatever the welfare analysis of them yields, it isevident that securitised assets are more fungible and therefore more useable forinternational transactions, so that the more bank-based European financial systemwith still somewhat less important securities markets may also pose a limit to thefurther expansion of the euro’s international role.

The conclusion of this brief summary of euro area financial market develop-ments is that in aggregate they are smaller than US financial markets (at currentexchange rates) and are already now larger than Japanese financial markets.6 Both

5 For example,Table 1shows that total private debt securities outstanding in the euro area wereabout half the size of those in the US in 2000.

6 As remarked earlier the low external value of the euro at present somewhat understates the sizeof aggregate euro area capital markets compared to the US. For discussions of the state of Europeanfinancial markets before the introduction of the euro, seeMcCauley and White (1997)as well asPrati and Schinasi (1997).


the money market and the primary corporate bond market develop swiftly. How-ever, some caution in the interpretation of these European aggregates is advisable,since they hide the fact that some structural features dating from the time whenthere were still many currencies and resulting from the existence of 12 differentcountries prevent the equivalence with the case of markets within a country, notablythe US. This caveat notwithstanding the short summary of market developmentsis quite suggestive regarding the reasons why international asset investors foundshort-term money market instruments in Europe most attractive and internationalliability managers corporate debt financing (see the data provided inSection 4).

2.3. Stability of the euro and confidence in its future stability

Price stability is an important precondition for the development and mainte-nance of the international role of a currency (Frenkel & Goldstein, 1999; Maehara,1993; Tavlas, 1991). It is a necessary condition for outside investors’ confidencethat their purchasing power will be preserved regarding nominal assets. Internalmonetary stability is also a precondition for external stability, in the sense thatthe exchange rate is not very volatile and that there are no persistent deprecia-tion expectations. In fact, it was the experience with the Deutsche mark (DM)that consistent appreciation expectations after abandoning the fixed exchange ratesystem in the early 1970s played an important role in the gradual emergence ofthe mark as an international currency. Internal and external stability of a currencytherefore limit the risks for external agents to use a currency for their internationaltransactions, so thatceteris paribusmore stable currencies (including those witha long-term appreciation trend) become more attractive than less stable ones.

The benchmark for the euro in terms of internal price stability and investorconfidence in the currency should not be set by some average of its predecessorcurrencies but rather by its most stable predecessor currencies, notably the DM.Fig. 1 shows the inflation record of the euro compared to the dollar and the yenin terms of the headline harmonised consumer price index (HICP) inflation ratefor the euro area as a whole. This measure has been calculated backwards for thetime before January 1999, because German inflation data for the early 1990s aredistorted by the shocks incurred through German unification. The figure suggeststhat internal monetary stability in the US and the euro area were fairly comparableduring the 1990s, whereas the Japanese data show the well known deflationarytendencies. Actually, for most of the time after the euro’s introduction inflationis lower than in the US. Similar statements can be made for inflation variability.Euro and dollar variability tend to be roughly comparable, whereas until relativelyrecently Japanese inflation volatility was often higher than the other two.

Is price stability in the euro area going to last? The Maastricht Treaty has setthe constitutional environment within which the Governing Council of the ECBconducts monetary policy with price stability being the primary objective. TheCouncil has defined price stability as a yearly increase of the HICP by less than2%, with a medium term horizon. Are these commitments credible?Fig. 2exhibits

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market inflation expectations as implied by 10-year government bonds indexed toinflation in France (as a proxy for the euro area) and the US. Each point of thecurves reflects the market’s expectations of average inflation over the following10 years. Since the start of stage 3 financial markets expected euro area inflationover the following 10 years to average about 1.5%, well within the ECB’s targetrange. Since mid 1999 inflation expectations for the US are somewhat higher, butnot very much so. (For Japan such index-linked bonds are not available.) The —by the time of writing — latest market consensus forecast (also indicated on theright-hand side ofFig. 2as the horizontal lines) shows that banks expected at theend of 2001 a euro area inflation rate of about 1.7% for the year 2002 and USinflation of about 1.9%.

In contrast to the domestic price stability objective, the ECB does not have anexchange rate target. Therefore apart from special circumstances, such as thoseprevailing in the intervention episode of September 2000, exchange rate fluctua-tions are the outcome of market forces. However, it is well known that short-termexchange rate volatility increases foreign exchange trading costs (Bessembinder,1994; Black, 1991; Bollerslev & Melvin, 1994) and the costs of hedging currencyrisk. Hence, too high volatility could discourage the use of the euro as a foreignexchange vehicle currency.

