House of Lords - European Union

Select Committee on European Union Thirteenth Report

CHAPTER 3: The impact of Economic and Monetary Union to date

40. Among the anticipated effects of the introduction of the euro, the clearest was that there would be a positive effect on trade within the eurozone; it was also expected that there would be substantial effects on the capital markets of Europe and positive effects on the stability and thereafter the growth of real output. More guardedly there was an expectation that in the course of time the euro could establish itself as a reserve currency. In this chapter we consider how far these expectations have been realised to date.

Trade

FIGURE 2

Values of total trade flows[25]

FIGURE 3

Eurozone—rest of world trade values[26]

41. Figures 2 and 3 chart values of trade flows within the eurozone, between the zone and the rest of the EU, between three major non-eurozone European economies and the rest of the world, and over a longer time-period, between the eurozone and the rest of the world. The charts are not adjusted for inflation. The charts show similar rates of growth in trade for all the flows with the exception of trade between the eurozone and the rest of the EU, which has more than doubled during the period.

42. There were good reasons to expect a positive impact on trade. The elimination of the cost of currency fluctuation between members of the eurozone involved a direct reduction in the cost of trade. As an extension of this, the reduction in the foreign exchange costs of trade was seen as reducing the fixed costs of trading, and making it easier for firms to establish the activities needed to support trading activities. Importantly, this effect has supported trade with non-eurozone countries as well as with eurozone countries alone. These factors and the introduction of increased price transparency are also seen by Commissioner Almunia, Pervenche Berès MEP, the European Investment Bank, Schwartz and Castañeda as having a positive effect on the economic performance of the eurozone (pp 50, 55, 59, 64-6, 70).

43. There exists a wide range of estimates of the effect of the introduction of the euro on trade but some of the earlier estimates[27] of a very positive effect have been substantially qualified by the realisation that it is inherently difficult to isolate an effect of the euro from the lagging, and ongoing, effects of other integration measures, in particular the Single Market programme, and the end of the communist bloc in Eastern Europe, with its strict controls on trade and migration. Indeed, the introduction of the euro can itself be viewed as a part of the creation of the Single Market. We conclude that the introduction of the euro has been a major influence on increased trade both within the eurozone and with other countries, but we are inclined not to subscribe to particular quantified estimates since it is inherently difficult to disentangle the effect of the euro from the Single Market process and other influences on trade (Philippe Maystadt, European Investment Bank p 65).

Capital markets

FIGURE 4

International money market instruments, bonds and notes[28]

44. Witnesses agreed that the euro has strongly stimulated the integration of European capital markets, most particularly the bond markets. According to Professor Walter (p 75), debt markets—in particular the government and corporate bond markets—have reached a high level of integration both in terms of liquidity and the availability of instruments. (By contrast, integration of equity markets has proceeded more slowly due to different national legal and tax systems.) Much of this activity is currently centred on the City of London.

45. One feature of this integration is that home bias—the tendency for investors to hold assets issued by institutions in their own country—has lost much of its importance[29]. The euro area's mutual fund industry has increased its proportion of non-domestic stock holdings from 40% in 1995 to 70% in 2003 (p 75). The European Investment Bank (p 66) notes that the decline in home bias in bond portfolios has occurred more in the eurozone than elsewhere, and quotes IMF research that shows that the share of assets from other EMU countries has increased notably in the portfolios of EMU countries and, to a slightly lesser extent, in the three non-EMU countries of the old EU15. In non-EU countries, on the other hand, EMU non-national asset holdings have not changed dramatically.

46. The ECB have also examined the changes in home bias (p 68). They also find that the reduction in home bias is indeed much more pronounced in euro area countries than elsewhere and there is little evidence to suggest that this is a global trend; the reduction in home bias of euro area investors has been much more pronounced in bonds than in equities.

