Lorenzo Bini Smaghi: The internationalisation of currencies - a central
banking perspective
Speech by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at the joint conference "The euro at ten: the next global currency?", sponsored by the
Peterson Institute for International Economics and Bruegel, Peterson Institute for
International Economics, Washington DC, 10 October 2008.
* * *
Introduction1
Ladies and gentlemen,
It is an honour to be here to celebrate the approaching tenth anniversary of the euro. It is a
privilege to represent the institution - the European Central Bank - which over the past ten
years has watched over the first steps of the euro and brought it up to be the second most
important international currency in the world. The euro is now leaving behind its childhood
and entering the phase of adolescence. As with many adolescents, it is faced with a common
question: "what would you like to do when you grow up?"
The ECB, like any parent, might tend to have an over-optimistic vision of its own child's
future. This is why we have adopted a policy of neither encouraging nor discouraging the
international use of the euro. It should be an entirely demand-driven process. Like modern
parents, we recognise that the euro does not belong to us but should develop according to its
own ambitions. We are here to ensure that it has a few key virtues, the first being stability.
There are already several people - including in the United States, where even the birth was
considered improbable a decade ago - who predict a bright future for the euro, anticipating
that it will surge to become the dominant international currency in the coming decades [Chinn
and Frankel, 2008]. Others, however, think that the euro is unlikely to overtake the US dollar
[Eichengreen and Flandreau, 2008a].
Today, I will not try to review what the euro has already achieved over the last decade. The
ECB regularly publishes a report that can be easily consulted [ECB, 2008a].
What I would like to do instead is to assess what the implications are, in particular from a
central banking point of view, of becoming an international currency. I will analyse both the
advantages and the challenges. I will then try to assess whether the euro has the potential to
further increase its role and examine what the main obstacles could be to achieving such a
status.
Implications of an international currency
Even though the euro is currently not the dominant international currency, it has become an
alternative to the US dollar as a reserve currency. Euro banknotes are a popular means of
payment and store of value in the EU's neighbouring countries. What are the implications for
the ECB and the euro area as a whole? I shall try to answer this question, drawing on the
economic literature.
There are two well-identified advantages that countries can obtain from having an
international currency. First, there are microeconomic gains stemming from lower transaction
costs. Whether the currency is used for international trade, borrowing in the international
markets or simply tourism, the costs of conversion to a foreign currency and the exchange
rate risk attached to these operations are eliminated. Second, the monetary authority issuing
an international currency has larger seigniorage revenues to the extent that foreigners hold
that currency in the form of non-interest-bearing liabilities, in particular as coins and
banknotes. These gains are, however, relatively small and are estimated to amount to less
than 0.05% of GDP for the euro area, as only a small fraction of the total cash in circulation -
10% to 15% - is held by non-euro area residents. International seigniorage gains are only
slightly larger for the United States, at about 0.1% of GDP, as more than half of their stock of
currency is estimated to circulate abroad [EC, 2008 and ECB, 2007].
There are other, broader, implications of issuing an international currency, which are less
well-documented and not as easily quantifiable. Both Britain in the period before the First
World War - from 1870 to 1913 - and the United States in the period after the Second World
War enjoyed a so-called "exorbitant privilege" from being at the centre of the international
monetary system [Meissner and Taylor, 2006]. The privilege stems from the possibility to
issue low-interest domestic currency-denominated liabilities to finance higher-yield
investments abroad. Both Britain before 1913 and the United States until the end of the
1980s were net creditors towards the rest of the world, and this exorbitant privilege may be
seen as their remuneration for being the so-called "bankers of the world". Over the past 20
years, the United States has shifted to a relatively large debtor position vis-à-vis the rest of
the world, but its income balance has stayed positive thanks to a positive return differential
between its external assets and its liabilities. For some economists, this is the result of the
transformation of the United States from world banker to "venture capitalist" with a
"leveraged" position, where fixed-income domestic currency liabilities finance riskier foreign
assets taking the form of equity and direct investment [Gourinchas and Rey, 2005].
