The internationalisation of currencies – A central banking perspective

Speech by Lorenzo Bini Smaghi, Member of the Executive Board of the ECBConference “The euro at 10: The next global currency?” hosted by the Peterson Institute of International Economics and BRUEGELWashington, 10 October 2008

Ladies and gentlemen,

It is an honour to be here to celebrate the approaching tenth anniversary of the euro. It is a privilege to represent the institution – the European Central Bank – which over the past ten years has watched over the first steps of the euro and brought it up to be the second most important international currency in the world. The euro is now leaving behind its childhood and entering the phase of adolescence. As with many adolescents, it is faced with a common question: “what would you like to do when you grow up?”

The ECB, like any parent, might tend to have an over-optimistic vision of its own child’s future. This is why we have adopted a policy of neither encouraging nor discouraging the international use of the euro. It should be an entirely demand-driven process. Like modern parents, we recognise that the euro does not belong to us but should develop according to its own ambitions. We are here to ensure that it has a few key virtues, the first being stability.

There are already several people – including in the United States, where even the birth was considered improbable a decade ago – who predict a bright future for the euro, anticipating that it will surge to become the dominant international currency in the coming decades [Chinn and Frankel, 2008]. Others, however, think that the euro is unlikely to overtake the US dollar [Eichengreen and Flandreau, 2008a].

Today, I will not try to review what the euro has already achieved over the last decade. The ECB regularly publishes a report that can be easily consulted [ECB, 2008a].

What I would like to do instead is to assess what the implications are, in particular from a central banking point of view, of becoming an international currency. I will analyse both the advantages and the challenges. I will then try to assess whether the euro has the potential to further increase its role and examine what the main obstacles could be to achieving such a status.

Even though the euro is currently not the dominant international currency, it has become an alternative to the US dollar as a reserve currency. Euro banknotes are a popular means of payment and store of value in the EU’s neighbouring countries. What are the implications for the ECB and the euro area as a whole? I shall try to answer this question, drawing on the economic literature.

There are two well-identified advantages that countries can obtain from having an international currency. First, there are microeconomic gains stemming from lower transaction costs. Whether the currency is used for international trade, borrowing in the international markets or simply tourism, the costs of conversion to a foreign currency and the exchange rate risk attached to these operations are eliminated. Second, the monetary authority issuing an international currency has larger seigniorage revenues to the extent that foreigners hold that currency in the form of non-interest-bearing liabilities, in particular as coins and banknotes. These gains are, however, relatively small and are estimated to amount to less than 0.05% of GDP for the euro area, as only a small fraction of the total cash in circulation – 10% to 15% – is held by non-euro area residents. International seigniorage gains are only slightly larger for the United States, at about 0.1% of GDP, as more than half of their stock of currency is estimated to circulate abroad [EC, 2008 and ECB, 2007].

There are other, broader, implications of issuing an international currency, which are less well-documented and not as easily quantifiable. Both Britain in the period before the First World War – from 1870 to 1913 – and the United States in the period after the Second World War enjoyed a so-called “exorbitant privilege” from being at the centre of the international monetary system [Meissner and Taylor, 2006]. The privilege stems from the possibility to issue low-interest domestic currency-denominated liabilities to finance higher-yield investments abroad. Both Britain before 1913 and the United States until the end of the 1980s were net creditors towards the rest of the world, and this exorbitant privilege may be seen as their remuneration for being the so-called “bankers of the world”. Over the past 20 years, the United States has shifted to a relatively large debtor position vis-à-vis the rest of the world, but its income balance has stayed positive thanks to a positive return differential between its external assets and its liabilities. For some economists, this is the result of the transformation of the United States from world banker to “venture capitalist” with a “leveraged” position, where fixed-income domestic currency liabilities finance riskier foreign assets taking the form of equity and direct investment [Gourinchas and Rey, 2005].

The greater ability to issue domestic currency liabilities has another important implication from a macro-financial stability perspective. To the extent that external liabilities are mainly in domestic currency, whereas external assets are denominated in foreign currency – as in the case of equity and foreign direct investment, and often also debt securities – issuers of international currencies tend to have a “long” position in foreign currency. As a result, fluctuations in exchange rates tend to produce counter-cyclical valuation effects on net external assets. When the exchange rate appreciates, foreign currency assets shrink in domestic currency terms and as a share of GDP. Conversely, following sharp devaluations – often associated with economic and financial stress – the foreign currency-denominated assets grow in domestic currency terms and liabilities are unaffected, improving the overall investment position when it is more needed [Lane and Milesi-Ferretti, 2005]. As an example, after the currency crises in both 1949 and 1967, sterling’s status as an international currency – with most of the large overseas liabilities still denominated in pounds – allowed the United Kingdom to cushion somewhat the impact of the devaluations [Cairncross and Eichengreen, 2003].

