Should the ECB care about the euro’s global role?

Benoît Coeuré 25 February 2019

a

A

There is a growing debate in Europe as to whether recent shifts in global governance should be seen as a reason to strengthen the global role of the euro (Juncker 2018, European Commission 2018, European Council 2018). According to some, being the issuer of a global reserve currency confers international monetary power, in particular the capacity to ‘weaponise’ access to the financial and payments systems.

This debate takes place against a gradual decline of the euro’s global role from the mid-2000s onwards (see Figure 1). Despite the euro area’s economic size and trading heft, the euro lags behind the US dollar by a wide margin for most measures of global standing (see Figure 2).

Figure 1 Index of the euro’s international role
(percentages; four-quarter moving averages)

Sources: BIS, IMF, CLS, Ilzetzki, Reinhart and Rogoff (2017) and ECB calculations.

Notes: Arithmetic average of the shares of the euro at constant exchange rates in stocks of international bonds, cross-border loans, cross-border deposits, foreign exchange settlements, global foreign exchange reserves and exchange rate regimes. Data on the share of the euro in global trade invoicing were not available; those on foreign exchange settlements are at market exchange rates. The latest data are for the fourth quarter of 2017.

Figure 2 Snapshot of the international monetary system
(percentages)

Sources: BIS, IMF, SWIFT, Gopinath (2015) and ECB calculations.
Note: Data as at the fourth quarter of 2017 or latest available. Data for the euro exclude intra-euro area transactions except for payments and invoicing.

As a result, the view is that if Europe does not actively promote the use of the euro in global financial markets and in international trade, it will be increasingly exposed to the risk that the monetary power of others is used against its interests (e.g. Tooze and Odendahl 2018).

The ECB does not take a view on foreign policy questions. It does not decide on the role of Europe in the world, or on who uses the euro globally or not. But, as central bank, we are not indifferent to the current debate, for two main reasons.

The first reason relates to the alignment between the policies that will strengthen the euro’s global role and the policies that are needed to make the euro area more robust. 

Specifically, three broad shortcomings are likely to have affected the international role of the euro.

First, international currencies need to provide stability and safety during times of global financial stress. This is what some have coined the ‘exorbitant duty’ of international currency status (Gourinchas et al. 2011, Caballero et al. 2015). US Treasuries are widely viewed by international investors as such a safe store of value (He et al. forthcoming). 

The euro area lacks this common safe asset. Since 2008, the number of AAA-rated euro area sovereigns fell from eight to three. Today, AAA-rated euro area sovereign debt amounts to just 10% of GDP. In the US it is more than 70% (see Figure 3).

Figure 3 Debt securities issued by central governments, 2018
(as a percentage of GDP)

Sources: OECD Government Statistics, IMF WEO and ECB staff calculations.
Notes: Outstanding amounts at market value for the euro area; publicly held Treasury securities outstanding for the US. The blue bars in the chart report debt securities as rated by both Standard and Poor’s and Moody’s (local currency long-term debt rating). 

Considerable progress has been made in improving the euro area governance framework in recent years.1 But for the euro to act as a true, effective hedge in times of stress, and therefore to attain and maintain international status, we need to further strengthen the fiscal dimension of Economic and Monetary Union (EMU).

Sound fiscal and structural policies are needed to provide international investors with what they need most: a large and elastic supply of safe assets. And since the journey towards a true European safe asset, one that does not vanish on rainy days, will be long and bumpy, we should also focus our efforts on “upgrading” the credit quality of outstanding debt by committing to credible fiscal rules.

The second shortcoming of the euro area is the segmentation of its capital markets. Deep and liquid financial markets are key ingredients of an international currency. Financial deepening was an important contributor to helping the dollar dethrone the pound sterling as the leading international currency (Chiţu et al. 2014).

Capital markets in Europe are still fragmented along national lines. Various legal and institutional barriers hinder the creation of a single European market. The Capital Markets Union should be a key priority for the next European Commission and Parliament (ECB 2015).

The third and final factor that has likely held back the international role of the euro relates to the ability of Europe to speak with one voice on international affairs. Empirical evidence suggests that nations that depend on the US security umbrella hold a disproportionate share of their foreign reserves in dollars.2

Of course, addressing this aspect extends beyond EMU. But it means that European initiatives to foster cooperation on security and defence, and to speak with one voice on international affairs, might help foster the euro’s global outreach, too.

