Download The Future of the Dollar-Euro Exchange Rate, 2002

North American Journal of
Economics and Finance 13 (2002) 56–71
The future of the dollar–euro exchange rate
Simon Neaime a , John Paschakis b,∗
b
a
Department of Economics, American University of Beirut, Beirut, Lebanon
Department of Economics, Atkinson College, York University, 4700 Keele Street, Toronto,
Ont., Canada M3J 1P3
Received 9 February 2000; received in revised form 11 February 2002; accepted 13 February 2002
Abstract
Monetary unification in Europe is expected to produce a major new international currency, which
may compete with the U.S. dollar as the currency of choice in foreign exchange transactions, financial
asset markets and central bank reserves. This study considers two important issues regarding the euro: its
global role as medium of exchange, unit of account, and store of value and its position relative to the U.S.
dollar. Among the main considerations are differences in cyclical behavior, inflation differentials, trade
patterns and capital flows, and risk-return assessments. External diversification of private portfolios
and of central banks’ reserve holdings will play a key role in determining the euro’s exchange rate.
Overall, despite its rough start, we argue that the euro may emerge as a challenger to the U.S. dollar.
© 2002 Elsevier Science Inc. All rights reserved.
JEL classification: F30; F31; F36
Keywords: Dollar; Euro; International currency; External value
1. Introduction
Monetary unification in Europe is expected to produce a major new international currency,
which may compete with the U.S. dollar as the currency of choice in foreign exchange transactions, financial asset markets and central bank reserves. While exchange rates within the
European Monetary Union (EMU) are permanently fixed, the euro interacts with the dollar
and the other non-EU (European Union) currencies via a system of freely floating or managed
exchange rates.
∗
Corresponding author. Tel.: +1-416-736-5232; fax: +1-416-736-5188.
E-mail address: [email protected] (J. Paschakis).
1062-9408/02/$ – see front matter © 2002 Elsevier Science Inc. All rights reserved.
PII: S 1 0 6 2 - 9 4 0 8 ( 0 2 ) 0 0 0 6 1 - X
S. Neaime, J. Paschakis / North American Journal of Economics and Finance 13 (2002) 56–71
57
This study considers two important issues regarding the euro: its global role as medium of
exchange, unit of account, and store of value and its value relative to the U.S. dollar. Both will
be determined by such factors as differences in cyclical behavior, inflation differentials, trade
and capital flows, and risk-return considerations. The external value of the euro will also be
affected by private portfolio diversification inside and outside the euro area, and by central
banks’ reserves diversification.1
The paper is organized as follows. Sections 2 and 3 explore the international role of the dollar
and the euro. Section 4 assesses different views on the dollar–euro exchange rate. Sections 5 and
6 focus on the effects of portfolio diversification, central banks’ reserve diversification, and the
U.S. current account deficit on the euro’s external value. Section 7 explores the experience with
the euro since its launch. Section 8 discusses credibility concerns. The last section concludes
the study.
2. The dollar as world currency
The U.S. dollar replaced the pound sterling after World War I as the dominant world currency
because of the size of the American economy and its global trade, the existence of large and
well-developed financial markets in the United States, and its more stable value.2 The dollar
has performed three international monetary functions. First, it has served as a store of value
because its value is relatively stable compared to other currencies. Holdings of dollar assets
have been the largest component of central bank reserves since 1970. Also, U.S. dollar bonds
make up a significant proportion of the international bond market. However, the share of U.S.
dollar bonds in the international bond market has fallen substantially since the early 1980s,
with a corresponding sharp rise in the share of yen-denominated bonds (BIS, 1997). Krugman
(1984) argues that the uncertainty caused by floating exchange rates is one disadvantage of
the dollar as a store of value. This uncertainty has resulted in a gradual diversification away
from the dollar since 1973.
Second, the dollar has served as an international unit of account with the prices of many
international commodities stated in terms of dollars. For instance, oil and gold prices are
always quoted in dollars, and trade in oil is invoiced in dollars. Whereas European firms
invoice a very large proportion of their exports in their own currencies, the proportion of
their imports invoiced in other currencies, and especially dollars, is significant. Developing
countries invoice overwhelmingly in dollars. However, the share of Japanese exports invoiced
in dollars has been falling over time, while the share denominated in yen is rising; and the
share of U.S. trade denominated in foreign currencies is rising (Black, 1985, 1990). The trend,
therefore, seems to be a decline in the share of dollar-denominated transactions in world
trade.