The greater ability to issue domestic currency liabilities has another important implication
from a macro-financial stability perspective. To the extent that external liabilities are mainly in
domestic currency, whereas external assets are denominated in foreign currency - as in the
case of equity and foreign direct investment, and often also debt securities - issuers of
international currencies tend to have a "long" position in foreign currency. As a result,
fluctuations in exchange rates tend to produce counter-cyclical valuation effects on net
external assets. When the exchange rate appreciates, foreign currency assets shrink in
domestic currency terms and as a share of GDP. Conversely, following sharp devaluations -
often associated with economic and financial stress - the foreign currency-denominated
assets grow in domestic currency terms and liabilities are unaffected, improving the overall
investment position when it is more needed [Lane and Milesi-Ferretti, 2005]. As an example,
after the currency crises in both 1949 and 1967, sterling's status as an international currency
- with most of the large overseas liabilities still denominated in pounds - allowed the United
Kingdom to cushion somewhat the impact of the devaluations [Cairncross and Eichengreen,
2003].
The issuance of an international currency could potentially also have significant implications
for the implementation of monetary policy. Let's consider the experience of the euro over the
past ten years in that regard.
On the one hand, it has been essential for the euro area to have its own monetary policy in
order to face idiosyncratic shocks and focus on the maintenance of domestic price stability.
This result would not have been possible without the introduction of the euro and the creation
of a large internal economic and trade area free of exchange rate risk. On the other hand, the
external demand for euro-denominated assets may affect domestic monetary aggregates,
complicating their relationship with inflation over the long run. Recent ECB staff research
shows that it is necessary to place money demand in the context of portfolio flows and
international asset prices in order to explain euro area M3 dynamics and measure excess
liquidity, which can pose risks to price stability [ECB, 2008b].
In addition, successful international currencies are used as external anchors by a number of
countries that prefer to fix the exchange rate and relinquish their monetary independence.
Such currency pegs eliminate one channel of adjustment of external imbalances for the
anchor currency. As long as the pegging countries are small relative to the issuing country,
this might not be a major problem. However, when the aggregate economic weight of all
pegging countries becomes large, the margin for adjustment of the nominal effective
exchange rate of the anchor currency becomes constrained. As a consequence, the
adjustment of the nominal effective exchange rate might require a more than proportional
adjustment of the bilateral rates of the remaining floating currencies.
Moreover, fluctuations in the demand and supply of the euro among international investors,
from both the private and public sectors, may have implications for the exchange rate. The
increasing attractiveness of euro-denominated assets as a potential alternative to US dollar
securities may generate sudden shifts in portfolio flows and unwelcome volatility in foreign
exchange markets. Another potential indirect channel of disturbance in the dollar/euro
exchange rate is possibly the role of the US dollar in the invoicing of oil and other major
commodities. Over the past few years, the surge in oil prices and other commodities - in US
dollar terms - has been associated with a negative relationship with the exchange rate of the
US dollar against the euro. In the case of oil prices, this could be the result of policies by
oilexporting countries to try to defend the purchasing power of a barrel of oil in terms of a
basket of international currencies, including, in particular, the euro. It must be acknowledged
that it is difficult to detect and isolate the direction of causality between the oil price and the
US dollar.
Overall, for the ECB and the euro area, the international role of the euro offers positive
opportunities and serious challenges. This explains the ECB's neutral stance aimed at
neither directly promoting nor hindering the international use of the euro.
The determinants of the international use of currencies
What are the conditions that cause currencies to dominate international markets? Do these
conditions favour a growing role for the euro?
There is a large body of literature on the determinants of the international use of currencies.
Most studies focus either on the store of value function of currencies and their role in foreign
exchange reserves [see Chinn and Frankel, 2008, for a recent review] or on the unit of
account and means of payment functions, including the invoicing of international trade [see
Kannan, 2007]. In the first case, users of an international currency are mainly concerned with
its ability to maintain a stable purchasing power over time. In the second case, users care
about transaction costs and the economies of scale that are obtained from tapping into a
large network.
In both cases, a number of political, institutional, financial and economic factors contribute to
increasing the popularity of an international currency. I will review these factors with
particular reference to the euro.
Economic and financial conditions
Let me start with the economic and financial conditions supporting the international role of
currencies. The size of the economy and its foreign trade flows are crucial to promoting the
international status of a currency. This is because there are scale economies and network
externalities in using the currency that is also used by other agents in international
transactions. The larger the economy and its trade flows, the more likely it is that smaller
economies will adopt the currency of the larger trading partner. In this respect, the critical
mass of the euro area, in economic terms, is large enough to exert gravitational attraction on
the rest of the world. In 2007, the euro area accounted for about 16% of world GDP,
measured at purchasing power parity, and its external trade was equal to more than 18% of
world trade, at current exchange rates.
In the invoicing of international trade, however, network externalities tend to generate only
one "winner". For several decades, the US dollar has served as a medium of exchange and
unit of account for homogeneous goods traded in organised exchanges, such as
commodities and oil. In this case, inertia is very important and it is very difficult to dislodge
the incumbent currency, whose use is associated with low information and transaction costs.
