Properties of the Euro-Europe's New Currency (2000)

ABSTRACT This paper analyzes the portfolio properties of the euro as it has been initially composed with 11 currencies and also in its anticipated future extended version comprising all 15 EC members. The period under investigation is January 1992 to October 1998. Using a U.S. investor's perspective, investing in the euro is a low risk-low return alternative compared to investing in the U.S. dollar. Results of the Gibbons, Ross and Shanken multivariate test show that the composition of the European common currency is mean-variance inefficient. PROPERTIES OF THE EURO - EUROPE'S NEW CURRENCY The launch of Europe's single currency, the euro, on January l, 1999, was without any doubt one of the most significant events in the economic and political development of Europe. In this major experiment in monetary arrangements, 11 European countries did unite in the European Monetary Union (EMU) with the European Central Bank (ECB) setting the short-term interest rate for the entire euro zone. The 11 countries that have adopted the euro are: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. To participate in the single currency zone, countries were required to meet several criteria prescribed in the Maastricht Treaty of 1991, relating to inflation, interest rates, government debt, and exchange rate volatility. The four national currencies not taking part in the euro - the British pound, Danish kroner, Greek drachma, and the Swedish. kronor - will set fluctuation bands against the euro. These will be 15 per cent bands, as with the old Exchange Rate Mechanism, although some may want to keep their currencies in narrower bands. On January 1, 1999, the conversion rates between the euro and currencies from the 11 nations participating in the shared currency were set (see the appendix for the official exchange rates). All ECUs were automatically converted to euros on a one-to-one basis. The introduction of the euro creates two important long-term factors which may lead to an increased demand for the euro at the expense of the U.S. dollar: ( 1 ) the use of the euro as a reserve asset and (2) as a means of payment. Jager and de Jong (1987) examined the attractiveness of the ECU as a reserve asset and find that its reserve function will be substantially undermined by the exchange rate stability that is pursued in the EMU. Following the euro's introduction, Europe's foreign exchange reserves will become somewhat `excessive' as there will be little need for them to hold reserves as intervention in the foreign exchange market will be carried out by the ECB. Temperton ( 1997) estimates that the excess holdings of foreign exchange reserves could be as much as $300 billion. Attempts to reduce these reserves holdings could put a severe downward pressure on the U.S. dollar. On the other hand, EC authorities may not want to see the value of the euro strengthen too much against the dollar out of fear of losing international competitiveness. Undoubtedly, the euro will gain importance as a vehicle currency for international trade and finance. Although about half of world trade is denominated in U.S. dollars, the U.S. accounts for only 13% of global exports. Since the 11 euro-zone nations represent a much higher percentage of world exports, it is to be expected that a larger share of world trade will be denominated in euro, at the expense of the U.S. dollar. The introduction of the euro will, therefore, have far-reaching consequences for financial and commercial enterprises worldwide. According to Robinson (1998) as a result of the euro, corporate treasurers will see greater degrees of consistency and conformity because of money market and interest rate convergence, a concentration of banking relationships, and the rise of an efficient secondary financial market that resembles the U.S. secondary markets. The euro's arrival will also force Europe's investors to formulate new strategies and expand the range of asset classes. …