47. There has also been a substantial expansion of the euro area debt markets with the vast majority of the debt issued by euro area issuers. Figures from the Bank of International Settlements show that in the first quarter of 1999 the outstanding quantity of euro-denominated fixed-income securities was €6.4 trillion, whereas by the fourth quarter of 2006 it was €11.7 trillion. Julian Callow told us that paper denominated in euro now accounts for about 27 % of the total outstanding global stock of debt securities. This compares with 22 % of stock in 1999, and 14 % denominated in yen in 2006 (Q 45). New bond issues denominated in euros now exceed new dollar denominated issues. Mr Callow believed that the EMU has also substantially accelerated the integration of the markets themselves in terms of improving standards of best practice for issuance and for transparency (Q 50).

48. The process of monetary union has encouraged investors to treat the European capital markets as a single space and to look for diversified investment opportunities in several Member States, rather than only in those States that dominated investors' preferences in the past (Callow, Commissioner Almunia, European Investment Bank Q 50, pp 51, 68). However, this process is not yet complete: having spent many years moving together, spreads have widened between German-issued bonds and less-traded eurozone government bonds, such as those issued by the Italian, Greek and Spanish governments in recent months[30].

49. Even though the money markets and the markets for government securities and private sector bonds are now highly integrated, and progress has been made towards the integration of stock markets, the integration of banking markets—in particular retail banking—is lagging behind. While consolidation of the banking sector notably through mergers has been fostered by the euro, credit markets remain fragmented, in large part due to regulatory and tax differences across Member States and the very limited extent of cross-border competition among banks[31] (Bruegel, Podkaminer pp 59, 69).

50. The creation of a common market in financial services has been recognised by all Member States as an increasingly important policy objective in the past decade[32]. The introduction of the euro does appear to have fostered some financial integration both within the eurozone and in the wider EU, although some of this might have occurred in any event. The introduction of the euro has stimulated integration in parts of the capital market and the Eurobond market has become well established. This still needs to be reinforced by other measures; historically, the protection afforded to national retail banking markets has resisted a substantial "euro effect".

Reserve currency

FIGURE 5

Percentage of known reserves (measured in US Dollars)[33]

51. Figure 5 shows the proportion of different currencies held in known currency reserves (measured by value). For the years prior to the introduction of the euro, holdings in ECUs and pre-euro currencies are compiled as a proxy for euro holdings. The euro has become an important reserve currency. The value of ECU and legacy currency reserves fell in the run up to the creation of the Euro due to uncertainty about its impact. The currencies of the countries going into the euro area constituted about 17 % of international reserves at the beginning of 1999, and since then the proportion of reserves held in euro has risen to about 26.4 % (as at Quarter 3 2007). This rise, which slightly exceeds the reduction in holdings in the late 1990s, has been at the expense of the Yen and US dollar. However, the dollar remains the dominant reserve currency as well as the currency of preference when it comes to trading in the foreign exchange markets.

52. The euro has established itself with remarkable speed as a widely accepted transactions currency. There are now more euro than dollar notes and coin in circulation across the world. The €500 note is the highest value note of any major currency in circulation; concerns that it might be subject to widespread counterfeiting have not yet been realised[34], but Professor Goodhart noted its potential use in the black economy (Q 38).

Exchange Rate

FIGURE 6

Exchange rates[35]

53. Recent developments in the euro-US dollar exchange rate—which have continued in the past four months—have caused some concern, in particular because of the effect that the increasing value of the euro has on exports of European goods. This process has potential for an asymmetric effect on the eurozone, with regions where exports make up a significant proportion of economic activity worst hit. It has been suggested that the current weakness of the dollar and strength of the euro is leading several countries to consider switching part of their reserves from dollars to euros, an action that would further weaken the value of the dollar (Callow, Portes QQ 60, 166).