Fig. 3shows the exchange rate volatility in the bilateral spot markets betweeneuro (proxied by the DM), dollar and yen.7 After the peak in volatility around theRussian and LTCM crises in the second half of 1998, the euro settled during itsfirst year of existence at exchange rate volatility levels around the one observed forthe mark before the start of stage 3. It followed a period, however, starting in 2000during which its volatility increased both against the dollar and against the yen,whereas the dollar was very stable against the yen. Then in the second half of 2001all the three bilateral volatilities moved very closely together. Overall, after 3 yearseuro volatility against the dollar appears very similar to historical DM volatility.It is unclear at this stage whether the somewhat higher average volatility againstthe yen since mid 1997 (compared to mark-yen volatility between 1990 and 1996)has disappeared in 2001 or will return.

The wide fluctuations of the dollar over the last three decades illustrated thateven a currency that passes through periods of lower valuation can maintain itsinternational status. Whereas short-term exchange rate levels have little do with thelong-term structure of the international monetary system and the role of currencies,it was the experience of the Bundesbank that in a given situation concrete exchangerate expectations may play an important role in the timing when a currency developsits international role. In the case of the DM international private investors andcentral bank reserve managers watched carefully when to diversify their portfolios.In this regard the gradual depreciation of the euro during the first 2 years was ofcourse not fostering its international use for investment purposes (although, as

7 Since the conversion rate between mark and euro is fixed since January 1999, mark volatilities inspot markets are identical to euro volatilities since then.

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will be discussed inSection 4below, it was not hindering its use for internationalfinancing purposes). However, we should be aware that after the downward cycleof the euro’s external value and when markets firmly expect it to appreciate, thena wave of external investments in euro-denominated assets may occur.

In sum, whereas internal monetary stability in the euro area is clearly supportingthe development of the international role of the euro, it does not provide for a greatadvantage compared to the dollar. Exchange rate movements have put the euro ata disadvantage to the dollar so far.

2.4. Size, strength and international linkages of the euro area real economy

The size of the domestic real economy compared to the rest of the world inconjunction with both the respective country’s competitiveness in internationaltrade as well as its integration in the international division of labour (“openness”)will determine how often agents from the rest of the world will have to transact withdomestic agents. For example, if a country’s trade plays an important role in theworld economy then foreign agents will have benefits from accepting this country’scurrency, since it can be easily re-used in other transactions. This factor has beenparticularly important for the dominance of sterling in the international monetarysystem during the nineteenth century until World War I, as Britain was the leadingnation in international trade and real investment, partly based on its internationallead in manufacturing.8 In a random-matching model of international monetaryexchangeMatsuyama, Kiyotaki, and Matsui (1993)have shown for example thata higher “economic integration” (the likelihood of meeting a foreign resident, ifone is a domestic resident) of a country with the rest of the world increases theprobability that the domestic currency is employed in cross-border goods trade.Rey (2001)argues within a 3-country model that if “Grassman’s law” holds agreater preference of foreign agents for domestic goods raises the likelihood of thedomestic currency developing a role as foreign exchange vehicle currency throughthe increased need of foreigners to purchase the domestic currency in the foreignexchange market.9

Table 2shows the relative sizes of the euro area, the US and Japan in 2000.Whereas the union of the 12 countries has a larger population than the US, theUS produces a larger gross domestic product (GDP). Japan is smaller in bothdimensions. In terms of foreign tradeTable 2suggests that euro area exports (15%of total world exports in 2000) were only very slightly larger than US exports atcurrent exchange rates (14%), whereas Japanese exports are again much smaller(7%). In contrast, US imports (19%) are larger than euro area imports. Given thesmall differences in trade figures between the euro area and the US and given the

8 Another factor was London’s role as the banking center of the world.9 “Grassman’s Law” (1973)describes the tendency that the largest part of exports among industrial

countries is usually denominated in the home currency of the exporter. The foreign exchange vehiclecurrency function has been described already bySwoboda (1969)andKrugman (1980).


Table 2Size and real international linkages of the euro area, the US and Japan, 2000

Indicator Unit Euro area US Japan

Population Millions 294 275 127

GDP EUR billions 6,422.0 10,640.0 5,145.0Share of world GDP in PPP termsa % 15.8 21.9 7.6

Exports of goods and services EUR billions 1,266.4 1,193.8 563.1Share of domestic GDP % 19.7 11.2 10.8Share of world exports % 15.1 14.3 6.7

Imports of goods and services EUR billions 1,247.0 1,587.8 488.5Share of domestic GDP % 19.4 14.9 9.4Share of world imports % 14.9 19.0 5.8

Sources: IMF (population, share of GDP, US and Japan trade data), WTO (aggregated world tradedata), ECB (trade data on euro area).