Third, the dollar has been used by central banks in their exchange intervention in the
postwar period. Dollar reserves constitute widely acceptable means of payment. Data on the
composition of official international reserves suggest that the share of the U.S. dollar in official
reserves, although declining, is still higher than the combined share of all other currencies taken
together (Alogoskoufis & Portes, 1997). The popularity of the dollar as an international reserve
currency, has been, to a great extent, the result of its great liquidity and low transaction costs
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(Dooley, Lizondo, & Mathieson, 1989). In the private sector, the dollar is currently used in 83%
of two-way transactions in foreign exchange markets, despite the fact that the EU accounts
for a higher percentage of world exports and imports than the United States (BIS, 1996). It
also intermediates in the financing of trade between EU and third countries, as well as trade
among third countries themselves.3 The relatively low transactions costs of using dollars as
compared to other currencies in foreign exchange markets make it the most popular vehicle
currency in the world today (Black, 1990; Krugman, 1980).4
The future international role of the dollar is largely an economic question. According to
Aliber (1979, p. 144), real factors, like the size and wealth of the U.S. economy, suggest
that the dollar will continue as the dominant currency. The role of monetary factors is more
uncertain, however. Economic mismanagement could tarnish the dollar’s attractiveness to
world investors. If the U.S. inflation rate were to rise relative to its major partners, then
eventually investors around the world would shift liquid wealth away from dollar-denominated
securities. In this case, the dollar is likely to depreciate in the foreign exchange market, and
its international role will decline.
3. The international role of the euro
The common European currency has had the potential of becoming a major international
currency from the very beginning (Salvatore, 2000). This is so, because the euro area (1) is about
as large an economic and trading unit as the United States; (2) has a large, well-developed, and
growing financial market, which is increasingly free of controls; and (3) is expected to deliver
a good inflation performance that will keep the value of the currency stable. The combined
15-nation EU is larger than the United States in terms of gross domestic product (GDP), global
trade, and population. The Japanese and European shares of world exports have been rising,
while the share of U.S. exports seems to have been stagnant (Alogoskoufis & Portes, 1997).
Thus, introduction of the euro carries with it the potential for creating the largest integrated
financial market in the world. This is all the more likely if the U.K. joins EMU, because of the
size of the U.K. financial sector.
A successful euro based on a consolidated European capital market may emerge as the
first real competitor to the dollar since it surpassed sterling after World War I. The euro may
challenge the global dominance of the dollar in trade invoicing, in bond portfolios, and in
official reserves. It may also help Europe capture a large share of the global market for a safe,
reliable vehicle currency (Rogoff, 1998).
The success of the euro as an international currency will depend to a great extent on the
desire of private investors to hold assets denominated in euros. The internal market for private
bonds in Europe is two-thirds the size of the American market and is already fairly unified
(BIS, 1997; McCauley & White, 1997). Establishment of the euro will promote integration
of the EU15 government debt markets. As euro financial markets become further integrated,
they will also become more liquid and deeper, transactions costs will fall, and euro assets
will therefore be more attractive to external investors. The anti-inflationary reputation of the
European Central Bank (ECB) may work in the euro’s favor in the longer term. If the ECB is
able to maintain price stability within the euro area, it will also be able to maintain its external
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value relative to other currencies. In this case, the euro will become an attractive store of value
and its vehicle currency role will expand.5
The international unit of account role of the European currency will depend first on whether
importers and exporters invoice in euro. EMU is likely to result in the almost exclusive invoicing
in euros by EU firms. Also, economies of scale in use of the euro will induce firms from other
areas that trade mainly with the EU to start invoicing in euros (e.g., Central and Eastern
Europe, the Middle East and North Africa), as will many multinational Japanese and U.S.
firms. The euro’s international unit of account role will grow at a rate determined by its ability
to capture more of the dollar’s vehicle currency position in non-U.S. trade (Portes & Rey,
1998). Therefore, it is very likely that the euro will eventually become the dominant unit of
account and means of payment in Europe and its immediate vicinity (North Africa and the
Middle East).