Yet even in this case, it would be possible to switch to a parallel invoicing system, including
the euro, if agents expected others to start using the new currency and technological
progress diminished transaction and information costs [Mileva and Sigfried, 2007].
Transaction costs are important not only in international trade but also in the use of
currencies as financing or investment instruments. For this reason, truly international
currencies must be backed by large, deep, liquid and efficient financial markets. In terms of
size, credit quality and liquidity, US dollar financial markets still have an edge over the euro
markets, although this gap seems to have narrowed since the launch of the euro in 1999
[Galati and Wooldridge, 2006]. The US Treasury bond market remains the most liquid
segment of the global bond market, whereas sovereign issuances are inevitably fragmented
in the euro area. However, this structural problem has been mitigated by the removal of
exchange rate risk since the introduction of the euro. Government bond yields have
converged across euro area countries and are increasingly driven by common factors,
although local factors continue to play a role [ECB, 2008c]. Indeed, the bid-ask spreads of
sovereign bonds denominated in euro are not much higher than the spreads of those
denominated in US dollar [Dunne et al., 2006]. Interestingly, the euro area bond market for
"corporate" issuance is quite well-integrated [ECB, 2008c] and effective bid-ask spreads are
possibly even lower than in the United States [Biais et al., 2006].
I have argued so far that investors take into account liquidity and transaction costs when
dealing with international currencies. Once these structural and cost differentials converge
across currencies, traders and investors can discriminate among various alternatives on the
basis of the return on their investment. In brief, international currencies must be able to
preserve their external value, avoiding inflation and sharp nominal devaluations. It is
wellknown that the erosion of the status of sterling as leading international currency was caused
by a series of large shocks accelerating a declining trend. The fading of the United Kingdom
as a major political and imperial power was accelerated by the First and Second World Wars.
The economic decline was highlighted by at least three devaluations in 1931, 1949 and
1967, which progressively undermined the confidence of international investors in the ability
of sterling to preserve its external value. Recent evidence suggests that the pound sterling
lost its dominance already in the mid-1920s, but then regained the lead in the second half of
the 1930s [Eichengreen and Flandreau, 2008b]. The jury is still out on this case, but it is
evident that inertia in the international use of currencies is much stronger in the case of the
invoicing of trade, where network effects favour the use of only one currency. Inertia is
somewhat less powerful when investors decide how to allocate their portfolio, leaving greater
room for currency competition.
Evidently, inflation and devaluations accompanying the demise of world currencies are not
natural accidents, but the result of wrong macroeconomic policies and structural
weaknesses. These often take a long time to emerge in the form of an erosion of external
competitiveness and a rise in external imbalances, fiscal profligacy and internal imbalances,
low productivity and, eventually, sluggish growth and high unemployment. Conversely, strong
and balanced economic performances foster the international status of currencies.
Where does the euro stand in terms of policies and their performance? The euro area fares
relatively well compared with major economic partners, although a greater effort has to be
made to raise productivity and lift the potential growth rate of the economy. The external
position is fairly balanced. The emergence of public deficits and debt is guarded by the
functioning of the Stability and Growth Pact. Over the past ten years, inflation has been kept
relatively low in spite of large supply-side shocks. The institutional setting of the ECB, with its
independence from political pressure and its mandate to preserve price stability, helped to
rein in inflationary pressures and indirectly fostered the confidence of domestic and foreign
residents in the capacity of the euro to preserve its value.
Political and institutional conditions
Let me turn to the political and institutional conditions for currencies to steadily take on an
international role. This is clearly a more complicated issue.
Historically, countries with stable political systems and the capacity to enforce the rule of law,
both inside and outside their borders, had currencies that were widely traded and accepted
internationally. Certainty with regard to property rights, which may be undermined by political
instability, and the ability of the issuer of the international currency to rule and to raise
revenues to repay its financial obligations are crucial in this case.
The existence of "hard power" certainly contributes to the ability to enforce property rights,
domestically and internationally, and thus helps in developing an international role for the
currency. From this point of view, Europe cannot compete at present with other providers of
"hard power". On the other hand, the success of Economic and Monetary Union provides
Europe with a form of "soft power". Such soft power is translated in different ways, such as
the anchoring of several currencies to the euro, the adoption of the independent central bank
model contained in the Maastricht Treaty, technical assistance on issues related to monetary
policy, payment systems, supervision, banknote issuance, etc.
