The implications of introduction of Euro on Dollar - by Sowmya Kumblekere

The implications of introduction of Euro on Dollar

- by Sowmya Kumblekere

As a Foreign Reserve currencyAs a Choice of Currency for oil trade

Contents

Introduction Chronology of world currencies Dollar as international currency Euro as emerging international currency Dollar VS Euro Foreign Reserve currency OPEC choice of currency Study findings References

Introduction

On Jan 1, 1999, Euro was inaugurated in Frankfurt, Germany to serve as a single currency to its member nations.

Membership of EU increased from 10 to 25 countries on may 1, 2004.

56 countries outside the Euro allow euro in their exchange rate regime.

Euro has potential of becoming the second largest currency reserve for the world’s financial system.

Introduction

What are the implications of this introduction of euro on US dollars?

Some other issues:– How fast will the dollar bubble burst?– How soon will euro be able to reduce

unemployment and improve European economies?

Chronology of World Currencies

Byzantine gold nomisma (in 5th –7th century)

Arab Dinar (mancus or marabotin, 8th –12th century)

Florentine fiorino (13th -14th century)Venetian ducato (15th century)UK pound sterling (16th century till WW2)US dollar (from second world war)

Factors for currency to be International currency

Size of the economy – determines potential share of currency in international trade

Importance in international trade – size linked to importance in international trade

Size, depth, openness, liquidity of domestic financial markets

Convertibility of currency – important factor. Restrictions limit use of currency

Macroeconomic policies – affect country's growth and openness of markets.

The US dollar

80% of hard currency reserves globally US currency used outside US– as store of value. Making it easy for US to maintain stable dollar

prices and have huge trade deficits. Dollar has remained stable. It has enjoyed

exchange rate arrangements. Risk on returns is very low.

In 1960, ½ of circulation outside, In 1990, 2/3rd of federal reserve currencies in circulation abroad.

Dollar: Reasons for acceptance

Size and ability to grow.Faith in stability of US political system and

transparency of the political and financial system

Availability of large amount of dollars around the world.

Dollar: benefits as a dominant currency

Benefits: US consumers, traders, tourists (can use dollar anywhere) and military. Plus, US treasuries get interest on assets held by federal reserve (approximately 12 billion per year)

Benefited as reserve currency – US was able to finance its current account deficits by issuing more currencies.

Euro

Euro system – a macroeconomic framework with one currency and one monetary policy, managed by one central bank.

Provide credible alternative to the dollar. Is second largest in terms of liquidity, depth and width. Its growth will add stability to international financial system.

Reserve positions - euro area has much larger reserves as compared to US.

Euro Vs Dollar

EURO area GDP: 15% Used as Reserve currency:

12.5% Economy: Much smaller World exports: 19.5% Economies as large as US

and net creditors to the world.

Euro will take time to reach similar status as dollar.

US GDP: 20.5% Used as Reserve currency:

66% Economy: much larger World exports: 15% Dollar will still prevail,

especially in unstable economies, due to worldwide acceptance.

Foreign reserve currency

Definition: one which is widely held in international central bank reserves. The dollar is currently the dominant reserve currency.

Developing countries: reserves play crucial role. To finance imports, foreign debt, and to intervene in currency markets to manage exchange rates.

In industrial nations, reserves mainly used for intervention functions.

Currency reserves in developing countries important to determine composition of reserve currency.

Studies

Reserve of dollars and euros in developing nations

Reserves in industrial nationsReserves globally held by all nationsShift in NE Asia

Shift in NE Asia

China sold US dollars in April, 2000. Hong Kong purchase of US treasuries gone down since

march 2000 Taiwan net purchase of US dollars is zero Euro saw a boost in 20billion in April, compared to

largest selling of US dollars. Central banks of countries, esp. China has accumulated

large foreign reserves due to growing trade surpluses + direct investment. To prevent interest rate rise hold currency low, they invest in euro.

Inferences: from foreign reserves study

ECB notes portfolio shifts “are expected to take place at a slower pace in the central bank community than in the private sector.”

Gradual shift unlikely to have much impact. Euros increased acceptance as reserve currency

might increase interest rates in US, increase borrowings in the euro area.

To have these negative impacts, euro share should rise with an absolute decline of US share. There is no evidence to suggest this (Binder 1996)

OPEC- dollar VS euro

Will euro establish in the financial market changing the dominancy of the dollar?

Recently Venezuela, China, Kuwait, Iraq change reserves to Euro.

OPEC’s interest in Euro – due to increasing value and influence of euro among commodity traders and analysts.

OPEC has 45% trade imports from Euro zone, while OPEC member countries are major supplier of oil to euro zone.

Issue: Whether UK and Norway will join Euro?

OPEC: why dollar?

US chief importer of oil. (But euro zone is even larger.)

Advantageous to US: no currency exchange risk. OPEC interested in currency that brings stable

store of value. Does not show shift to any other currency in near

future. In short run, dollars will be used. In the long run,

will dual currency prevail?

Inferences: from OPEC study

Major goal is not to jeopardize or threaten market stability in any way.

Depends a lot on member countries and the countries they trade with. If trade mainly with Asia or US, then Euro may not play key role. Common interest of both buyer and sellers.

If Euro used, both buyers and sellers will have to share currency risks.

To increase value of euro needs to be equal or near dollar as reserve currency + role of financial institutions is also crucial in assimilating euro into world market. Stability of Europe

Study findings: Conclusion

Central banks role is key. Any dollar weakness may increase and hasten interest towards euro and its acceptance. “ Central banks traditionally refrain from abrupt and large changes in the composition of their foreign reserves” (ECB 1991).

Euro has potential for growth. But needs acceptance – needs to establish itself and gain credibility.

Its diversity might pose problems and EU might need to resolve many fundamental issues.

Study findings - Conclusion

As reserve currency depends largely on what developing countries prefer. They show a tendency towards the dollars at present.

Sale of dollar and the purchase of euros by central bank –will lead to a drop in the value of dollar relative to euro. This will lead to increased interest rates on US Government securities. In contrast, Euro value would increase and euro interest rate would drop. The whole process however will take substantial time.

References

http://www.epinet.org/content.cfm/webfeatures_viewpoints_helsinkispeech - Euro and impact on dollar 1999

http://www.ecb.int/key/00/sp000113.htm - international impact of the euro

http://www.federalreserve.gov/boarddocs/testimony/1998/19981008.htm - General reading on currencies, particularly dollar

http://www.hsbc.com.tw/tw/product/fund/images/gs_200307_e.pdf - Euro as a reserve currency

http://www.rense.com/general27/rec.htm - euro as asia’s second currency

http://www.opec.org/NewsInfo/Speeches/sp2002/spAraqueSpainApr14.htm - SPEEDH BY OPEC MINISTER REGARDING EURO AS RESERVE CURRENCY

http://research.stlouisfed.org/publications/review/01/09/septoct.pdf - the creation of euro and role of dollar in international markets

http://research.stlouisfed.org/wp/1997/97-021.pdf - role of euro as an international currency