Whether the private sector will use the common currency as a means of payment (in foreign
exchange transactions) will depend on transactions costs. Lower transactions costs resulting
from greater efficiencies will promote the euro’s medium of exchange function. The extent
to which the inter-bank market and the non-bank private sector will adopt the euro will thus
depend on the success of financial deregulation in bringing down the cost of banking in the
EU, and on central bank and regulatory policies determining the cost of using the euro payments mechanism (Giovannini & Mayer, 1991; Folkerts-Landau & Garber, 1992). Further, the
emergence of the euro as an international currency will depend on the willingness of the ECB
to allow the euro to become a global currency. So far, “the Eurosystem has adopted a neutral
stance neither fostering nor hindering the international use of its currency.”6 Alogoskoufis and
Portes (1997) argue that the economic fundamentals favor the euro, but, because of history
(inertia), the dollar will remain quantitatively dominant for some time.7
Following establishment of EMU, there will be a reduced need for foreign exchange market
intervention in dollars by national EU central banks. This will entail a significant decline in
the use of the dollar as an international means of payment by official institutions. The euro
will not necessarily become a major reserve currency outside the EU, however, unless foreign
exchange intervention by non-EC countries is also in euros. It is a potential substitute for the
dollar in the portfolios of EU central banks that do not participate in the final stage of EMU,
or in the portfolios of non-EU central banks that decide to peg their exchange rate to the euro.
These may in due course include, for example, the central banks of the economies of Central
and Eastern Europe.
4. Views on the dollar–euro exchange rate
The international use of the euro will have implications for its exchange rate, both in the
short and in the long run. A successful money requires both trust in the reliability of its issuer
and a reasonable degree of stability in its value (Black, 1985). However, there is a distinction
between a currency’s internal and external value. In the case of the euro, the internal value is
dependent upon maintaining stable prices within the euro area. Since the ECB’s priority is that
of price stability, the euro will retain its internal value provided that inflation is contained so that
rising prices do not erode real wealth. The external value of the euro, however, is represented
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by the exchange rate, the price of the euro in terms of other currencies. A stable internal value
of the euro is a precondition for a stable external value relative to other currencies.
Before the introduction of the new currency, experts and academic writers held differing
views with respect to its external value. Some observers argued that as soon as the ECB
establishes its own credibility, there would ensue portfolio diversification from dollars into
euros by private investors and central banks (Bergsten, 1997a, 1997b; Portes & Rey, 1998).
This rise in demand for euro assets was expected to lead to an appreciation of the euro against the
dollar.8 Massive private asset demand shifts into the euro have not occurred so far, suggesting
that this process will not take place in the near future and that it will wait until the ECB has
had time to establish confidence in its monetary policy.
Others have suggested that the ECB will be less interested in targeting exchange rates
between the euro and the dollar and yen in the early phases of EMU on the grounds that
doing so would weaken its commitment to price stability. Creation of European economic and
monetary union makes Europe more of a large, relatively closed economy, like the United
States. Such an economy may be less inclined to fix the value of the euro against the dollar and
may be tempted instead to adopt a policy of “benign neglect” toward the dollar (Eichengreen,
1997; Eichengreen & Ghironi, 1998).
A third view states that the euro may remain weak because of structural rigidities in Europe’s
economies (Feldstein, 1997b, 2000).9 According to this view, companies looking to invest are
avoiding the euro-zone’s combination of high social security payments, stringent employment
protection and restrictions on working and opening hours, in favor of the freer and easier
British and American markets. Without essential structural and economic reforms in the euro
area, foreign direct investment (FDI) will not flourish in the euro-zone, and the euro risks
remaining undervalued in the longer term.
5. Portfolio and reserve diversification and liquidity effects
The dollar–euro exchange rate will also be closely linked to portfolio management decisions.
European and foreign investors will add euro assets to their portfolios. This will occur for
reasons of diversification. In addition, if euro assets yield expected returns in excess of dollar
assets, substitution into euro assets will occur. In this process, the euro will tend to appreciate
against the dollar. Arifovic (1996) shows that exchange rates are affected by changes in agents’
portfolio decisions about what fraction of their savings to place in each currency. Changes in
relative rates of return on two currencies change the portfolio shares of the currencies.
The euro may also have an impact on central banks’ foreign exchange reserves. The dollar’s
dominance in official international reserves appears to be greater than America’s weight in
the world economy would justify. Estimates show that the dollar accounts for over half of all
official reserves in the world, more than twice the U.S. share of global output. While there is
little doubt that central banks will bring the euro into their reserve portfolios (Alogoskoufis
& Portes, 1997),10 the open question is to what extent and at the expense of which other
currencies.