Economic growth

FIGURE 7

Annual inflation rates in original eurozone countries[36]

FIGURE 8

Annual GDP growth rates in original eurozone countries[37]

FIGURE 9

Annual GDP growth rates in the eurozone & selected other industrialised countries[38]

54. Figures 7, 8 and 9 chart inflation rates in the eurozone and growth rates in the eurozone and other industrialised countries.

Figure 7 shows that inflation rates in the original eurozone countries are beginning to move in alignment with each other, although there is more divergence in rates than in 1997 and 1998, when all but one member had rates within 1.5% of each other.
Figure 8, GDP growth rates in the original eurozone countries, indicates that growth rates are becoming more aligned, although the eurozone members still have significant differences in annual growth rates.
Taking the eurozone as a whole, figure 9 indicates that growth has generally been below the rates achieved in the USA and Sweden, but broadly similar to growth in the UK, Denmark and the EU as a whole.

55. Clear evidence on the effect that the introduction of the common currency has had on growth in the eurozone is difficult to establish, not least because of the short period of time that the zone has been in place. We received no evidence that growth has been impeded by the single currency. Figure 9 shows that growth in the eurozone has been broadly in line with other developed countries in Europe and worldwide. The lack of structural reforms (especially with regard to product and labour markets), the failure to complete the single market, and a general failure to implement the Lisbon Agenda for Jobs and Growth aggressively are impediments to growth that may have undermined the impact of the single currency[39]. Alternatively there is the possibility that growth during this period was being boosted by the lag effects of earlier single market reforms, and the enlargement of the European Union in 2004.

56. Many of the benefits of EMU came about before the adoption of the single currency as a result of the structural reforms undertaken by Member States to meet the criteria laid down by the Maastricht Treaty for the adoption of the euro. This pace of reform has however slowed down since 1999 (as noted in Chapter 2). Several Member States took advantage of the short term benefits of eurozone membership (i.e. low interest rates, exchange rate stability) which helped them finance their development but have not taken advantage of the recent stable economic period to implement the necessary structural reforms that would allow them to make further, sustainable, reductions in their levels of national debt (see paragraphs 24-30).

57. In addition the increase in trade due to the adoption of the single currency (discussed in paragraphs 41-43) has had a positive impact on economic growth in the eurozone.

General conclusion

58. The euro has resisted external shocks to date, and does not face any forseeable likelihood of disintegration. None of the fears, expressed at the time of its launch, about a divisive or negative impact on European economies has been borne out. Its existence has contributed to economic development and low inflation in the eurozone. This is a static analysis of developments during the first decade of the currency's operation and not a comparison with what might have occurred without the currency. The relatively short history of the currency makes firm conclusions difficult to draw after only one decade of the currency's operation.

25 Source: Eurostat. Back

26 Source: Eurostat. Back

27 For example, HM Treasury noted in their EMU study, EMU and trade (HM Treasury, 2003) that some studies had suggested a potential doubling in trade, although an impact of up to 10% was thought to be more likely. Back

28 Source: Bank for International Settlements Quarterly Review, December 2007. Back

29 Finance theory suggests that investors' portfolios should hold assets from different countries in proportion to the assets' market capitalisation. The lack of integration in global markets prevents this. Back

30 This can be largely attributed to the liquidity shortage although the phenomenon had been identified before the summer of 2007. Spreads have widened in less frequently traded debt instruments while German debt remains a benchmark product and is thus relatively liquid. Market participants suggest that the initial convergence was caused by an influx of capital into the eurozone as sovereign wealth funds rebalanced their holdings into euro (Financial Times, 27 February 2008). Back

31 The Commission published a Green Paper on Retail Financial Services in the Single Market in 2007 (COM(2007) 226). Back

32 This issue is also discussed in chapter 7 of European Union Committee, 5th Report (2007-08): The Single Market: Wallflower or Dancing Partner (HL 36) Back

33 Source: International Monetary Fund. Back

34 The ECB publish biannual information on Euro bank note counterfeiting which indicate that lower denomination notes are more commonly produced by counterfeiters. Back