Note: Greece did not yet belong to the euro area in 2000.a 1999.

small size of international goods transactions compared to financial transactionsthese factors may not play the most important role in the relative use of the euroand the dollar.

The link between size and growth rate of the domestic real economy and theinternational use of the domestic currency has not been made in a clear way in thetechnical literature. However, one could imagine that a successful and sustainablyfast growing economy benefits from greater confidence in political stability. Itmay also hold that a faster growing economy leads to higher asset returns, therebyattracting foreign investment leading to enhanced investment currency use.

Fig. 4 shows that the US economy grew faster over the last decade than boththe euro area or the Japanese economy (except for the most recent time). For thelast few years Japan was also lagging the euro area in this regard. Productivity dif-ferences between countries can be measured using growth rates in output per hourworked, as exhibited inFig. 5. The numbers indicate relatively similar productivitydevelopments across the three countries/areas during the nineties, except for thelast years when the US led both the euro area and Japan. In sum, to the extent thatreal domestic performance fosters the international role of one’s home currency,over the last decade the dollar may have benefited from the strong performance ofthe US economy.

2.5. Previous use of the euro’s predecessor currencies

As mentioned inSection 2.1, one of the big lessons of international monetaryhistory is that the “ranking” of international currencies changes very slowly. Themain reason for this found in the literature is the economies of scale in the use of cur-rencies, which in the presence of some market imperfections preventing full con-testability imply self-realising forces in that use. Practically, the most widely used

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international currency will usually have the largest and broadest financial markets,sustained by the numerous transactions related to that same role. Absent a major ex-ogenous shock or structural change, it is quite difficult for another currency to bene-fit from the network externalities that could raise it to a comparable role; hence, theinertia in changes of the international use of major currencies. Formal theoreticalmodels of international currencies that feature network externalities and economiesof scale in use includeMatsuyama et al. (1993), Hartmann (1998, chap. 3, whoalso empirically tests for the existence of scale economies)andRey (2001).

Despite some gradual movement towards greater diversification since the break-down of Bretton Woods in the early 1970s, there is no doubt that overall the dollarhas been the most widely used currency on a global level for most of the time afterWorld War II. In the last decades also the DM has developed an important interna-tional role, which was particularly pronounced in Europe. Similarly, post-BrettonWoods also the yen developed a considerable international role without, however,having the strong regional role in Asia as the DM acquired in Europe. The conclu-sion is that when the euro was introduced the dollar still benefited tremendouslyfrom scale economies related to its widespread previous use.

It is not so easy to assess what the euro’s “previous use” is. Since it can beregarded as a new currency, one view is that it basically starts from scratch, i.e.,the previous international role was zero. Given that the euro was forged out of its10 predecessor currencies by irrevocably fixing their exchange rates to each otherthis view is of course somewhat extreme.10 Another view would be that the euro’s“previous use” would resemble the aggregate international roles of its predecessorcurrencies. In practice, this would mean that it would be slightly larger than therole of the DM before stage 3. However, this view faces the complication that animportant part of the DM’s international role was confined to the euro area, whichbecame domestic in January 1999. So perhaps the most realistic assessment ofthe euro’s role inherited from the past is in between the two views, namely aboutthe previous role of the DM outside the euro area. In other words the euro woulddepart from a much smaller previous role than the dollar and, depending on thedimension of international currency considered, from a larger or similar role whencompared to the yen.

3. The euro’s international role and the ECB’s monetary policy

The move of a currency from a purely domestic one to an international one orthe expansion of the international role of a currency can affect the way monetarypolicy is conducted and the way in which it influences the economy in various ways.The ECB conducts monetary policy according to its “stability-oriented monetarypolicy strategy” published in its Monthly Bulletin at the start of stage 3 (ECB,

10 Belgium and Luxembourg had already a currency union before the start of stage 3, so that thenumber of direct predecessor currencies is effectively 10 and not 11.


1999a, 2000). Therefore, in this section the implications of the international roleof the euro are discussed in the context of this strategy.

The ECB’s monetary policy strategy is based on a quantification of its primaryobjective of maintaining price stability and on a clear and a transparent frameworkfor analysing risks to price stability. Price stability has been defined as an annualincrease in the HICP for the euro area of below 2%. Price stability according tothis definition is to be maintained over the medium term.