Since the euro-launch, the world’s central banks have not significantly changed the composition of their reserves. Countries with the largest reserve holdings, including China and
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Hong Kong, have not adjusted their euro holdings. With combined currency reserves of $650
billion, the Asian countries exert considerable influence in determining the international reserve currency of dominance.11 An important point is whether the tendency of extra-European
central banks to expand their holdings of euros will come mainly at the expense of the dollar
or other EU currencies like the Deutsche mark or French franc and currencies like the Swiss
franc (Eichengreen, 1997). The prospects for the reserve currencies will depend on where
economic growth (and the demand for reserves) is concentrated. China and the South Asian
countries are not only fast growers but also have a growing demand for reserves. They also
trade much more extensively with the United States and Japan than with the EU, which is
less open to imports from the newly industrialized countries. If output, trade, and the demand
for reserves keep growing fastest in Asia, this bodes well for the reserve currency status of
the dollar and the yen and poorly for the euro. Rapid growth in Eastern Europe works in the
opposite direction, of course, but only so long as the countries of that region remain outside
the EU and its monetary union.
6. Balance of payments and fiscal considerations
Since the 1980s, the United States has run substantial current account deficits, while Japan
and Europe have experienced surpluses during the same period. The United States has become
the world’s biggest debtor nation after having been a net creditor for 70 years. According
to Bergsten (1999), America’s net foreign debt now approaches $2 trillion. Trade flows are
a fundamental determinant of both the current level and the future path of the exchange
rate (Rodriguez, 1980). Other things the same, trade deficits generate the expectation of a
deteriorating net foreign asset position for the United States and, in turn, the fall of the dollar.
Other things, of course, are not the same. If world demand for dollar assets outpaces the
trade-induced growth of supply, the dollar will appreciate rather than depreciate. That has
been the case recently, and the appreciation of the dollar has played a central role in helping
to keep the lid on inflation.
In 1998, the federal government of the United States achieved a budget surplus for the first
time in 30 years. It has also achieved budget surpluses in the years 1999 and 2000, at a time when
many European countries were still struggling with the legacy of accumulated public debts.
The decrease in U.S. government borrowing associated with the budget surpluses, coupled
with a less restrictive U.S. monetary policy, will tend to push down U.S. real interest rates.
If lower U.S. interest rates discourage foreign investors from purchasing dollar-denominated
securities, the dollar will come under downward pressure in the foreign exchange markets. A
slowing U.S. economy would reduce the trade deficit and introduce another influence, which
would cloud the outlook for the dollar.
7. The euro since its launch
The euro was introduced at the value of $1.17 at the start of 1999. Upon its launch, expectations were high that the value of the euro would increase against the U.S. dollar, as investors
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and central banks shifted into the new currency. To the surprise of forecasters, the euro’s exchange rate gradually deteriorated from $1.1877 shortly after its inception to a life-time low
of $0.82 in October 2000, a drop of 35% from its launch rate. Concerns about the continued
decline in the value of the euro prompted the ECB to raise interest rates seven times between
November 1999 and October 2000, taking its main lending rate to 4.75 from 2.5%. Also, the
ECB intervened in the foreign exchange markets four times in autumn 2000—once in concert
with the world’s other leading central banks. Both the concerted and unilateral interventions
had only a modest effect on the euro’s slide.
From December 2000 onward, Europe’s single currency started gaining against the dollar
and the yen. By early January 2001, the euro had risen to about $0.96. Subsequently, it drifted
downward to a range between $0.882 and $0.83. Since mid-March 2001, the euro has remained
weak.
There does not seem to be any single explanation for the decline of the new currency
since January 1999. Many currency specialists believe that the weakening of the euro was
not appropriate in terms of economic fundamentals, and that it is undervalued against the
dollar.12 Corsetti (2000) and Corsetti and Pesenti (1999, 2000), present evidence indicating
that expected growth differentials were the most important variable explaining the euro–dollar
rate during 1999–2000. Overall, beliefs about the future of the U.S. economy have been more
optimistic than those about the European economy, despite the fact that the observable news
about the whole set of fundamentals did not warrant this optimism (De Grauwe, 2000). In the
modern, capital account-dominated world, the more buoyant economy is likely to attract more
internationally mobile capital seeking high returns, which makes the currency appreciate. In
the case of the dollar, the faster relative growth of the U.S. economy attracted massive capital
inflows for long-term investment including equities, bonds and direct investment leading to
the euro’s decline.13 Indeed, balance of payments data show a rise in direct investment by euro
area residents in the U.S. in recent years. Moreover, empirical studies indicate a significant
correlation between these capital flows and exchange rate developments (IMF, 2001, p. 2).
