House of Commons - Treasury

Select Committee on Treasury Eighth Report

II. ECONOMIC AND MONETARY UNION SINCE 1999

5. On 1 January 1999, the eleven participating EU countries commenced Stage Three of European Economic and Monetary Union.[8] In accordance with the Maastricht Treaty, the currencies of the eleven countries were locked together,[9] so creating a new currency, the euro. The euro is at the moment a store of value and unit of account—there will not be any euro notes and coins in circulation until 1 January 2002.[10] At a stroke, the participating countries removed exchange rate volatility with one another and transferred responsibility for setting interest rates to the European Central Bank (ECB). The commencement of Stage Three took place in the aftermath of the global financial crisis of the autumn of 1998, which created considerable financial market volatility and uncertainty about the global economic outlook.[11] Mr Bootle commented that the creation of the euro was "an extraordinary thing to have achieved ... and all the more so given the international conditions that existed at the time".[12] Commissioner Solbes added that the euro had been introduced "smoothly" and argued that fears that it would be impossible or dangerous to introduce a single monetary policy across the euro-area had proved unfounded.[13] The Chancellor said the creation of the single currency had been "technically ... a very smooth exercise".[14] Stage Three of EMU commenced despite the prevailing financial and economic conditions, and the euro was introduced smoothly.

USE OF THE EURO

6. Although the euro does not yet exist in physical form, it has developed a widespread role. The euro has subsumed the role of its eleven constituent currencies (or "legacy currencies"), in particular the Deutsche Mark, in central bank reserves.[15] However, Mr Barty, of Deutsche Bank, thought that there had been "little [additional] switching of central bank reserves into the euro" to date, although he added that this situation may change as the new currency matures due to the size of the euro-area economy, particularly if the euro appreciates.[16] The CBI argued that the euro is "not yet in any sense" a reserve currency, and that growth and convergence within the euro-area, and perhaps even UK membership of the single currency, would be required for the euro to be able to assume reserve currency status.[17] Mr Forder, Fellow of Balliol College, Oxford, said that, apart from a "certain prestige benefit, ... the material economic benefits [of reserve currency status] are rather slight",[18] and a recent OECD working paper highlighted the potential risks for the real economy if the euro took on the role of a reserve currency.[19] Dr Duisenberg, President of the ECB, has said that it "will neither hinder nor deliberately encourage" the establishment of the euro as an international currency, but rather "leave this to market forces".[20]

7. Financial markets immediately adopted the euro in place of the legacy currencies—for example, the new currency was quoted in the wholesale foreign exchange and deposit markets from the start of Stage Three, according to the Bank of England.[21] In international capital markets there is evidence that the use of the euro has exceeded that of its legacy currencies. According to Bank for International Settlements data,[22] in 1999 gross issuance of euro-denominated bonds and notes accounted for 39 per cent of total world issuance, compared to only 28 per cent in 1998 for the euro's legacy currencies, an increase which Professor Buiter described as "quite remarkable".[23] Mr Barty explained that the euro had "undoubtedly allowed the creation of a much deeper and larger financial market in Europe" compared to the previous eleven legacy currencies,[24] which was also evident in the equity markets.[25] Mr Bootle explained that this more liquid market had "greatly increased the attractions for borrowers" of selling debt in euros.[26] However, Business for Sterling argued that "low interest rates in a declining currency" were also stimuli for increased borrowing in euros.[27]

8. There is evidence that the euro is currently being used by firms and individuals in the euro-zone, although on a limited scale. A European Commission study published in December 1999 found that within the euro-area only 1.9 per cent of company payments and 0.8 per cent of consumer payments were made in euros.[28] A recent HM Treasury survey, however, found that the euro was increasingly being recognised in the euro-zone, if not actually used, particularly as a result of the dual pricing of goods in euro and legacy currencies.[29]

THE VALUE OF THE EURO

Internal Value

Figure 1: PPP value of the euro against sterling and the US dollar

January 1999 = 100
Source: Main Economic Indicators, OECD, June 2000

9. The internal value of the euro, as measured by the rate of inflation of the euro-area, has been stable since its launch. In 1999, the rate of OECD-measured inflation in the euro-area was 1.1 per cent.[30] Dr Duisenberg recently explained that the internal stability of the euro meant that citizens of the euro-area "can be confident that their [euro-denominated] savings and pensions will keep their value over time".[31] Indeed, comparison of euro-area inflation with that experienced in the US since the launch of the euro shows that the euro has strengthened relative to the US dollar on a purchasing power parity (PPP) basis, as shown in Figure 1—on the same OECD measure, US inflation was 2.2 per cent in 1999 and has remained higher than euro-area inflation during 2000.[32]

External Value

Figure 2: External value of the euro against sterling and the US dollar

Values based on the monthly average of daily rates at the close of the London market.
Source: HM Treasury, Pocket Databank, Table 15, 14 Jul 00