The assessment of risks to price stability are carried out using two forms ofanalysis. First, in recognition of the fundamentally monetary origins of inflationover the medium term the ECB assigned a prominent role to money in the formu-lation of its monetary policy. This prominent role — the so-called first pillar ofthe strategy — is signalled by the announcement of a quantitative reference valuefor the growth of the broad monetary aggregate M3. On 6 December 2001 theGoverning Council of the ECB confirmed that the reference value would remainat 4.5% and would be reviewed again in December 2002. More generally the firstpillar consists of a number of analyses and tools directed at the examination of theinformation content of monetary aggregates and their components (in particularcredit) for future price developments.

Second, recognising the important information relevant for monetary policydecisions contained in other indicators, a broadly based assessment of a widerange of other variables — the so-called second pillar — is also carried out by theECB and constitutes a further basis for monetary policy decisions. The indicatorsconsidered include for example the exchange rate, wages, the yield curve, measuresof real activity, business and consumer surveys, etc. as well as the ECB’s staffmacroeconomic projections and other organisations’ forecasts. This strategy iswell designed to deal with any changes in the economic environment related to theinternational role of the euro.11

3.1. Implications for the first pillar of the strategy

An important aspect of monetary aggregates as indicators for price develop-ments is that they measure precisely the holding of short-term assets by residents,i.e., funds that can become easily demand-effective. For statistical reasons thismeasurement starts from the liability side of the balance sheets of the central bank(notes and coins) and of private financial institutions (deposits, short-term secu-rities, etc.; in the euro area the large number of institutions selected — typicallybut not only banks — are called monetary and financial institutions (MFIs)). For apurely domestic currency, these liabilities will be identical to domestic short-termasset holdings. Now, the internationalisation of the currency can change the re-lationship between domestic short-term liabilities and domestic short-term assetholdings, since part of the liabilities are held by non-residents.

11 For a detailed discussion of the strategy, its intellectual underpinnings and its working in the firstyear seeIssing (2000)andIssing et al. (2001).


First, in the process of internationalisation non-residents may increase theirholdings of banknotes denominated in the respective currency (a phenomenonoften denoted as direct currency substitution). However, these foreign holdingsmay not become demand-effective easily, so ideally one would like to deduct cashcirculating abroad from monetary aggregates. This is not easy, because of theanonymous character of cash holdings. The central bank knows obviously howmany notes it printed and put in circulation, but it can only estimate which share ofthem circulates domestically with immediate relevance for domestic expenditures.This means that to the extent that changes in foreign banknote holdings create atrend or volatility in the aggregates, they may be more difficult to use for monetaryanalysis. Overall, however, the holding of euro banknotes by non-residents is notan important problem for the use of M3 as a prominent indicator of price pressuresin the euro area. The reason is that the share of currency in circulation is rathersmall in such a broad aggregate (about 6% of the total in the case of the euro area),so that only minor distortions could occur.

Second, as the euro internationalises a larger share of MFI liabilities could beheld by non-residents (an increase of the investment currency function, for ex-ample). This can easily become quantitatively more important than foreign notecirculation and therefore lead potentially to a more important disconnection be-tween domestic short-term liabilities and domestic short-term asset holdings. Theproblem is not with the large share of deposits and repurchase agreements (re-pos), where non-resident holdings can be deducted since banks know the ownersand their residency. The M3 components more difficult to correct for non-residentholdings are money market fund shares or units and short-term MFI debt instru-ments (below 2 years of maturity) where the holders are often not known to MFIs.Actually, the ECB observed increasing foreign holdings of these instruments afterthe start of stage 3 that may have risked distorting M3 growth rates. The problemwas solved by the Eurosystem in raising information from money market fundsand international central securities depositories on the identity of holders (see theexplanatory Box inECB, 2001e, pp. 10–13).12 Thus, after the adjustment M3 isnow relatively robust to any future change in the international holdings of euroarea short-term marketable paper.

3.2. Implications for the second pillar of the strategy — the roleof the exchange rate

The list of indicators that are looked at for the purpose of the second pillar of thestability-oriented monetary policy strategy of the ECB is too long to be possiblydiscussed exhaustively in the present paper. However, an indicator of particular

12 However, in the end only a small part of the developments observed by the ECB were relatedto the euro’s internationalisation, since after a period during which foreign holdings of MFI debtsecurities denominated in euro and in foreign currencies strongly grew in parallel, the strong growthin euro-denominated marketable debt ebbed down (seeECB, 2001e, Box 1, Chart B).


interest in the present context is the exchange rate. It was sometimes stated thatthe development of an international role by the euro could lead to an early appre-ciation of the euro exchange rate, implying some risks for the euro area and worldeconomies (see, e.g.,Alogoskoufis & Portes, 1997; Bergsten, 1997). This viewrelied on swift capital inflows into the euro area through external asset demands asa consequence of an increased consolidation and integration of domestic financialmarkets. Others pointed out that the effect may become ambiguous if external assetsupplies react at a similar time scale as external asset demands, and if internationalissuance of bonds denominated in euro was fast and large enough it could evenbe reversed (McCauley, 1997). These two views can be synthesised by saying thatinternationalisation as such does not give a direction to the exchange rate. If itproceeds first at the financing side the exchange rate may get under downwardpressure, while if it proceeds first on the investment side it may develop upwarddynamics. Some observers considered that if the ECB would not get an “advancecredit” from financial markets in terms of confidence and credibility and thereforewould have to build it up in a slow process, the euro may start via a temporarydownward cycle.