The second reason why the current debate on the euro’s global role is relevant for the ECB is that a stronger international role of the euro would likely have tangible implications for the conduct and transmission of monetary policy.

First is the effect on exchange rate pass-through. The more the domestic currency is used for trade invoicing, the less the pass-through to import prices in the face of fluctuations in the exchange rate. The tight correlation between domestic currency invoicing and exchange rate pass-through is evident in the euro area (see Figure 4).

Figure 4 Exchange rate pass-through to import prices vs. euro invoicing across euro area countries

Source: The international role of the euro, ECB, July 2015.
Notes: Long-run exchange rate pass-through is estimated using a standard log-linear regression model of the quarterly log change in import price unit values on the quarterly changes of the standard broad measure of the NEER-38 of the euro, a quarterly effective measure of inflation in production costs of the euro area’s major trading partners and the quarterly log change in industrial production (excluding construction). The estimation sample spans the time period from the first quarter of 2000 to the last quarter of 2014. The share of euro invoicing reported on the x-axis is the average over the sample period. The black line is a fitted regression line. 

The degree of pass-through, in turn, has competing effects on the transmission of shocks. On the one hand, lower pass-through means that import prices are better shielded from exogenous exchange rate shocks, and monetary policy can focus more on domestic sources of inflationary pressures.3 On the other hand, increased local currency pricing would, in principle, attenuate the exchange rate channel of monetary policy.

That said, exchange rate pass-through has already notably declined over the past two decades in the euro area, mainly due to the declining share of commodity imports and the increasing role of global value chains (Cœuré 2017). 

The second way in which an international currency is relevant for monetary policy is its effect on financial conditions. In principle, international currency issuers enjoy greater monetary autonomy. They often tend to influence monetary conditions globally, thereby creating spillovers and spillbacks through international trade and finance. 

For example, the increased use of the euro as an international funding currency would amplify the international risk-taking channel of monetary policy, which operates through international bank leverage.4 And if the euro were used more for trade among third countries, a depreciation of the euro would make all euro-denominated exports cheaper, from euro area and non-euro area firms alike. This would cause an increase in global trade with potentially positive spillbacks, not least as the euro area is more open to trade than the US (see also Boz et al. 2017).

At the same time, international currencies are not isolated from foreign spillovers. It is well documented, for example, that the large demand for US securities by foreign central banks in the run-up to the financial crisis contributed to the decline in longer-term US interest rates, thereby in part offsetting the parallel tightening efforts by the Federal Open Market Committee.5

It is not that these effects are completely absent in the euro area today. As the second most important reserve currency, demand from foreign central banks can also be expected to have affected euro area financing conditions (Cœuré 2018b).

But there is a difference, and it is due to the aforementioned lack of a single safe asset. According to the IMF’s Coordinated Portfolio Investment Survey, foreign central banks currently hold more than 40% of their euro-denominated debt reserves in German government bonds, well above Germany’s share of total outstanding euro-denominated sovereign bonds, which is around 15%.

The implication is that a better functioning economic and monetary union could be expected to lead to a more even distribution of reserve demand effects, and more generally flight-to-safety effects, across the euro area. This, by itself, would benefit the transmission of our monetary policy.

The flipside is that central banks in smaller economies could turn more frequently to the ECB for currency swap lines when the tide turns – i.e. if and when international liquidity in euro dries up.

The ECB would then be called on to increase its activities as an international lender of last resort. Any extension of the global network of currency swap lines would, however, have to be based on sound monetary arguments. Central banks are mindful of global financial stability, but they always act in full discretion and within domestic mandates.

Concluding remarks

In sum, two tentative conclusions can be drawn at this stage. The first is that the decline in the euro’s international role in recent years is primarily a symptom of the initial fault lines of EMU. Efforts that help overcome the shortcomings in the design of EMU may, therefore, also foster a stronger international role of the euro.

The second conclusion is that a stronger global role for the euro may have tangible consequences for the conduct of monetary policy, all of which we would need to understand and take into account when designing the common monetary policy for the euro area. But provided the right economic policies are adopted, a stronger global role of the euro could help facilitate the transmission of monetary policy across euro area financial markets and reduce perilous fragmentation.

Author’s note: This column is based on a speech at the Council of Foreign Relations (Cœuré 2018a). I would like to thank J. Gräb, A. Mehl and J. Yiangou. I remain solely responsible for all opinions contained herein.