Fig. 1 plots the exchange rate of the euro against the dollar since 1990. Prior to 1999, these
rates are based on the exchange rates of the “synthetic euro” against the dollar. The euro started
to depreciate significantly after its launch in 1999. At the beginning of the year 2000, the euro
fell below parity with the dollar. It can be seen that the decline in the euro since early 1999
continues a trend that began in 1995. Since that time, the euro has depreciated by about 35%
against the dollar.
From an exchange rate perspective, there is a correlation between revisions to projected
growth for the U.S. and the euro area and movements in the dollar–euro rate. By the first
quarter of 1999 forecasts for Europe were being revised downward and those for the United
States upward. By the middle of the second quarter of 1999, forecasters were expecting U.S.
growth to outpace European growth by over 1.5% points. Even the short-lived upswing of the
euro in July 1999 was related to an improvement in the expected relative growth performance
of the euro area. Among the key elements coinciding with the sudden rebound of the euro
was the July release of better-than-expected business surveys from Germany, France and
Italy pointing to a recovery in European industrial production. According to European Union
estimates published in October 2000, euro-zone GDP grew in the second quarter of the year
2000 at an annual rate of 3.7%, which was still lower than the U.S.’s second quarter rate of
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Fig. 1. Dollar–euro exchange rate, 1990–2001, (dollars per euro). Source: ECB.
6.1%. Fig. 2 shows the actual real GDP growth rates over the period 1992–2001 (the growth
rates for the years 2001–2002 are projected rates).
Expected growth can increase aggregate demand, both because investment demand rises
and because households consume more in expectation of higher future incomes. This demand
effect will tend to push up real interest rates. In turn, higher real interest rates draw in foreign
capital, causing the exchange rate to appreciate. In support of such a demand effect, there is
evidence of a widening in short- and long-term interest rate differentials between the U.S.
and the euro area. As shown in Fig. 3, the gap between U.S. and European short-term rates
widened over the period 1999–2000. Since inflation expectations were relatively stable, there
appears to have been a significant shift in real interest differentials in favor of U.S. assets. Over
this period, the U.S. inflation rate was actually pushed down, as higher productivity growth
Fig. 2. Real GDP growth, 1992–2002, (percent change). Source: IMF World Economic Outlook.
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Fig. 3. Short-term interest rates (%), 1994–2001, (1-month bank deposit rates). Source: ECB and U.S. Federal
Reserve Board of Governors.
temporarily reduced growth in unit labor costs, and the strong dollar pushed down import
prices (Fig. 4). Since that time, monetary policy has been eased substantially in the United
States, where nominal short-term interest rates are now at a 40-year low.
At the same time as the interest rate differential widened in favor of U.S. assets and the
dollar appreciated against the euro, the U.S. current account deficit rose sharply relative to
that in the euro area (Fig. 5), reflecting both the surge in domestic demand and the effects of
a higher exchange rate on competitiveness. The U.S. current account deficit for the year 2000
hit a record $435.88 billion—the largest annual deficit on record. The annual deficit amounts
to about 4.4% of the almost $10 trillion GDP, up from about 3.6% of GDP in 1999. This
combination of events points to a substantial positive shock to aggregate demand in the U.S.
relative to the euro area.
Fig. 4. CPI inflation rates, 1992–2001, (percent change). Source: IMF World Economic Outlook.
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Fig. 5. Current account balances, 1990–2001, (percent of GDP). Source: OECD.
It is also important to point out that the euro has unified and expanded capital markets within
continental Europe at an astonishingly rapid rate. This financial development has created a
huge new euro-denominated bond market with lower interest rates and a marked lengthening of
the term structure of corporate finance within Europe. This improved availability of long-term
finance to European corporations has enabled them to launch numerous takeover bids for U.S.
companies in 1999 and 2000. But governments and corporations outside the euro-zone have
also taken advantage of the improved state of European capital markets. Foreign borrowers,
including developing countries, have found a ready market for euro-denominated bonds at 1%
point or less than for their dollar-based financing. This unexpected surge in capital outflows
from Europe since January 1999 has led to the euro’s surprising weakness (McKinnon, 2000).