The inflation and inflation expectation figures discussed above inFigs. 1and 2clearly dismiss a potential credibility problem of the ECB as an explanationfor the euro’s early depreciation. Similarly the international investment currencystory is rejected by the data. Early advances of the euro as a financing currencyare consistent with the asset supply story explaining part of its depreciation (seeDetken & Hartmann, 2000and the data displayed in the next section, in particu-lar Figs. 6 and 7). However, this element may have been less important than thegrowth differentials observed between the euro area and the US (seeFig. 4) andthe foreign direct and equity portfolio investment portfolio flows from the euroarea to the US (plus some foreign exchange market “exuberance”).

Despite the more closed character of the euro area economy compared to thenational economies before stage 3, following exchange rate developments is im-portant within the ECB monetary policy strategy, because with a share of exportsand imports of 19–20% in GDP (seeTable 2), considerable price pressures canstill develop from the external side. However, it is important to distinguish thesignificant indicator role of the exchange rate for the ECB from any intentions topursue some form of direct exchange rate policy or even target. Pursuing exchangerate targets is not an advisable approach for the ECB, since it would considerableconstrain its ability to pursue the primary objective of maintaining price stabilityin the euro area. Moreover, it may become a source of moral hazard, since marketparticipants relying on a central bank to target an exchange rate may not hedgetheir positions any more. To the extent that the development of a greater invest-ment currency role of the euro can be associated with occasionally large portfolioshifts between the two or three main currency areas when investor expectationschange, a monetary policy is called for that does not lose sight of the primaryobjective of price stability and that thereby firmly anchors market expectations.Such a policy that is clear and stable in its messages will help avoiding any abrupt

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shifts in investor expectations that lead to such portfolio shifts, which then mayvia the exchange rate channel lead to undesirable volatility in domestic inflation.

4. The first 3 years of the euro: towards a tripolar world?

Since the euro has been introduced only 3 years ago, it is much too earlyfor any definitive assessment of its long-term place in the international monetarysystem. This seems all the more true against the backdrop of the slow speed atwhich national moneys tended to emerge as international currencies in history andconsidering the fact that euro notes and coins were just introduced in January 2002.Nevertheless, it appears interesting to briefly sketch a few developments during itsfirst 3 years of existence. This will allow discussing the often mentioned prospectsfor bipolar or tripolar structures around the major currencies in the internationalmonetary and financial system.

4.1. The current international use of the euro

In the light of the importance of international capital markets in recent times, wewill mainly focus on a selection of data we have available on international financialtransactions. Let us start with the segment of international capital markets wherethe largest and perhaps also the most astonishing developments occurred.Fig. 6displays the shares of the three major currencies in the issuance of internationalbonds and notes (maturity above 1 year) by non-residents. Before 1999 the data forthe euro are derived by aggregating the issuance in all euro predecessor currenciesand by eliminating all external financing that occurred within the euro area (i.e., aDM bond issued by a Belgian corporate is carved out of the aggregate, since fromthe perspective of the euro this is domestic not international financing). The figureshows that the share of the euro in global international bond financing increasedwith EMU from about 20% to about 30%. Apart from the special second quarterof 2000 when the yen experienced a short revival, the euro trends to come nowmuch closer to the dollar, in this very large market.13 However, as the series inFig. 6 illustrate, international bond financing can also be quite volatile.

In funding with more short-term debt securities (below 1 year of maturity) theeuro’s role also increased as displayed in the next chart (Fig. 7). In this (in termsof flows) slightly smaller market segment the dollar’s historical advantage was

13 The issuance of international bonds and notes over all currencies, excluding home currencyissuance, is about 1 trillion dollars a year. The stock of outstanding bonds and notes according to thesame definition is about three times as large. The temporary increases of international dollar and yenbond financing at the expense of the euro in Q2 2000 seem to have been related to large euro areadomestic issuance of telecommunications firms in need of funding for their bidding in mobile phonelicensing auctions. This fact created uncertainty for liability managers whether the euro bond marketwas able to absorb additional issues.


much larger, although gently declining during the 1990s. Still the euro’s share also“jumped” by about 10 percentage points at the start of stage 3, whereas the yencontinues to play a small role.