The issuance of an international currency could potentially also have significant implications for the implementation of monetary policy. Let’s consider the experience of the euro over the past ten years in that regard.

On the one hand, it has been essential for the euro area to have its own monetary policy in order to face idiosyncratic shocks and focus on the maintenance of domestic price stability. This result would not have been possible without the introduction of the euro and the creation of a large internal economic and trade area free of exchange rate risk. On the other hand, the external demand for euro-denominated assets may affect domestic monetary aggregates, complicating their relationship with inflation over the long run. Recent ECB staff research shows that it is necessary to place money demand in the context of portfolio flows and international asset prices in order to explain euro area M3 dynamics and measure excess liquidity, which can pose risks to price stability [ECB, 2008b].

In addition, successful international currencies are used as external anchors by a number of countries that prefer to fix the exchange rate and relinquish their monetary independence. Such currency pegs eliminate one channel of adjustment of external imbalances for the anchor currency. As long as the pegging countries are small relative to the issuing country, this might not be a major problem. However, when the aggregate economic weight of all pegging countries becomes large, the margin for adjustment of the nominal effective exchange rate of the anchor currency becomes constrained. As a consequence, the adjustment of the nominal effective exchange rate might require a more than proportional adjustment of the bilateral rates of the remaining floating currencies.

Moreover, fluctuations in the demand and supply of the euro among international investors, from both the private and public sectors, may have implications for the exchange rate. The increasing attractiveness of euro-denominated assets as a potential alternative to US dollar securities may generate sudden shifts in portfolio flows and unwelcome volatility in foreign exchange markets. Another potential indirect channel of disturbance in the dollar/euro exchange rate is possibly the role of the US dollar in the invoicing of oil and other major commodities. Over the past few years, the surge in oil prices and other commodities – in US dollar terms – has been associated with a negative relationship with the exchange rate of the US dollar against the euro. In the case of oil prices, this could be the result of policies by oil-exporting countries to try to defend the purchasing power of a barrel of oil in terms of a basket of international currencies, including, in particular, the euro. It must be acknowledged that it is difficult to detect and isolate the direction of causality between the oil price and the US dollar.

Overall, for the ECB and the euro area, the international role of the euro offers positive opportunities and serious challenges. This explains the ECB’s neutral stance aimed at neither directly promoting nor hindering the international use of the euro.

What are the conditions that cause currencies to dominate international markets? Do these conditions favour a growing role for the euro?

There is a large body of literature on the determinants of the international use of currencies. Most studies focus either on the store of value function of currencies and their role in foreign exchange reserves [see Chinn and Frankel, 2008, for a recent review] or on the unit of account and means of payment functions, including the invoicing of international trade [see Kannan, 2007]. In the first case, users of an international currency are mainly concerned with its ability to maintain a stable purchasing power over time. In the second case, users care about transaction costs and the economies of scale that are obtained from tapping into a large network.

In both cases, a number of political, institutional, financial and economic factors contribute to increasing the popularity of an international currency. I will review these factors with particular reference to the euro.

To sum up, currencies emerge as international players thanks to a combination of a large number of conditions. These include geopolitical influence, political stability and the enforcement of the rule of law, as well as good political and economic governance. Only large economies generating meaningful network externalities possess international currencies. They must also be economies with deep, efficient and open financial markets where it is possible to invest without the risk of incurring large transaction costs or capital losses. Eventually, once all these factors have been accounted for, the quality of economic governance and economic institutions and the ability to devise policies which support confidence in the external value of the currency can make the difference. Obviously, inertia in the international use of currencies is strong and sudden changes in their relative position are unlikely, barring very large shocks.

Since its introduction ten years ago, the euro has emerged as the second most important currency in the world. The euro area offers the opportunity of a large, deep and increasingly integrated financial market for foreign operators willing to hold euro-denominated assets. The monetary policy conducted by the ECB has certainly contributed to supporting confidence in the euro. We now face a different type of challenge, related to the integrity and sustainability of the single market in the face of a major financial crisis.

Given the dimension of the current turmoil, it is not surprising that market participants view the ongoing developments with some concern. After all, the birth of the euro was followed by a substantial depreciation of the euro against all other currencies. The young currency and the young central bank needed to be tested in good and in bad times. The premature death of the euro was pre-announced several times. The sceptics had to concede.

In my view, one element has to be taken into account in analysing the current situation, in the light of Europe’s past experience. Either a strong response is provided to the challenges posed by the current turmoil to the single financial market within the existing institutional framework, or the framework itself will be changed in favour of a more centralised system of supervision and crisis resolution. This is how the euro was born, after all, as it became clear, in particular after the 1992-93 foreign exchange crisis, that it was not sustainable to run different monetary policies within a single market. The same logic could apply in the case of financial regulation and supervision. And national authorities know it.