The Impact of the Euro Since its Launch - Dissertation Example

The Impact of the Euro Since its Launch Abstract European Monetary Union (EMU) and the economic convergence that the unification has inspired among the member nations is one of the most important phenomena in the recent periods in the development of the international foreign exchange systems and in the capital markets. The culmination of the EMU finally into a single currency in euro has provided strong incentives to strengthen the domestic economic policies. Thus the common currency has brought about macroeconomic stability integration that has resulted in tangible benefits for the member nations. But in spite of the advantages, euro had to face a lot of challenges in the form of guarding against the major international economic shocks, cater to the changing economic conditions not only in the member nations but also in the global economic conditions and bringing out stability in the exchange rates. The currency had also to revive itself from the initial downturn it suffered and later to sustain the growth achieved by it as an international currency. This paper presents the major advantages and disadvantages of the currency as a single currency and the impact it created on the various economic fronts since its inception. 1.0 Introduction; The major purpose of introduction of Euro was to take on the challenges of competition posed by the growing attitude of globalization. The other object envisaged by the European Union through the introduction of Euro was to overcome the barriers imposed by the diversities posed by the different economies. These diversities are caused by the conflicting monetary and fiscal policies of the various governments and the multifarious tariffs and restrictions placed on trade and investment. Before the introduction of Euro the euro-zone currencies were greatly influenced by the rise or fall in the rate of US dollar. The introduction and existence of euro has led to the positive impact of alleviating the financial crisis faced by the euro-zone countries since 1998. Further positive effects of the common European currency in the form of price stability, cheaper and better banking facilities, increase in the competitiveness of the industrial enterprises and welfare of the consumers in general have resulted during the last 8 years of the existence. Most generally the vastness of the European internal market with a single currency made Europe a potential competitor to the market of the US. With this background this paper discusses the impact of the Euro currency on the economies of the countries that joined with the common currency and also the impact on the United Kingdom of not joining the euro. The paper also discussed the relative advantages and disadvantages of the single European currency. 2.0 Achievements of Euro: This part of the paper examines how far euro has achieved the purposes for which the common currency was brought in to existence. There are basically definite positive impacts of the currency from an economist’s perspective. But the currency also had to face some key challenges that the currency still trying to overcome through the years. The major achievements of the euro can be enumerated as below: 2.1 Protection and Stability of the economies: The foremost achievement of the euro is providing a protection and stability of the various economies in a fast changing global environment. The effect of large economic shocks like 9/11 incident in the USA, increased oil prices and the Iraq war had their impacts on the other economies of the nation which had an equal impact on the European economies. Euro has acted as an effective shield for the member economies against the impact of these adverse factors. Further stability in the form of removal of risks emanating from exchange rate volatility and making the currency stronger had also been achieved since the introduction of the currency. 2.2 Low and Stable Inflation Rates: Maintenance of a slow and stable inflation rates was another distinct advantage witnessed with the introduction of the euro. Joaquin Almunia (2007) comments that inflation in the euro area has fallen from rates of around 7% on average in the 1980s and above 4% in the early 1990s to just around 2% as of April 2007. This achievement is particularly marked when you look at individual countries, including Greece, where inflation has dropped from close to 20% in the early 1990s to a little over 3% in the beginning of 2007. 2.3 Fall in Interest Rates: The third achievement of the common currency is the reduction in the interest rates. The best example in this respect can be found in Greece where the interest rates have come down to 3.75 percent while it was in double digits in the year 1999. For reaching this position the monetary policies of European Central Bank (ECB) is the main reason. The role of ECB is highly commendable in this respect, while comparing the fact it has taken more than decades in some other countries. 2.4 Economic Integration: Another important accomplishment of the currency after its introduction is the contribution it has made to the economic integration for the continent. This was able to be achieved by the currency acting as a strong catalyst for the trade and foreign direct investment in Europe. The trade in between the member countries is showing a rise form 5 to 15 percent according to Joaquin Almunia (2007). Similarly rough estimates indicate an FDI inward figure of almost 60 percent since the currency was introduced. The economic integration was evidenced by the increased use of cheaper mortgages and loans by the European consumers and companies. The boom in the financial markets was also the result of the presence of the strong currency. “The Member States that share the single currency are also benefiting from highly integrated markets for derivatives, corporate bonds and money.” Joaquin