Data on international private investments have proven to be more difficult tocome by. One relatively reliable source is bank assets held in foreign currencies, asreported to the Bank for International Settlements (BIS). They are shown inFig. 8,following an analogous statistical methodology as the one for bonds and moneymarket instruments. It is apparent that euro holdings by non-resident banks haveincreased gradually since the introduction of the euro, reaching 24% of the totalby the first quarter of 2001. This gradual growth of the euro in international bankinvestments came mainly at the expense of the Japanese yen, whereas about halfof international bank investments continue to be denominated in US dollar. This“vote of confidence” in the euro is particularly remarkable against the backgroundof its early depreciation.

Are all indicators for the euro’s international role pointing to the upside, already3 years after its introduction? It was argued by a few observers that some euro spotforeign exchange markets exhibited lower volume and higher trading costs in1999 than the corresponding DM markets before EMU (see, e.g.,Hau, Killeen,& Moore, forthcoming). At this stage it remains an open issue whether slightlyreduced foreign exchange market liquidity of the euro compared to the DM wasa robust and lasting phenomenon in the spot market (see, e.g., the discussion inECB, 2001d). More insights into this issue may become available when the BISreleases the final data for its 2001 foreign exchange turnover survey. Until thistime it can be noted that — according to the BIS’ preliminary data (BIS, 2001,Table 3) — the euro’s total FX turnover (spot, forward and swap) amounted to38% of the global aggregate, whereas the dollar and the yen have 90 and 23%,respectively.14 This means that the euro’s overall share is very similar to the oneof the DM in 1992 and 1995 (39 and 36%) and higher than the one of the DM in1998 (30%).15

Regarding official reserve holdings the International Monetary Fund’s annualreport documents that central banks around the world have not made any importantportfolio changes since the euro was introduced. The euro’s share of about 13% atthe end of 1999 and 2000 (IMF, 2000, appendix I, Table I.2) reflected roughly the

14 The sum of all currencies’ turnover adds up to 200%, since each foreign exchange transactionimplies a turnover in the currency bought and a turnover in the currency sold.

15 The 1992, 1995 and 1998 mark figures may not be strictly comparable to the 2001 euro figures,since the former are not adjusted for intra-euro area foreign exchange trading. The elimination ofcurrency trading between euro predecessor currencies should reduce the percentage share of aggregateeuro trading (the aggregate of euro predecessor currency trading before January 1999), since it isdeducted from the denominator and the numerator of a number between 0 and 1. In the mid-1990sit was estimated for spot foreign exchange markets that the aggregation of euro predecessor currencytrading to non-euro currencies and the elimination of trading between euro predecessor currencies wouldlead to euro shares in total spot FX trading at or slightly above the shares of the DM in depending onthe number of countries introducing the euro (seeHartmann, 1996, Tables 9 and 10).

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aggregate of euro predecessor currencies before stage 3 of EMU, after correctionfor the mechanical re-denomination of DM reserve holdings in euro area centralbanks’ portfolios into domestic assets and after the dissolving of their ECU swapagreements.16 Whereas this re-denomination implied an arithmetic reduction ofthe euro’s share compared to the total euro predecessor currency aggregate, thecurrent share of the euro in global official reserves is at about the same level as theDM’s share in the years preceding stage 3.

Also in terms of currency pegging and the role of the euro as an anchor recentchanges were relatively moderate. More than 50 countries currently involve theeuro in their exchange rate regime (seeECB, 2001d, Table 3C). Solutions adoptedrange from very strict links to the euro (euroisation or currency boards) to looserforms of anchoring (crawling fluctuation bands or managed floating). Of course,most of the EU accession candidate countries give a role to the euro in theirexchange rate policies. Denmark participates in the ERM II. It should be pointedout, however, that (i) the choice of using the euro as an anchor currency is aunilateral decision, which does not involve any commitment on the part of theEurosystem, and (ii) the economic weight of the countries anchoring to the euro inone way or the other is small (around 4% of world GDP or 17% of euro area GDP).

When pulling the data together it emerges that overall the euro is currently thesecond most widely used international currency in the world, behind the dollarand in advance of the yen. In some dimensions its current international role isquite similar to that of the DM (outside the euro area), the only European currencywith widespread international use before stage 3 of EMU (for example for officialreserves and probably also in foreign exchange markets). In other dimensions it isquite close to the aggregate roles of all euro predecessor currencies, always net ofintra-euro area uses (for example, international investment currency use, althoughinternational bank investments in euro have already increased gradually). How-ever, on the financing side of international capital markets the euro experienced asignificant extension of its role compared to the predecessor currency aggregate,although most of the international debt securities issued in euro by non-residentsseem to have been purchased by resident investors. Despite some volatility inthe flow of international bond issues, this expansion has been sustained until thepresent day. Nevertheless, the dollar has preserved its status as the most importantinternational currency so far.

