Select Committee on Treasury Eighth Report


The Euro since its Launch

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.


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]


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]

8   Those being Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. Back

9   The conversion rates into the euro equated to the central bilateral rates of the Exchange Rate Mechanism (ERM), and were "consistent with [euro-area Member States'] economic fundamentals and are compatible with sustainable convergence" according to the European Union-see Joint Communiqué on the Determination of the Irrevocable Conversion Rates for the euro, European Union, 2 May 98. Back

10   Presidency Conclusions, Luxembourg European Council, 12 Dec 97, paragraph 41 Back

11   See, for example, Treasury Committee, Second Report, 1998-99, The World Economy and the Pre-Budget Report, HC 91-I Back

12   Q2 Back

13   Q98 Back

14   Q573 Back

15   Q17 Back

16   Q18; Ev, p11 Back

17   Ev, p71 Back

18   App 23, paragragh 2 Back

19   A recent OECD working paper said that if international reserve demand for euro was erratic and constituted a relatively large proportion of total euro demand, this could create volatility in euro-area monetary aggregates and so "render the monetary aggregates less useful as a guide to inflationary pressures in the domestic [euro-area] economy". This may therefore create instability in euro-area broad money supply, M3 (one of the two pillars of the ECB's strategy, see paragraph 19), so hampering the interpretation of the monetary aggregate for future inflation. See EMU, the Euro and the European Policy Mix, Jonathan Coppel, Martine Durand and Ignazio Visco, Working Paper 232 (ECO/WKP(2000)5), Feb 2000, OECD (hereafter Policy Mix), paragraph 21 Back

20   The International Role of the Euro and the ESCB's Monetary Policy, speech by Dr Wim Duisenberg, 20 Nov 98 Back

21   Practical Issues Arising from the Euro, Bank of England, Jun 99, Chapter 3, paragraphs 24-5 Back

22   International Banking and Financial Market Developments, Quarterly Review, Bank for International Settlements, Feb 2000 (hereafter BIS Quarterly), p22 Back

23   Q2 Back

24   Ev, p11 Back

25   Q13 Back

26   Ev, p2 paragraph 12 Back

27   App 16, paragraph 12 Back

28   Quarterly Review of the Use of the Euro, No 1, European Commission, Dec 99 in Second Outline National Changeover Plan, HM Treasury, Mar 2000, p55 Back

29   Third Report on Euro Preparations, HM Treasury, Nov 99, pp20-2 Back

30   Pocket Databank, HM Treasury, 7 July 2000 (hereafter Pocket), table 16  Back

31   Statement on the euro by Dr. Willem F. Duisenberg, President of the European Central Bank, Press Release, ECB (hereafter Euro statement), 5 May 2000 Back

32   Pocket, table 16 Back

33   Monthly Report, Deutsche Bundesbank, May 2000, p13 Back

34   Nominal exchange rates do not adjust for inflation or costs and are those exchange rates quoted in the foreign exchange market. Adjustment for such factors produces the real exchange rate, and because euro-area inflation has been lower since January 1999 than US inflation, the extent of the real depreciation of the euro against the US dollar is less than the nominal depreciation of the bilateral exchange rate. Back

35   Monthly Report, European Central Bank, Jul 2000, table 10, p56* and Monthly Report, European Central Bank, Jun 2000, table 10, p56*. Calculated as the percentage change in the average exchange rate between the months of January 1999 and June 2000. Back

36   The effective exchange rate of the euro is calculated by the ECB on the bilateral euro exchange rates weighted by the average manufactured goods trade in the period 1995-97 and captures third-market effects.  Back

37   Monthly Report, European Central Bank, Jul 2000, table 10, p56* and Monthly Report, European Central Bank, Jun 2000, table 10, p56*. Calculated as the percentage change in the average exchange rate between the months of January 1999 and June 2000.  Back

38   Quo Vadis Euro?-The Cost of Muddling Through, Daniel Gros, Olivier Davanne, Michael Emerson, Thomas Mayer, Guido Tabellini and Niels Thygesen, Centre for European Policy Studies, May 2000 (hereafter Quo Vadis Euro?), p43 Back

39   App 18 Back

40   Q2 Back

41   Quoted in Quo Vadis Euro?, p47 Back

42   Good start for the euro-what's to come?, Deutsche Bank Research, 15 Jan 99 Back

43   Calculated as the percentage change in the average exchange rate between January 1999 and January 2000. Back

44   As of 20 July 2000 Back

45   Q100 Back

46   Q254 Back

47   Q258 Back

48   Policy Mix, paragraph 8 Back

49   Ev, p4 Back

50   Monetary Policy and Manufacturing Industry, speech by Mervyn King, Deputy Governor of the Bank of England (hereafter King speech), 29 Mar 2000 Back

51   Ev, p2 paragraph 10 Back

52   Quo Vadis Euro?, p20 Back

53   Ev, p71 Back

54   Ev, p4 Back

55   Monthly Report, European Central Bank, Jul 00, Table 8, p44* Back

56   App 27; Treasury Committee, 1999-2000, Minutes of Evidence, February Inflation Report, HC 286-i and -ii, Q116 Back

57   BIS Quarterly, p23 Back

58   Q18 Back

59   Six Months in the Life of the Euro-What Have We Learnt?, Professor Willem H Buiter, 29 Jun 99, (hereafter Six Months), p6  Back

60   Ev, p2 paragraph 14 Back

61   King speech  Back

62   App 30 Back

63   Ev, p4 Back

64   Q8 Back

65   App 18 Back

66   Q258; Ev, pp3, 4, 11; App 30; Six Months, p3 Back

67   Q2 Back

68   Q100 Back

69   The economic consequences of the decline in the external value of the euro are discussed in paragraph 24 Back

70   App 27 Back

71   Ev, p3 paragraph 18 Back

72   Q2 Back

73   Euro statement Back

74   Q104 Back

75   Q99 Back

76   Q22 Back

77   Q24 Back

78   Euro statement Back

79   Ev, p76 Back

80   Qq254-5, 573; Ev, pp3, 4; App 6, App 15 paragraph 3.1.ii, Apps 19, 22, 30 Back

81   Global Equilibrium Exchange Rates: Euro, Dollar, "Ins", "Outs" and Other Major Currencies in a Panel Cointegration Framework, Enrique Alberola, Susanna G. Cervero, Humberto Lopez and Angel Ubide, Working Paper WP/99/175, International Monetary Fund, Dec 99, p26 Back

82   App 18 Back

83   Qq26, 28; also see App 19 section 3 Back

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