Almunia (2007) 2.5 Establishment of a Strong Currency: The importance gained by the currency in the foreign exchange markets is of a great significance which is the unique advantage resulted from the emergence of the common currency. The importance of the currency can be assessed by the fact that 49 percent of the global bond market consisted of euro currency for the year 2006 overtaking the US which stood at 37 percent. The might of the currency has resulted in the growing confidence on the currency. The power of the currency has not only benefited the European countries but also many developing nations by higher export realizations in their currencies against Euro. 3.0 Areas of Shortcomings created by Euro: In spite of the various achievements that were possible to accomplish with the introduction of the single currency, there were certain areas where the currency had failed to prove its power of providing a stronger currency for the development of the economies covered by the EU. 3.1 Downturn in the Currency Value: The first issue that the currency was to handle was the down trend in the value of the currency during the period 2001-2002. The recovery performance of the currency was very low compared to the past performance of the currency vis-à-vis the performance of the industries and trading enterprises. However the trend as of now is very encouraging with a growth rate of 2.7 percent for the year 2006. The phenomenal growth rates in different EU may not necessarily because of the currency factor but could be attributed to the structural and economic reforms administered by those countries. The growth in the product and labour market might also have contributed to the growth of the economies. 3.2 Lack of Adjusting Capabilities to Country Specific Developments: Within the EU area after the introduction of the currency, the competitiveness in the countries of Germany and Austria have shown improvement while there was a declining trend in the countries like Spain, Ireland, Italy and The Netherlands. In fact these countries witnessed a loss of competitiveness. Large Current account imbalances, differences in the inflation rates, persistent swings in the economic activities caused by the common currency are the main reasons for the variations in the competitiveness among different member countries. These economic situations are the result of the time taken for the countries to adjust themselves to the common currency. The single currency factor basically affect the fiscal policies of the governments concerned, the financial markets that affect the economic cycles and the functioning of the product and labour markets in these countries. 3.3 Resulted in Weak Public Finances: The single currency had made the member countries struggle putting their public finances in a stronger position. This was the result of the problems faced by the member countries in making their budgets sound during 1999-2000 even when the currency was going strong. This has affected the budgetary policies in the subsequent periods when the currency was facing a downturn. An additional problem faced by the member countries in the public finance sphere is the low quality of public finances. It was difficult to direct the budget provisions towards sectors like R& D and education that will promote the economic growth. Instead much of the budget provisions were for making good the deficit and debt reduction. The provision of public finances for ageing societies posed the problem of consolidating the public finances. Due to the increase in the ageing population public spending on pension, health care and long term care show increasing tendencies. It increased the strain on the public finances providing these expenses in the new currency Apart from the shortcomings created within the EU, the currency had also to face challenges from the impact of changes in the global economy. 3.4 Effect of Unemployment: When higher unemployment situation continues would lead to pressure on the fiscal expansion and fiscal transfers. “However the Growth and Stability Pact (GSP) limits the scope for extra government spending and the central EU budget is less than 1.3% of GDP” (Thames Valley Chamber of Commerce 2002) 3.5 Citizens’ perspectives of the Currency: Accustomed to the using of the old currencies the citizens of the different nations found it difficult to adopt themselves with the new currency in terms of its effect on the prices and also on the economy. Hence there was a potential cause for concern that the currency will lack support from the public. 4.0 Economic Benefits of having Euro as a Single Currency: Euro as a common currency for the European Union has brought a number of economic benefits to the member nations. These include macro economic stability and resilience as well as more efficient functioning of the single market. The major economic advantage that has resulted from the launch of euro is to make a foundation for a sustainable long-term economic growth. “Price stability, sound public finances and low interest rates constitute ideal conditions to foster economic growth, investment and employment creation within the euro area.”(Europa) 4.1 Price Stability: The foremost economic advantage that was resulted from the adoption of euro as the common currency is the price stability in the market. “The ECB has been given the clear mandate to ensure stable prices. Indeed inflation came down in the euro area from about 4% in the early nineties to just above 2% in recent years.” (Europa 1). 4.2 Elimination of Transaction Costs: The need for using different currencies in the different nations was eliminated with the introduction of euro. The elimination of the different currencies has reduced the exchange rate fluctuations and the transaction costs that were being incurred in the exchange of currencies. This has resulted in the reduction of uncertainties and the costs relating to the international trade. 