4.2. The structure of the international monetary system

Before the start of stage 3 of EMU a widely debated issue was whether theintroduction of the euro could lead to a bipolar (around dollar and euro, each

16 Euro area central banks had issued ECU swaps against dollars and gold before stage 3. Thetermination of these contracts impliedceteris paribusa decrease in ECU reserves and an increasein dollar and gold reserves. Their DM reserves became euro reserves in January 1999 and thereforedomestic assets.


one with comparable roles) or tripolar (around dollar, euro and yen) internationalmonetary system and what the consequences of such developments would be forthe international financial architecture and for international financial stability. Thedata on currency uses in this section and those on factors determining currencyuses in the previous one tell us a little bit about the prospects for such events.Clearly, at the current juncture there is little that can be seen on the horizon aboutan emerging tripolar system. The size of domestic Japanese financial markets andthe difficulties in the Japanese banking system, the deflationary tendencies in theJapanese economy and a smaller share in world exports and the small currentinternational role of the yen compared to that of the dollar all suggest tremendousobstacles to a much enlarged international role of the yen.

Regarding the euro and the prospects for a bipolar international system thepicture is more mixed. Clearly the current use and strength of the dollar as well asthe size, liquidity and breadth of US financial markets are a strong underpinning fora continuing dominant international role, even though the US economy has recentlyentered a more difficult period. The euro had a good start in the international arena,despite the downward slide in its external market value during the first 2 years. Itestablished itself as the second most widely used currency in the world, at leasttaking over the DM’s previous role and in a few important dimensions alreadygrowing much beyond. It disposes of a domestic real economy of comparablesize to the US, with similar trade linkages. Internally, it is at least as stable asthe dollar and comparable to it in terms of exchange rate volatility. However, inorder to catch up with the dollar substantial further development and integration ofeuro area financial markets would be necessary. Despite substantial efforts by thecompetent European authorities, such as theEU Commission’s (1999)FinancialServices Action Plan, this process is likely to take time. Moreover, given theinertia observed in changes of international currency uses, it may not be sufficientto fundamentally change the current “ranking” of currencies. In other words, whentalking about the possibility of a truly bipolar international monetary system, it ismost likely that we refer to a very long-term horizon. Whether this view comestrue or not, it remains that the role of the ECB is one of neutrality in relation to theeuro’s role in the international monetary system.

Assuming that the bipolar scenario will materialise will that be good or bad forthe world economy?17 This question is often discussed in terms of stability. Someargue that episodes without clear international monetary leadership are associatedwith instability (see, e.g.,Kindleberger, 1973), whereas “hegemonic” systems aresupposed to be inherently more stable (see, e.g., the “hegemonic stability” hy-potheses discussed inEichengreen, 1987). For example, large short-term portfolioshifts between two leading and fiercely competing international moneys couldcause enhanced exchange rate volatility. Others argue that with only two or threemain global players international policy co-ordination to deal with any imbalances

17 For a general discussion of this issue, seeIssing (1965).


would be relatively easy (Alogoskoufis & Portes, 1993). There is a certain risk thatthis will lead to calls for a greater weight of exchange rates in the leading cen-tral banks’ objective functions or even attempts to introduce fixed exchange rateregimes between the major currencies (see, e.g.,Bergsten, 1997). Such proposalshave to be taken with a good grain of scepticism, since external objectives of cen-tral banks can easily divert them from their “domestic” objective, i.e., in the firstplace the primary objective of price stability.

5. Conclusions

The euro is still a young currency. It was introduced in January 1999 and eurobanknotes and coins started circulating in the euro area in January 2002. It is some-what courageous to write about “grand ideas,” such as the euro’s international rolein comparison to well established currencies like the US dollar. Nevertheless, inthis article an attempt was made to undertake a discussion of what are the factorsthat are likely to determine the external role of the euro, how euro internationali-sation relates to the ECB’s monetary policy and where the euro currently standsin the international monetary system.