References

Bernanke, B (2005), “The Global Saving Glut and the U.S. Current Account Deficit”, speech at the Homer Jones Lecture, St. Louis, Missouri, 14 April.

Bruno, V and H S Shin (2015), “Capital flows and the risk-taking channel of monetary policy”, Journal of Monetary Economics 71(C): 119-132.

Boz, E, G Gopinath and M Plagborg-Møller (2017), “Global Trade and the Dollar”, NBER Working Paper No 23988.

Caballero, R, E Farhi and P-O Gourinchas (2015), “Global Imbalances and Currency Wars at the ZLB,” NBER Working Paper, No 21670.

Chiţu, L, B Eichengreen and A Mehl (2014), “When did the dollar overtake sterling as the leading international currency? Evidence from the bond markets,” Journal of Development Economics 111: 225-245.

Cœuré, B (2017), “The transmission of the ECB’s monetary policy in standard and non-standard times”, speech at the workshop “Monetary policy in non-standard times”, Frankfurt am Main, 11 September.

Cœuré, B (2018a), “The euro’s global role in a changing world: A monetary policy perspective”, speech at the Council of Foreign Relations, New York, 15 February.

Cœuré, B (2018b), “The persistence and signalling power of central bank asset purchase programmes”, speech at the 2018 US Monetary Policy Forum, New York City, 23 February.

Eichengreen, B, A Mehl and L Chiţu (forthcoming), “Mars or Mercury? The Geopolitics of International Currency Choice”, Economic Policy.

European Central Bank (2015), “Building a Capital Markets Union – Eurosystem contribution to the European Commission’s GreenPaper”, 24 June. 

European Commission (2018), “Towards a stronger international role of the euro”, European Commission contribution to the European Council and the Euro Summit, 5 December.

European Council (2018), “Statement of the Euro Summit”, 14 December. 

Gourinchas, P-O, N Govillot and H Rey (2011), “Exorbitant Privilege and Exorbitant Duty”, Working Paper Series, University of California, Berkeley. 

He, Z, A Krishnamurthy and K Milbradt (2019), “A Model of Safe Asset Determination,” American Economic Review, forthcoming.

Juncker, J C (2018), “The Hour of European Sovereignty”, State of the Union Address 2018.

Kaminska, I and G Zinna (2014), “Official Demand for U.S. Debt; Implications for U.S. Real Interest Rates”, IMF Working Papers, No 14/66.

Krishnamurthy, A and A Vissing-Jorgensen (2012), “The Aggregate Demand for Treasury Debt”, Journal of Political Economy 120(2): 233-267.

Miranda-Agrippino, S and H Rey (2015), “US Monetary Policy and the Global Financial Cycle”, NBER Working Paper, No 21722.

Tooze, A and C Odendahl (2018), “Can the euro rival the dollar?”, CER Insight, Centre for European Reform, 4 December.

Endnotes

[1] For instance, there is now a single supervisor for large banks, a single framework for resolving failing institutions, a single fund to finance those resolution activities and, soon, a single backstop for that fund. The European Stability Mechanism provides a safety net for sovereigns threatened with losing market access, provided that they implement sound economic policies.

[2] See Eichengreen et al. (forthcoming). This is not a new phenomenon. During the late 19th century, the increasing importance of French francs in Russia’s reserves in the years after the Franco-Russian alliance of 1894 reflected similar security patterns. 

[3] Price increases in local currency by exporters will, of course, still be transmitted to domestic consumer prices. 

[4] Bruno and Shin (2015) argue that looser US monetary policy encourages global banks to leverage more in dollars (on the supply side) and emerging markets to borrow more in dollars (on the demand side). The latter reflects the fact that the ensuing dollar depreciation flatters emerging markets’ balance sheets, hence appearing less risky. Miranda-Agrippino and Rey (2015) find evidence of large financial spillovers from the hegemon to the rest of the world. US monetary policy explains an important share of the variance of returns of risky assets around the world.

[5] See Bernanke (2005). On the impact and transmission channel of foreign official purchases on US Treasury yields in the mid-2000s, see also Kaminska and Zinna (2014) and Krishnamurthy and Vissing-Jorgensen (2012).

a

A

Topics:  EU institutions EU policies Monetary policy

Tags:  international currency, euro, ECB, euro's global role

Member of the Executive Board, European Central Bank

Events

CEPR Policy Research