4.3 Increased Competition: With the euro as currency it is possible for the countries to compare the prices of goods and services in the same lines on the basis of the common currency. With this advantage the competition among the consumers and businesses has increased considerably. With the increased competition the businesses could offer higher qualities of products and lower prices for consumers. The businesses in this process were able to earn higher real income. 4.4 More Opportunities for Investors: The opportunities for the investors also have increased providing way for higher investments and trade resulting from the adoption of the common currency. 5.0 Economic Disadvantages of a Country that have not Opted for Euro: Quite obviously the country that has not opted for adopting the euro as common currency would be deprived off of all the benefits that would be available for the countries. In addition the country would suffer from the following disadvantages also: “Foremost among the disadvantages of euro zone membership is the loss of a country’s monetary policy and consequently its ability to reduce the negative effects of domestic and foreign economic developments” Veronika B Horniakova (2006). The European Central Bank sets the single interest rate which works out to the advantage of the countries in times economic changes. Obviously this advantage would not be available to the country that has not joined in the currency. Fixed and Single Exchange rate usually helps the countries control the adverse effects of internal and external shocks. Countries that do not join the currency will have to control the individual country’s economic shocks on their own methods which often would be a trial and error method and may turn out to be disadvantageous to the country concerned. When the interest rate and exchange rate autonomy is surrendered to a common authority the responsibility for controlling the shocks of the economic changes would lie with the common authority and the individual country need not bother itself about changing the interest rate or exchange rate. This advantage will not be available to the country that has opted not to join the euro. The country should depend on labour market adjustments which is rather complicated. 6.0 Introduction of Euro and Impact on Prices: Immediately after the introduction of the euro as a single currency there were two impacts observed on the prices. They were actual impact on prices and the perceived impact. The actual impact on the price levels while switching over the currencies was negligible. The perceived impact is a phenomenon that is an unavoidable side effect of a currency changeover. The perceived impact was visible in those countries where it was mandatory to display double pricing. “Curiously enough, people in countries with mandatory double pricing complained about rising prices just as much as people in the other countries. This suggests that the actual impact should be seen as independent of the perceived impact.” (Thomas Eife) However, wrong perceptions could have been avoided by using better communications. Thus many of the problems encountered in the changeover of the currencies were the results of the inefficiencies in the policy making process, that could have been avoided with the policymakers using the effective instruments on their hands. In this way even future small price movements can be avoided by changing the system of policymaking. 7.0 Impact of the United Kingdom not Joining Euro: The question of whether the UK should join the Euro is one of the most significant economic decisions of the decade. On deciding this issue, the UK government’s policy was announced by the Prime Minister in February 1999 and in 2003 the Finance Minister after his assessment of the five economic tests announced that Britain was not yet ready to join the Euro. According to Britain USA website the five economic tests are: There should be sustainable convergence between Britain and the economies of a single currency There should be sufficient flexibility to cope with the economic change There should be a positive effect on investment There should be positive effect of the single currency on the financial services industry The single currency should produce a positive effect on the growth and employment. After an application of these tests UK decided not to join the euro presently. Because of this possibly UK might have deprived of some of the advantages resulting from a unified currency. The UK might suffer from the following possible consequences of not joining euro: The foreign direct investment that should flow in to the UK would be affected by UK not joining the euro. This is so because there is a possibility that not joining euro would create instability for the sterling currency. This may create a dent in the foreign direct investment in UK. Moreover not joining euro may create an impression among the investors that UK has distanced itself from Europe might affect the perceptions of the prospective investors to reconsider their decision to invest in UK. According to an article from Thames Valley Chamber of Commerce (2002) Britain's share of new foreign investment projects into the EU has fallen from 28% in 1998 to 21% in the first half of 2001. The foreign direct investments into France were showing an increasing trend. The UK not joining euro may create a significant damage in the financial sector of UK. The possibilities are that the position of the city of London may get affected as a financial nerve center of Europe. This may happen due to the fact that at some point of time Frankfurt or Paris might get a preferential access to euro by virtue of regulations imposed by European Union that favour the banking and investment institutions operating in Euro-zone. It is observed by Thames Valley Chamber of Commerce (2002) that the economic growth