8. Credibility concerns
The 2-year-old ECB has yet to establish its credibility and anti-inflationary reputation. It
would have to deliver price stability before it can convince the international financial markets
that it is indeed pursuing an anti-inflationary policy. So far, a major problem for the credibility
of the euro is the uncertainty about the workings of the ECB and its policies. “The transmission
mechanism of monetary policy to the price level in the euro area is not known with certainty”
and “uncertainty about the transmission mechanism is exacerbated” by the lack of “harmonized
and comprehensive data . . . for the new monetary and economic area” (Issing, 2000). There are
no historical data allowing analysts to know with any precision the behavior of the monetary
aggregates on a European scale; interpretation of movements in the harmonized Consumer
Price Index also creates problems.
The ECB’s response to the euro’s fall has been criticized as “inconsistent” and “incoherent.”
There have been “policy missteps by an inexperienced ECB Board” and conflicting statements
and public disagreements among the ECB officials, raising “doubts about the competence of
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the new central bank” (Eichengreen, 2000a, 2000b).14 Further exacerbating the credibility of
the euro was the intangibility of the euro itself. Since euro notes and coins were not available
before January 1, 2002, there was little usage by the public. Thus, the euro remained a ‘virtual
currency’, lacking tangibility and visibility. The ECB believes that when the euro is in the
pockets of the Europeans, it will become “a very popular currency, a solid store of value, and
a symbol of European unity.”15
The political climate of the area is also affecting the credibility of the euro. “There are
‘political difficulties’ with the ‘centralization of supervision”’ and “potential inefficiencies and
conflicts of interest between member countries that the present situation creates.” Feldstein
(1997a, 2000) argues that since the real rationale for EMU is political and not economic, it
will likely result in increased conflicts and tensions among euro nations. Tensions will arise
over sharing of power and the lack of built-in stabilizers to deal with cyclical unemployment
caused by asymmetric shocks.
Finally, the ECB has to acquire the experience needed to manage monetary policy over such a
diverse economy as Europe’s. It has already faced problems of running a single monetary policy
for a diverse economy because of the disparity between the growth rates of individual countries
in the euro-zone. For instance, Ireland, Spain, and the Netherlands have had higher rates of
growth than Germany and Italy for several years, and Germany and Italy are more dependent on
exports and the exchange rate than more peripheral euro-zone countries. Therefore, interest rate
and exchange rate changes are not affecting all member states symmetrically in the euro-zone.
Besides, there are also other explanations for the depreciation of the euro. First, is a surge
in supply of euro-denominated assets associated with the introduction of the euro in 1999
and the completion of the intra-European bond market (Meredith, 2001; McKinnon, 2000).
This reflected a sharp increase in the issuance of euro-denominated bonds by both resident
and nonresident issuers, which came at the expense of both the dollar and the yen. Obviously,
the demand for euro-denominated bonds must have expanded to accommodate this increased
supply. In reality, little of the excess supply of euro bonds was purchased by international
investors, and most of the rise in issuance has been absorbed by euro-zone residents (Detken
& Hartmann, 2000). The direction of these portfolio effects—toward increased borrowing and
reduced investment in euros—has put downward pressure on the euro.
Another view attributes the euro’s weakness since 1999 to a relative shortcoming of demand
within the euro-zone (Cohen & Loisel, 2001). This situation was itself the outcome of a
policy-mix where fiscal policy was tight and monetary policy was loose. Fiscal tightness was
imposed on the euro-zone by the Maastricht fiscal criteria, while monetary looseness has
resulted from the convergence of interest rates to the lower end of the zone. This was an
opposite situation to the fiscal expansion during the first years of the Reagan administration,
which led to the strength of the dollar in the early eighties. Since the supply of European goods
rose relative to domestic demand, this excess supply induced euro-zone producers to cut the
prices of their goods in order to increase demand for their exports. Therefore, this “policy
regime shift” led to both a nominal and a real deprecation of the euro, enabling the European
producers to export the excess supply of their output.
