The euro and the dollar: strut your stuff

What will European economic and monetary union mean for the greenback?

THE indecent haste with which governments in the European Union are pushing towards a single currency may be driven more by politics than by economics; but hordes of studies have at least tried to weigh the costs and benefits of European economic and monetary union (EMU) to member countries. However, economists have given little attention to what the euro will imply for the rest of the world. In particular, what will it mean for the dollar?
     Economists split into two camps on this question. One group suggests that replacing the rock-solid D-mark with a soggy euro will prompt investors to switch into dollars, lifting the greenback against the new European currency. Not only will the European Central Bank lack the inflation-fighting credentials of Germany's Bundesbank, runs the argument, but EMU will include countries that have fudged the budgetary criteria in the Maastricht treaty on monetary union.
     Another camp, however, argues that the creation of the euro as a rival to the dollar may encourage central banks and investors to diversify out of dollars, pushing the greenback down. The dollar's share of foreign-exchange reserves has already fallen to 64%, down from 80% in the early 1970s. There is scope for this to fall further: the dollar's weight in world reserves still far exceeds America's in the world economy: the ratio of American GDP to global output is just over one-fifth.
     The effect of EMU on the dollar largely depends on how both European and non European central banks adjust their reserve holdings. Consider European central banks first. The total foreign-exchange reserves of EU members currently amount to over $370 billion, far more than those of either America or Japan (see chart). Add in their holdings of gold (valued at market prices) and the EU's reserves are more than double Japan's and nearly quadruple America's.
     Central banks hold reserves for two main reasons. First, as a cushion to meet temporary shortages in the foreign currency needed to make payments for trade or to pay interest; and second, as a means of supporting the value of their currencies if the need arises.
     After EMU goes ahead, the need for participating countries to hold reserves will decline on both counts. They will no longer need such big war chests to defend their currencies' positions in Europe's exchange rate mechanism against speculative attacks. And after monetary union, member countries will need to pay for much less of their imports with foreign currency because trade between them will take place in euros. Thus they will need smaller foreign exchange reserves.
     If (a very big if) all 15 EU countries eventually join a single currency, then over 60% of their current foreign trade would be reclassified as "domestic". However, EMU will also automatically reduce participating countries' reserves, because those that are currently held in other EU currencies will no longer count as foreign exchange. The D-marks held by the Bank of France, for instance, will be converted into euros. France's reserves will immediately drop, but there will be no implications for exchange rates.
     Even so, European central banks will still be left with excess dollars, which over time they are likely to dump. How so? Using rough estimates of the current composition of the EU's foreign reserves, the average ratio of foreign-exchange reserves to imports in the 15 countries will almost double after EMU; the ratio of total reserves (including gold) will jump from 29% at present to 59%. Not only would that leave Europe's reserves much higher relative to its imports than the equivalent ratio in America, but a hefty 90% of those reserves will be in dollars. It seems almost certain, therefore, that European central banks will dump dollars, both to trim their reserves and to diversify into other currencies, such as the yen and Swiss franc. This will tend to weaken the dollar against the euro.

Competition for Mr Universe
     In practice, not all 15 countries will participate in EMU from day one, so the overhang of dollars will be smaller. Economists at J.P. Morgan, an American bank, assume more realistically that in January 1999 just eight countries join EMU (Austria, Belgium, Finland, France, Germany, Ireland, Luxembourg and the Netherlands). With this smaller membership, "foreign" imports do not drop by as much. Even so, reckons the bank, this will leave them with excess dollar reserves of perhaps $70 billion.
     What about central banks outside the EU? The creation of a single European currency should boost the euro's attractiveness as an international currency for invoicing trade, as a tool of intervention and as an investment. If the European central bank can establish its inflation-fighting credibility, then for the first time since the end of the second world war the dollar could face a competitor of equal muscle. The EU's total GDP is bigger than America's, and monetary union will help make European capital markets broader and more liquid, and hence more of a match for America's.
     On simple diversification grounds, there is a strong case for central banks to hold more euros. For example, Japan's foreign-exchange reserves are thought to be almost entirely composed of dollars, and thus in the long term switching some into euros might seem prudent. As the role of the euro increases, some countries, especially in Eastern Europe, may choose to peg their currencies to it.
     The euro is also likely to play a bigger role in the invoicing of trade than the current sum of its constituent parts. This is because the currencies of big exporters tend to be used disproportionately in invoicing. For example, almost 50% of world trade is invoiced in dollars, far above America's 13% share of world exports. J.P. Morgan calculates that after EMU 17% of world exports will originate from the eight European core countries. If, as the bank assumes, the ratio of exports to invoicing is the same for the euro as for the D-mark, then this implies that 25% of world exports might be invoiced in euros, up from 16% today.
     Adding together the three sources of increased demand for euros--European central banks' excess reserves of dollars, diversification by non-European central banks and trade invoicing--J.P. Morgan estimates that the demand for the new European currency could increase (and hence that for dollars will fall) by $600 billion over the next decade.
     So contrary to the current popular view of the euro as a "weak" currency, EMU may actually create a rather strong one. This could be awkward for Europe: it would exacerbate the existing problems of European competitiveness, and so depress output and jobs. Moreover, if the new European central bank initially pursues a super-tight monetary policy to establish its credibility, governments will be forced to offset this with laxer fiscal policy. The consequent policy mix--tight money and loose fiscal policy--will be an exact replay of America's policies in the first half of the 1980s, which caused the dollar to soar. It would be a bitter irony if greater currency stability within Europe resulted in a bigger shift against currencies outside it.

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