of London is slower than that of Frankfurt and Paris except for the foreign exchange market. Not joining euro might distance the country from Europe with the result that UK would have very less political influence within the European Union. The absence of UK from the membership of important bodies constituted to take important decisions would adversely affect the power of UK to protect its own interests. It might also be possible that the country is not able to prevent the introduction of new rules and policies that may weaken the position of the country. The joining of Britain to euro had been often discussed both as an economic issue and at times as an economic decision. There had been various arguments for and against the country UK joining euro. The arguments that were offered for joining euro are: It had been observed that based on the ‘five tests’ the requirements for the financial services sector has largely been met. It is not necessary that UK should have the floating exchange rate the country should be able to adjust itself to the changed economic conditions using the labour costs and labour market. Hence there is no need to maintain its own currency just for adjusting itself to the changes of the economy. Moreover floating exchange rates do not deliver stable and well aligned exchange rates. The economic welfare is greatly facilitated by lower exchange rate transactions costs. In fact elimination of exchange rates between European countries by the common currency had eliminated the exchange rate revaluations and devaluation and thus would also help UK in the same way. The adoption of a volatile interest rate by European Central Bank taking into account the prevailing economic conditions in all the member countries is better and more efficient than the rates being adopted by Bank of England. There were arguments put forth against Britain joining the euro which cannot be ignored as having no substance. The arguments were: The first argument was that there had been instances where the currency unions have collapsed in the past and the EMU may follow suit. In contrast to the requirements of the UK economy, the deflationary monetary policies being followed by the European Central Bank that addresses the economic stagnation and higher structural unemployment will suit only the European economies. Following the example of Ireland in departing from the sterling currency, it is possible that countries may cancel their membership with the EMU and reestablish their own currency and follow an inflationary policy, when they find it difficult to continue with the common currency. Lack of exchange rates of their own prevents the countries having a mechanism for adjusting the economic imbalances caused by varied shocks. Thus UK may retain the option of devaluation if necessary to help the economy in stabilizing itself. Without an independent currency, the countries would find it difficult to control recessionary trends. UK entering EMU would signify the transferring of domestic monetary autonomy to the European Central Bank and it amounts to giving up the exchange rate flexibilities. “Joining a currency union with no monetary flexibility requires the UK to have more flexibility in labour markets and in the housing market.” (Ask.com) 8.0 Past Performance and the Future of Euro: The process of internationalizing of euro is a costly and long-drawn process and also is driven by market forces. There are various economic factors that determine the growth of a currency to its international magnitude. No doubt that most of these economic factors would have acted on the euro in sustaining its growth and maintaining its position within and outside the euro area. As per the European Commission (2006) the internationalisaiton of euro includes: the size and the openness of the economy; a developed financial system with deep and liquid markets; incumbency and inertia. Within the abovementioned playing field and based on the past performance the future role of euro has to deal with: 8.1 Enhancing the potential for growth in the Euro area: It can be said that the while the member nations can expect more positive outlook for the economies, the actual performance of euro as a currency has not been spectacular in the area of GDP growth. “Annual average real GDP growth in the euro area was 3.4 per cent in the first two years of EMU, but over the last five years the euro area has managed average real GDP growth of only 1.4 per cent. This compares with average real GDP growth of 2.6 per cent in the US over the same period.” European Commission (2006) In order the euro emerges as a successful international currency in providing significant economic growth to the member nations, there must be wider structural reforms that are being undertaken by the member unions. Though efforts have been taken by some of the nations, it is important that these efforts are enlarged to a maximum possible extent. Any inadequate implementation of reforms would not result in a desired level of growth of the currency and also of the currency. Unless euro raises its performance with respect to its growth, the currency may not be able to reach its full potential as an international currency. 