There are also some non-monetary demand side shocks, which are found relevant (Dopke,
Gottschalk, & Kamps, 2001). First, the strong rise in oil prices since summer 1999, which
is equivalent to a major income transfer from the European economies to the oil exporting
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countries. The corresponding effect for the U.S. economy was smaller, as it is itself a major oil
producer. Such a worsening of relative non-monetary demand conditions in Europe is likely
to have induced a weakening of its currency. Second, the surge in U.S. equity prices in 1999
and 2000, which led to a larger positive demand shock in the U.S. than in most overseas
economies. During this period, equity prices rose more in U.S. markets, and equity market
capitalization was much larger relative to GDP in the U.S. than in the euro area. Higher equity
prices exert positive income effects on aggregate demand. They increased both consumption
and investment spending, pushing up real interest rates in the faster-growing U.S. economy,
at least in the short run. It is probable that this development accounts for a noticeable part of
the divergence in demand conditions in this period and hence for the relative strength of the
U.S. dollar in recent years.
However, the effect of both portfolio shifts and monetary demand shocks on the euro–dollar
rate should diminish overtime. First, the surge in U.S. equity market capitalization has been
corrected with the decline in equity prices from peaks in 2000. Second, oil prices have weakened sharply in recent months, reversing the negative real income effects on the euro-zone.
Finally, the portfolio effects, which are likely to have been strongest in the early stages, are
likely to wane over time, as asset stocks and international interest-rate differentials adjust. All
these developments should help reduce excess demand in the United States, creating scope for
some reversal of euro weakness.
9. Conclusion
This study has considered two important issues regarding the euro: its international role
and its value relative to the dollar. A number of studies point toward a significant potential
global role for the euro. Within a time frame that is difficult to specify, European economic and
monetary unification is expected to produce a euro capable of challenging the role of the U.S.
dollar as the dominant international means of payment, unit of account, and store of value.
Given the euro’s fundamentals—the EU’s economic size, the liberalization and integration of
its financial markets, and confidence in its international creditor status and stability-oriented
monetary policy—the most likely outcome is that the dollar will have to share international
currency status more or less equally with the euro.
The international role of the euro will depend critically on the economic strength of the
euro-zone relative to that of the United States. If Europe’s growth is stimulated by EMU
and the increase in Europe’s share of global trade and GDP comes at the expense of U.S.
share, then the network externalities to which the dollar owes its dominance will be eroded.
Conversely, if the euro area experiences a period of stagnation in Europe, the euro’s impact on
the international role of the dollar will be marginal. Low and stable inflation in Europe together
with the creditor status associated with current account surpluses enhance the attractiveness
of the euro as an international currency, particularly when compared to the current account
deficits of the United States. Hence, while the euro is likely to take on a prominent role as
an international currency, history shows that dominant currencies are not easily unseated, so
that the encroachment of the euro on the dollar is likely to be much slower than many analysts
suggest.
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S. Neaime, J. Paschakis / North American Journal of Economics and Finance 13 (2002) 56–71
For most of 1999, 2000 and 2001, market sentiment has been against the currency, due to the
perceived weakness of the euro area relative to the United States and Japan. In the short-term,
the euro will fluctuate significantly with respect to the dollar because of the different cyclical
positions of the two economies. The euro will recover in value against the dollar once the
euro-zone’s economic growth rates catch up with those of the U.S. and long-term capital
movements become more balanced between the two areas.
While the euro area’s fundamentals indicate positive growth in the medium term, the value
of the euro is dependent upon confidence of the markets in maintenance of solid economic
fundamentals in the future. Among these are positive GDP growth, a current account surplus,
a decrease in the unemployment rate, and containment of inflation. The long-term value of
the euro also depends upon the confidence of the markets in the commitment of the euro
governments to implementing the structural reforms in the labor, product and financial markets
which are required to enhance the EMU’s long-term global competitiveness. Even with strong
fundamentals in place, if there is little confidence of future sustainability, markets will be
hesitant to diversify out of the U.S. dollar into euro.
Notes
1. The question of euro strength has received some attention. See, for example, Alogoskoufis and Portes (1997), Bergsten (1997a), and Portes and Rey (1998).
2. According to Aliber (1979, p. 141), the demise of sterling as the world’s pre-eminent
currency was the result of both monetary factors, including an inflationary monetary
policy (overproduction of sterling) during the war, and real factors, including the sharp
decline in British foreign investments and sluggish British industrial performance.
3. To date, dollars are in wide use in Latin America (especially Argentina) and in the
former Soviet bloc (especially Russia). Dollar transactions are also widespread in the
Middle East (where dollars are typically used to pay guest workers), in parts of Asia
and, of course, in the global illegal trade (Rogoff, 1998).
