Nevertheless, the implications of the launch of the euro for developing countries are already important and could become more far-reaching in the future. The availability of the euro as an alternative to US dollar borrowing allows better hedging of risks. Given the importance of trade with the euro area, hedging of terms of trade fluctuations would optimally give a substantial weight to the euro in external debt. At present, outside the countries geographically close to the euro area, sovereign debt issuance in euros has been small (ECB 2005, 2007a). Such a situation can be expected to change over time. As well as hedging trade fluctuations, a mix of debt in euros as well as dollars would decrease the effect of changes in U.S. monetary policy on developing countries’ debt service obligations, and on their ability to repay, which is substantial at present (Dailami et al., 2005). While holding euro debt would correspondingly subject developing countries to unexpected movements in the ECB’s monetary stance, since dollar and euro interest rate movements are not perfectly correlated, there is something to be gained from diversification.

Increased debt issuance in euro may also lead to increased holdings of euros in reserves, while global imbalances may lead to expectations of lower dollar returns than in the past. While noting that reserve currency use is subject to inertia, Eichengreen and Mathieson’s (2000) empirical results using pre-euro data show that the currency denomination of debt is a strong predictor of reserve currency use. The size of the US current account deficit and the anticipated need for further real effective depreciation of the dollar to help correct that deficit may in the future weigh heavily on the dollar. While the range of estimates of dollar depreciation is wide, an extended period of dollar depreciation might produce widespread shifts out of nominal dollar-denominated assets, to the benefit of the euro. Chinn and Frankel (2005) consider various scenarios for future reserve currency use, and those with dollar depreciation as well as UK membership in the euro zone see the euro overtaking the dollar by 2020.

Should it come about, a bi- or multi-polar world may produce occasional large movements in exchange rates that have serious consequences for developing countries. Policy coordination between the euro area and the United States could then be crucial to prevent disorderly markets and financial instabilities. Policy coordination may not be necessary in normal times between the dollar area and the euro area, when floating exchange rates, accompanying monetary policies that are oriented primarily to achieving domestic targets for inflation and economic activity, do their job in facilitating adjustment to different shocks hitting the two regions. More problematic are times when there are reasons to be concerned about the sustainability of existing exchange rates. In those times, policy coordination may be desirable to guide currency values or limit the rapidity of exchange rate movements and prevent disorderly markets. This was the situation in the mid-1980s, when the US dollar was widely perceived to be overvalued, and the Plaza 17