10. The external value of the euro against major global currencies has fallen markedly since the launch of the single currency, as shown by Figure 2, leading the Bundesbank to comment that "obviously, the euro's internal strength is not being duly appreciated on the foreign exchange markets".[33] In the period from its launch in January 1999 to June 2000, in nominal terms[34] the euro depreciated by 18 per cent, 11 per cent and 23 per cent against the US dollar, pound sterling and Japanese yen respectively.[35] Using the ECB's calculation of the euro's nominal effective exchange rate against 39 trading partners,[36] the new currency declined by 11.3 per cent over this period,[37] which led the Centre for European Policy Studies (CEPS) to opine that "the euro's weakness is thus not only a reflection of the strength of the [US] dollar. The euro has also been weak against many other major currencies as well".[38] The decline in the external value of the euro was in marked contrast to expectations at the start of 1999, when, Mrs Rosewell, a Specialist Adviser to the Committee on monetary policy, observed, "many commentators thought that the euro would be a strong currency",[39] and consequently the decline in the euro's external value came as a "considerable surprise to many people", according to Mr Bootle.[40] When the euro was launched, it was worth $1.18. A survey of currency forecasters in January 1999 found that the average of the forecasts expected that the euro would appreciate by 2.5 per cent from that level to $1.21 by January 2000.[41] Deutsche Bank, for example, acknowledged that, while there were risks of euro depreciation, support for the euro created by the "likelihood of increasing portfolio and reserve shifts into the new currency" caused them, on balance, to expect the euro to appreciate steadily through 1999 to be some 3.5 per cent higher than its launch value by January 2000.[42] Against the consensus of expectations, however, by January 2000 the euro had depreciated by 12.7 per cent[43] to a rate of $1.014 and declined still further in subsequent months. Having fallen to its lowest level to date of $0.886 and £0.567 on 4 May 2000, the euro's external value has since rebounded to $0.925 and £0.616.[44]

Possible Explanations

11. Witnesses each provided different explanations for the decline in the euro's external value since its launch. Some of these explanations are summarised below, primarily with reference to the euro/dollar exchange rate, although some may equally apply to the euro/sterling and euro/yen exchange rates:

Overvaluation of the euro at launch: Commissioner Solbes believed that at the end of 1998 the value of the ecu, the euro's predecessor, was "too high".[45] Ms Lea, of the Institute of Directors, added that immediately prior to launch "there was a lot of enthusiasm ... and it [the euro] was probably overvalued at launch; so to have it come off a bit was probably not that unexpected"[46]
Unrealised expectations of relative euro-area, US and UK growth: The global financial crisis in late 1998 caused a lowering of expectations for future US growth and interest rates, so weakening the US dollar. However, as 1999 progressed, Ms Barker, of the CBI, said there were "surprises on growth" that were downward for Europe and upward for the UK and the US which,[47] according to a recent OECD working paper, provided a "significant force underlying the depreciation of the euro over much of 1999"[48]
Interest rate differentials: Higher interest rates provide an incentive to hold a currency[49]—UK and US short-term interest rates have been above the euro-area's rates since the start of 1999. Mr Mervyn King, Deputy Governor of the Bank of England, has recently said that "changes in relative interest rates explain only a small part of the rise in sterling against the euro",[50] and it is clear that the euro/yen exchange rate has not been driven by relative interest rate differentials
Concerns about future inflation: This could perhaps result from a lack of confidence in the ECB and could reduce the external value of the euro because inflation would weaken the internal value of the currency. Mr Bootle noted, however, that this fear has not been reflected in European bond markets,[51] and analysis by the CEPS supported this view[52]
Fiscal laxness by euro-area countries: Doubts that some euro-area countries would follow fiscally prudent courses may have undermined the external value of the euro because of fears of political disharmony and inflation. The June 1999 announcement that the Italian Government was to increase its planned borrowing level caused the euro's external value to weaken
Inflexibility of the euro-area economy: The CBI believed that a lack of structural reform in the euro-area, and the failure to communicate the progress that had been made,[53] may have depressed the external value of the euro. The perception of structural rigidities in the euro-area signalled an "underlying economic weakness" compared to the US in the view of Professor Begg and Mr Ardy,[54] which might serve to constrain growth expectations
Capital withdrawal from the euro-area: In 1999 there was a flow of net portfolio investment out of the euro-area of _29 billion and a similar flow of net direct investment of _139 billion.[55] Sir Edward George, Governor of the Bank of England, and Credit Lyonnais UK believed that these substantial sums had been a factor behind the decline in the external value of the euro[56]
Increased borrowing in euros: Borrowing in euros would affect the external value of the euro if the sums borrowed were converted into foreign currencies. Bank for International Settlements data indicate that while in 1999 net issuance of euro-denominated bonds and notes was over double that in 1998, net issuance to European countries represented 90 per cent of that increase.[57] The rise in euro-denominated borrowing through bonds and notes may therefore have had only a limited effect on the external value of the euro
The euro has not yet become a reserve currency: Reserve currency status could enhance the credibility of the euro currency,[58] so improving its desirability. However, as noted in paragraph 6, additional demand for the euro as a reserve currency beyond that of its legacy currencies has not occurred to any significant extent. Professor Buiter has downplayed the significance of this factor[59]
Reduced risk diversification leading to less investment in euro assets: The replacement of eleven currencies with one reduced investors' diversification possibilities offered by the different risk characteristics of the countries' individual monetary policies. Mr Bootle believed that this had made the euro less attractive to investors than its legacy currencies[60]
Increase in the perceived risk of holding the euro: Mr Mervyn King has argued this may have been the result of uncertainty about the new currency and the institutions that would manage it, "leading to a fall in the [external] value of the euro against all currencies, including sterling".[61] However, Professor Portes, of the London Business School, believed this factor alone could not have been responsible[62]
Poor communication: Garbled and conflicting views on the euro may have failed to provide a clear indication of the views of policy makers about the currency, and may also have raised fears of conflicting aims amongst policy makers. Professor Begg and Mr Ardy explained that "discordant voices from Frankfurt and elsewhere ... have sown uncertainty ... [which] reinforced worries about a new and untried currency".[63]