4. The global use of the dollar allows the U.S. to earn international seigniorage—the
ability to obtain real resources (net imports) in exchange for costless notes (Cohen,
1971). In effect, by being willing to hold this international money, foreigners extend
free credit to the United States. Krugman (1998) points out that the U.S. will lose from
the introduction of the euro, but the seigniorage loss will amount to only a few billion
dollars.
5. According to Kouri and de Macedo (1978), the safest currency for all investors, regardless of their country, is the currency of the country with the least unpredictable
inflation. In the absence of capital controls and restrictions on the use of foreign currencies, one would expect the safe currency to gain increasingly widespread use as the
unit of denomination of financial instruments.
6. Portes and Rey (1998) argue that Europe would gain by promoting the use of the euro
as a rival international currency to the dollar, but such a policy would go against the
interest of both Japan and the U.S.
7. In October 2000, Iraq convinced the United Nations (UN) to allow its customers to pay
for its crude oil in euros rather than in dollars. The Iraqi move will increase monthly
S. Neaime, J. Paschakis / North American Journal of Economics and Finance 13 (2002) 56–71
8.
9.
10.
11.
12.
13.
14.
69
demand for euros on the market, and is a “gentle reminder of the euro’s potential,”
if other oil producing countries were to do the same. See Christopher Swann, “Iraqi
Vendetta against Dollar Gives Welcome Boost to Euro.” Financial Times, Wednesday,
November 1, 2000, p. 20.
According to Patat (1997), it is not clear that this must be the case since the supply
of euros will also increase, as there will be more borrowers in euros. Therefore, the
portfolio effects on the exchange rate are likely to be mixed between demand and
supply effects.
Also, see “Propping up the Sickly Euro,” Editorial, Financial Times, Saturday, November 4, 2000, p. 6.
Mundell (1998) points out that while the dollar will continue to be an important part
of the international monetary system, it is no longer necessary or even healthy for the
U.S. or the rest of the world to rely solely upon the dollar.
Since January 1999, the number of euros in China’s foreign exchange reserves has
remained small due to euro’s depreciation against the U.S. dollar and the yen, which
has prompted caution among China’s central bankers toward the currency. However,
in the last few months of 2001, China acquired euros and will continue to move more
of its hard currency reserves into Europe’s common currency. See James Kynge and
Hugh Carnegy, “Beijing Expresses Concern over Euro Weakness,” Financial Times,
Wednesday, October 25, 2000, p. 8; and Karby Leggett, “China Adds to Euro Hoard,”
Globe and Mail, Wednesday, November 21, 2001, p. B12.
Hamalainen (2000) argues that “the exchange rate movements of freely floating currencies do not always reflect macroeconomic fundamentals, at least not in the short run”
and that “it is often difficult to identify the underlying factors behind these movements.”
According to Corden (1994), fundamentals matter in the longer run and sometimes in
the short run—but often the prospects for the fundamentals are unclear, so that expectations are dominated by uncertainty. Expectations depend not only on “assessments of
the future consequences of the current fundamentals” but also upon “expectations about
future fundamentals based on current assessments of political and economic prospects.”
Niehans (1977) notes that the “long-term course of exchange rates seems to conform
closely to the relative rates of monetary expansion, while the short run fluctuations
show a bewildering variety of seemingly erratic patterns . . . In the intermediate run,
however, the adjustment process may be significantly influenced by variations in trade
flows” (p. 1256).
In 1998, many analysts predicted that investment opportunities in the newly created
euro economy would generate a large capital inflow—a scenario leading to a strong
currency. The expected large capital inflows never materialized. Instead, as the data
indicate, there has been a large flow into the U.S. from the 15 EU countries and the euro
area has had sizeable net capital outflows.
Such as the “inadvertent disclosure of interest rate changes to the press in advance of
official announcements . . . failure of ECB to release its inflation forecasts, to articulate the model on which those forecasts were based, and to adopt a transparent basis
for its policy decisions, which arguably undermined the new institution’s credibility”
(Eichengreen, 2000a).
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15. Tony Barber and Christopher Swann, “The Euro’s Struggle for Acceptance,” Financial
Times, Friday, March 2, 2001, p. 13.
Acknowledgments
The authors would like to thank two anonymous referees, and the editor of the Journal for
valuable comments and suggestions on an earlier draft of this article. Useful comments from
Arman Mansoorian and John Smithin are also acknowledged.
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