Starting from the historical observation that the roles of important internationalcurrencies tended to change only very slowly four factors were identified: Thebreadth, liquidity and openness of domestic financial markets; the stability of thecurrency and confidence in its future stability; the size, strength and internationallinkages of the domestic real economy; as well as the previous use of the cur-rency. It turned out that the euro area disposes of potentially very large domesticfinancial markets. However, in order to match those of the US continued furthergrowth, integration and broadening of those markets would be necessary. In termsof stability, the ECB fulfilled its constitutional mandate to maintain price stabilitysince the start of stage 3. Indicators of inflation expectations reflect a high degreeof market confidence that this will remain so in the future. During the past years,however, the inflation record in Europe and in the US is almost indistinguishable.The relative sizes of the euro area and US economies are similar and also their tradelinkages to the rest of the world. However, the US economy has shown a some-what more robust real performance over the last years, at least until quite recently.Finally, although the euro benefits from some heritage of the international rolesof its predecessor currencies, notably of the DM, the dollar as the most importantinternational currency since World War II had of course a much stronger positionbefore stage 3 of EMU, even when compared to the aggregate of euro predecessorcurrencies. In sum, despite somewhat similar sizes of the real economy in the euroarea and the US and despite comparable domestic monetary stability in both areas,several important factors determining the international role of a currency still givea relatively large advantage to the dollar.

The further internationalisation of the euro would also imply some changesin the environment in which the ECB conducts its monetary policy. Its stability-


oriented monetary policy strategy is flexible enough to deal with these changes.For example, the statistical measurement of monetary aggregates — such as M3for the first pillar of the strategy — and their behaviour may be altered throughchanges in the euro’s international role. However, improvements in the statisticalframework of M3 — such as the recent identification of the size of non-residentholdings of short-term securities — can avoid the occurrence of any significantbiases. Moreover, in the analysis of M3 the ECB can take the international factorsinto account and explain them to the public.

Regarding the second pillar of the ECB monetary policy strategy, the role of theexchange rate as an indicator for external pressures on domestic prices seems to beparticularly relevant in relation to the international use of the euro. Euro interna-tionalisation may be associated with changes in the level and the volatility of theexchange rate. Contrary to what has often been written the sign of level changesis not unambiguously positive. It rather depends on whether euro internationali-sation proceeds faster on the investment side than on the financing side whetherthe exchange rate appreciates in response to it or depreciates. It is important thatwithin the ECB strategy the exchange rate performs the function of an indicator,and there is no attempt to achieve an exchange rate target. From the perspective ofthe main objective to maintain price stability, this is an important distinction. Anyattempt to target the exchange rate would limit the ECB’s ability to maintain pricestability. We know that a greater role of the euro in international investment can beassociated with a greater risk of large and abrupt flows in and out of the currency,which could distort price developments in the euro area through higher long-termexchange rate volatility. It is therefore important to conduct a monetary policy thatfirmly anchors financial market expectations in the price stability orientation ofthe central bank, thereby minimising the likelihood of destabilising capital flows.

The assessment of the euro’s present international role indicates that 3 yearsafter its introduction it is the second most widely used international currency inthe international monetary system, behind the US dollar and in advance of the yen.This general picture is in line with the status of the factors identified earlier. Duringthe first 3 years the euro experienced a large expansion as a financing currency,relating to a significant increase in the issuance of euro-denominated internationalbonds, notes and money market instruments. It also experienced a gradual increasefor foreign currency bank investments. In other dimensions, such as official foreignexchange reserve holdings and perhaps also foreign exchange market trading, itsrole roughly resembles the one of the DM before stage 3 of EMU (net of intra-euroarea use).

The current situation of international currency uses misses the characteristicsof a “tripolar” international monetary system in which the dollar, the euro and theyen compete on an equal level. Judging from the factors determining currencies’international roles it appears relatively unlikely that the yen could catch up withthe dollar any time soon. The gap for the euro is smaller and it seems ratherunavoidable that the euro maintains and probably also further expands its currentinternational role. However, the historical experience of international currencies


suggests that whether it will be able to catch up with the dollar is rather a long termissue. A key role in this regard will play the further integration and developmentof euro area financial markets. The ECB is neutral as to whether the euro shouldfurther expand its international role or not. If private market participants decideto use it more or less in the international sphere, it will neither hinder nor fosterthese processes. However, price stability is a decisive characteristic of any goodcurrency, and also a necessary condition for its international use. In this regard thestability-oriented monetary policy of the ECB is without any doubt contributingto the euro’s potential of expanding its international role, without this, however,being the underlying objective.

Acknowledgments

The authors wish to thank Carsten Detken, Hans-Joachim Klöckers andCaroline Willeke for useful comments as well as Andres Manzanares andSandrne Corvoisier for able data assistance.

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capital markets with a single currency(pp. 76–104). Oxford: Oxford University Press.

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the international role of the euro

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