Good economic governance is also a fundamental ingredient of successful international
currencies. The Dutch guilder in the 17th and 18th century, the British pound in the 19th and
early 20th century, the US dollar in the late 20th century: all were (or are) international
currencies backed by strong empires and states, but also supported by the economic power
and success of their issuers.
Some academics regard political and economic governance as the "Achilles heel" of the euro
[e.g. Cohen, 2007]. They claim that the delegation of monetary and economic responsibilities
across Member States and EU institutions is unclear and they lament the lack of a single
unitary governance structure, the so-called "commander in chief", behind the euro. Over the
past year, the financial turbulence has posed a serious test for the monetary authorities
throughout the world. The reaction of the ECB has shown that the central bank can act
rapidly and effectively to address liquidity issues.
As the crisis has evolved from a liquidity to a solvency problem, the challenge has moved
increasingly to supervisory authorities and finance ministers. The ability to provide a
coordinated European response is being tested. On specific occasions, such as the bail-out
of the banks Fortis and Dexia, the framework has functioned properly. On the more general
response to the crisis of confidence in the financial system, it is paradoxical that the relatively
healthier European banking system might have to suffer more because of the uncoordinated
and piecemeal reaction of national authorities. There is also a risk of a re-nationalisation of
the single market for financial services, as a result of different solutions being implemented in
different countries.
The fear of many academics and observers has long been that, without a specific framework
for crisis resolution, the European banking system would be unable to address major shocks.
The problem might turn out to be a different one. The absence of a crisis resolution
framework does not prevent effective solutions from being found and implemented. But since
these solutions are different from country to country, they may lead to problems of
discrimination and difference of treatment, undermining the functioning of the single market.
This certainly would not contribute to the international role of the euro. And this is confirmed
by the weakening of the exchange rate over the last two weeks.
Another important institutional condition for the international success of currencies - closely
linked to good economic governance - is trade and financial liberalisation. By definition, only
currencies that can be freely converted for trade or investment purposes have the potential to
achieve the status of international currencies. According to Barry Eichengreen, the US dollar
owes part of its success in maintaining its position as main reserve currency to the absence
of truly convertible competitors after the Second World War. In his view, the international use
of potential reserve currencies - such as the French franc, the Japanese yen or the
Deutsche Mark - was directly or indirectly discouraged by the respective governments
[Eichengreen, 2005].
Convertibility is not an issue in Europe, but protectionism, especially against foreign capital,
might be. We are currently observing attempts in different countries to limit the inflow of
capital from foreign countries, in particular in so-called "strategic sectors". However, the
definition of "strategic" remains vague and can give rise to quite imaginative interpretations.
Concluding remarks
To sum up, currencies emerge as international players thanks to a combination of a large
number of conditions. These include geopolitical influence, political stability and the
enforcement of the rule of law, as well as good political and economic governance. Only
large economies generating meaningful network externalities possess international
currencies. They must also be economies with deep, efficient and open financial markets
where it is possible to invest without the risk of incurring large transaction costs or capital
losses. Eventually, once all these factors have been accounted for, the quality of economic
governance and economic institutions and the ability to devise policies which support
confidence in the external value of the currency can make the difference. Obviously, inertia in
the international use of currencies is strong and sudden changes in their relative position are
unlikely, barring very large shocks.
Since its introduction ten years ago, the euro has emerged as the second most important
currency in the world. The euro area offers the opportunity of a large, deep and increasingly
integrated financial market for foreign operators willing to hold euro-denominated assets. The
monetary policy conducted by the ECB has certainly contributed to supporting confidence in
the euro. We now face a different type of challenge, related to the integrity and sustainability
of the single market in the face of a major financial crisis.
Given the dimension of the current turmoil, it is not surprising that market participants view
the ongoing developments with some concern. After all, the birth of the euro was followed by
a substantial depreciation of the euro against all other currencies. The young currency and
the young central bank needed to be tested in good and in bad times. The premature death
of the euro was pre-announced several times. The sceptics had to concede.
In my view, one element has to be taken into account in analysing the current situation, in the
light of Europe's past experience. Either a strong response is provided to the challenges
posed by the current turmoil to the single financial market within the existing institutional
framework, or the framework itself will be changed in favour of a more centralised system of
supervision and crisis resolution. This is how the euro was born, after all, as it became clear,
in particular after the 1992-93 foreign exchange crisis, that it was not sustainable to run
different monetary policies within a single market. The same logic could apply in the case of
financial regulation and supervision. And national authorities know it.
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