Transcript The implications of introduction of Euro on Dollar

The implications of introduction
of Euro on Dollar
- by Sowmya Kumblekere
As a Foreign Reserve currency
As a Choice of Currency for oil trade
Contents
 Introduction
 Chronology of world currencies
 Dollar as international currency
 Euro as emerging international currency
 Dollar VS Euro
 Foreign Reserve currency
 OPEC choice of currency
 Study findings
 References
Introduction
 On Jan 1, 1999, Euro was inaugurated in
Frankfurt, Germany to serve as a single currency
to its member nations.
 Membership of EU increased from 10 to 25
countries on may 1, 2004.
 56 countries outside the Euro allow euro in their
exchange rate regime.
 Euro has potential of becoming the second largest
currency reserve for the world’s financial system.
Introduction
 What are the implications of this
introduction of euro on US dollars?
 Some other issues:
– How fast will the dollar bubble burst?
– How soon will euro be able to reduce
unemployment and improve European
economies?
Chronology of World
Currencies
 Byzantine gold nomisma (in 5th –7th
century)
 Arab Dinar (mancus or marabotin, 8th –12th
century)
 Florentine fiorino (13th -14th century)
 Venetian ducato (15th century)
 UK pound sterling (16th century till WW2)
 US dollar (from second world war)
Factors for currency to be
International currency
 Size of the economy – determines potential share
of currency in international trade
 Importance in international trade – size linked to
importance in international trade
 Size, depth, openness, liquidity of domestic
financial markets
 Convertibility of currency – important factor.
Restrictions limit use of currency
 Macroeconomic policies – affect country's
growth and openness of markets.
The US dollar
 80% of hard currency reserves globally
 US currency used outside US– as store of value.
 Making it easy for US to maintain stable dollar
prices and have huge trade deficits.
 Dollar has remained stable. It has enjoyed
exchange rate arrangements. Risk on returns is
very low.
 In 1960, ½ of circulation outside, In 1990, 2/3rd of
federal reserve currencies in circulation abroad.
Dollar: Reasons for
acceptance
 Size and ability to grow.
 Faith in stability of US political system and
transparency of the political and financial
system
 Availability of large amount of dollars
around the world.
Dollar: benefits as a dominant
currency
 Benefits: US consumers, traders, tourists
(can use dollar anywhere) and military.
Plus, US treasuries get interest on assets
held by federal reserve (approximately 12
billion per year)
 Benefited as reserve currency – US was
able to finance its current account deficits
by issuing more currencies.
Euro
 Euro system – a macroeconomic framework with
one currency and one monetary policy, managed
by one central bank.
 Provide credible alternative to the dollar. Is
second largest in terms of liquidity, depth and
width. Its growth will add stability to international
financial system.
 Reserve positions - euro area has much larger
reserves as compared to US.
Euro Vs Dollar
 EURO area
 GDP: 15%
 Used as Reserve currency:
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12.5%
Economy: Much smaller
World exports: 19.5%
Economies as large as US
and net creditors to the
world.
Euro will take time to
reach similar status as
dollar.
 US
 GDP: 20.5%
 Used as Reserve currency:
66%
 Economy: much larger
 World exports: 15%
 Dollar will still prevail,
especially in unstable
economies, due to
worldwide acceptance.
Foreign reserve currency
 Definition: one which is widely held in
international central bank reserves. The dollar is
currently the dominant reserve currency.
 Developing countries: reserves play crucial role.
To finance imports, foreign debt, and to intervene
in currency markets to manage exchange rates.
 In industrial nations, reserves mainly used for
intervention functions.
 Currency reserves in developing countries
important to determine composition of reserve
currency.
Studies
 Reserve of dollars and euros in developing
nations
 Reserves in industrial nations
 Reserves globally held by all nations
 Shift in NE Asia
Shift in NE Asia
 China sold US dollars in April, 2000.
 Hong Kong purchase of US treasuries gone down
since march 2000
 Taiwan net purchase of US dollars is zero
 Euro saw a boost in 20billion in April, compared
to largest selling of US dollars.
 Central banks of countries, esp. China has
accumulated large foreign reserves due to growing
trade surpluses + direct investment. To prevent
interest rate rise hold currency low, they invest in
euro.
Inferences: from foreign
reserves study
 ECB notes portfolio shifts “are expected to take
place at a slower pace in the central bank
community than in the private sector.”
 Gradual shift unlikely to have much impact.
 Euros increased acceptance as reserve currency
might increase interest rates in US, increase
borrowings in the euro area.
 To have these negative impacts, euro share should
rise with an absolute decline of US share. There is
no evidence to suggest this (Binder 1996)
OPEC- dollar VS euro
 Will euro establish in the financial market
changing the dominancy of the dollar?
 Recently Venezuela, China, Kuwait, Iraq change
reserves to Euro.
 OPEC’s interest in Euro – due to increasing value
and influence of euro among commodity traders
and analysts.
 OPEC has 45% trade imports from Euro zone,
while OPEC member countries are major supplier
of oil to euro zone.
 Issue: Whether UK and Norway will join Euro?
OPEC: why dollar?
 US chief importer of oil. (But euro zone is even
larger.)
 Advantageous to US: no currency exchange risk.
 OPEC interested in currency that brings stable
store of value.
 Does not show shift to any other currency in near
future.
 In short run, dollars will be used. In the long run,
will dual currency prevail?
Inferences: from OPEC study
 Major goal is not to jeopardize or threaten market
stability in any way.
 Depends a lot on member countries and the
countries they trade with. If trade mainly with
Asia or US, then Euro may not play key role.
Common interest of both buyer and sellers.
 If Euro used, both buyers and sellers will have to
share currency risks.
 To increase value of euro needs to be equal or near
dollar as reserve currency + role of financial
institutions is also crucial in assimilating euro into
world market. Stability of Europe
Study findings: Conclusion
 Central banks role is key. Any dollar weakness
may increase and hasten interest towards euro and
its acceptance. “ Central banks traditionally refrain
from abrupt and large changes in the composition
of their foreign reserves” (ECB 1991).
 Euro has potential for growth. But needs
acceptance – needs to establish itself and gain
credibility.
 Its diversity might pose problems and EU might
need to resolve many fundamental issues.
Study findings - Conclusion
 As reserve currency depends largely on what
developing countries prefer. They show a tendency
towards the dollars at present.
 Sale of dollar and the purchase of euros by central
bank –will lead to a drop in the value of dollar
relative to euro. This will lead to increased interest
rates on US Government securities. In contrast,
Euro value would increase and euro interest rate
would drop. The whole process however will take
substantial time.
References
 http://www.epinet.org/content.cfm/webfeatures_viewpoints_helsinkis
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peech - Euro and impact on dollar 1999
http://www.ecb.int/key/00/sp000113.htm - international impact of
the euro
http://www.federalreserve.gov/boarddocs/testimony/1998/19981008.
htm - General reading on currencies, particularly dollar
http://www.hsbc.com.tw/tw/product/fund/images/gs_200307_e.pdf Euro as a reserve currency
http://www.rense.com/general27/rec.htm - euro as asia’s second
currency
http://www.opec.org/NewsInfo/Speeches/sp2002/spAraqueSpainApr1
4.htm - SPEEDH BY OPEC MINISTER REGARDING EURO AS RESERVE
CURRENCY
http://research.stlouisfed.org/publications/review/01/09/septoct.pdf the creation of euro and role of dollar in international markets
http://research.stlouisfed.org/wp/1997/97-021.pdf - role of euro as
an international currency