12. While cyclical economic factors may have influenced the euro through a number of channels, Professor Begg argued that "nothing structural changed at the beginning of January 1999 to explain why the euro should suddenly fall ... If there are long term problems they would manifest themselves over a period of years—not as quickly and as reversibly as the change in the euro has been".[64] While cyclical differences in the euro-area and the US were, in the view of witnesses, a plausible explanation for at least part of the depreciation of the external value of the euro against the US dollar, it is difficult to ascribe any particular weight to this or any of the other factors cited by witnesses. Mrs Rosewell cautioned that "in the short term, currency rates respond in a complex way" to a number of pressures, adding that "there is no simple relationship between the exchange rate, interest rates and economic performance".[65] Indeed, the depreciation in the external value of euro experienced since January 1999 was not unprecedented in the view of many witnesses,[66] and Mr Bootle argued that "it is simply another example of exchange markets moving currencies to a considerable degree".[67] Commissioner Solbes offered assurance that "the volatility of a currency is something that happens very often".[68]

Consequences and Future Prospects

13. The implications for Stage Three of EMU of the decline in the external value of the euro were not considered significant by some witnesses.[69] Credit Lyonnais UK argued that it was "wrong to judge the credibility of the ECB and the single currency in terms of the [external] value of the euro against the [US] dollar", adding that "Americans do not perceive the dollar in this way".[70] Mr Bootle said that the depreciation of the external value of the euro should not be interpreted "as a sign that the currency is fundamentally flawed".[71] Professor Begg observed: "internally ... things have worked well within Euroland; externally we are dominated, especially in this country, by what we see on the foreign exchange markets which is that the euro is a complete disaster. I think that is a false perception".[72] Nevertheless, as the President of the ECB has observed, "a persistently lower euro exchange rate may ... undermine the perception of the euro as a stable currency",[73] a view shared by Commissioner Solbes, who agreed that the "psychological effect of [euro] weakening is not positive", although he hoped this was simply a consequence of a "period of volatility ... which is, of course, not permanent".[74] He also thought that the external value of the euro mattered insofar as it had an effect on inflation.[75] Dr Gros argued that the fall in the euro's external value to date was not seriously a "menace" to price stability and, as a consequence, the ECB was unlikely to intervene,[76] adding that, if it did, intervention would need to be coordinated with other central banks to be effective.[77] The ECB has, however, attempted to 'talk up' the euro, most notably in a statement by Dr Duisenberg in May 2000 in which he said that the ECB would "monitor the euro exchange rate very closely".[78] The Institute of Directors concluded that "given the lack of major labour, tax and social security reforms ... in Euroland it is difficult to see the euro as a strong currency".[79]

14. Some witnesses predicted that the external value of the euro would appreciate in due course.[80] However, as demonstrated at the launch of the euro, expectations of future exchange rates do not necessarily come to fruition. A recent IMF working paper calculated that, at end-1998, the euro was 7.4 per cent undervalued against the US dollar, yet, despite this apparent misalignment, the currency's deprecation continued throughout 1999.[81] Mrs Rosewell wrote that the future course of an exchange rate could not be predicted on the basis of whether it seemed over- or under-valued.[82] This may explain the degree of circumspection in regard to predicting when and by how much the external value of the euro might appreciate; while Dr Gros, of the CEPS, was confident that fundamental equilibrium exchange rate theory would support an appreciation of the external value of the euro, he was rather unspecific as to when this would take effect, merely saying that he expected the euro to appreciate over a ten year period.[83]