8.2 Enhancing Financial Market Integration within EU: Euro becoming an attractive currency for the investors depends on the deep and liquid financial markets for assets denominated in euro. The currency must be supported by a financial system which is developed to support a large level of trading and risk taking. The support for the currency by the prevalent financial systems in the member nations has improved to some extent after the introduction of the common currency. However due to diverse economic, social and cultural preferences of the member states the EU financial system was highly fragmented. Until the introduction of the currency exchange rate risks and high transaction costs charcterised the financial markets within the euro area. The adoption of euro has helped the member nations to reduce the transactions costs in the foreign exchange markets and the volatility in the exchange rates have been altogether removed with respect to the financial markets of the member countries. This signifies the contribution of euro towards the enhancement of the integration of the financial markets in euro area. The adoption of Financial Services Action Plan (FASP) was an important step taken in this respect to create a single market regulatory frame work. Still there is scope for further improvement in the finance market integration. There exist some obstacles in the form of adoption of a standardized legal system governing the securities issue variations in settlement and clearing systems across the various member nations should be minimized differences in tax structures that hamper the cross-border investments should also be reduced to the minimum 8.3 Enlargement of the Euro Area: Another area where the future of euro can be expanded is the enlargement in the euro area. From the introduction of the euro as a common currency there has been overwhelming response from various nations to integrate themselves with the currency in view of the stability the currency has created in the economies of those nations who have decided to join the currency. The enlargement of euro to additional countries and the expansion of its horizon depend largely on the aggregate fiscal and monetary policy stance of the euro area. However the chances for euro enlarging its operational area depends on the increase in the efforts for achieving greater policy coordination of EU, widening the unified representation and participation of Euro in the major international economic and financial institutions and radical changes in the mindsets of policy makers of member nations to adapt their monetary policies in line with the changes in the global economy. 9.0 Conclusion and Recommendations: Retrospectively looking at the performance and impact of euro as a major international currency during the last eight and a half years, one of the major achievements of euro can be found in its emergence as a solid and single stable currency in the foreign exchange arena. Such emergence also clear suggests that euro with its contribution for the economic integration in the euro area and for the stability of the financial markets has a distinct possibility of declining the international role of US dollar and even replacing it in the course of time. Though it may take a longer time the gradual process of the currency will enhance its role as a major international currency with a larger role to play in the global economy. The objectives of raising the growth potential in the euro area, increasing the financial integration within Europe and improving the external representation of the euro area need to given more thrust. For achieving these objectives and also to increase its internationalization stature the obstacles involving standardization of the legal systems, variations in the clearing systems and removal of differences in tax structures need to be attended immediately. In order to sustain the growth attained by euro the following needs to be attended to: Generally the overall risks to the price stability remain on the higher side. Hence it is important that price stability is contained by enforcing a strong vigilance on the factors affecting the stability. Pushing forward the economic reforms and fiscal consolidation is another area which needs particular attention. Doing this is the key challenge for the policy makers and hence the member countries should strive to attempt continuously at the structural reforms. More efforts should be taken to minimize the variations in the taxation structures and to improve the settlement and clearing systems so that the financial markets can be improved. In respect of the new countries that opt to join in the euro it may be necessary to make some changes in their respective national legislations to lay the foundation required for the introduction of euro. Thus based on the experiences with the introduction of euro it is possible to expand the horizon of the currency gradually and effectively in the course of time. The key success of euro as a single currency can be cited in maintaining the price stability and thereby gaining the credibility and confidence of the European citizens. This has raised the desire for more nations to join the currency. Hence the enlargement of the euro area beyond the existing boundaries is also not out of question, provided the nations adapt themselves suitably to provide the basic framework for the introduction of the currency and take the advantages resulting there from. In due course England may also decide to join the euro and make it stronger than as is presently. References: 1. Ask.com What are the arguments for and against joining the Euro http://www.historylearningsite.co.uk/euro.htm 2. Britain USA Britain’s Economy: The Euro http://www.britainusa.com/sections/index_nt1.asp?i=41137 3. Europa The Euro: Our Currency http://ec.europa.eu/economy_finance/euro/benefits/benefits_1_en.htm 4. Europa 1 What have been the main benefits of the euro? http://ec.europa.eu/economy_finance/euro/slovenia/docs/press1en.pdf 5. European Commission (2006) The International Role of the Euro: Past Developments and Future Perspectives http://72.14.235.104/search?q=cache:yGY41me9i2cJ:www.oenb.at/en/img/deroose_tcm16-41773.pdf+Expansion+of+the+Euro/Future+of+the+Euro.&hl=en&ct=clnk&cd=11&gl=in&client=firefox-a 6. Joaquin Almunia (2007) Unveiling the priorities for EMU: looking ahead at 10 years of the single currency European Commissioner for Economic and Monetary Affairs; The Economist Conference Athens, 25 April 2007 http://europa.eu/rapid/pressReleasesAction.do?reference=SPEECH/07/251&format=PDF&aged=0&language=EN&guiLanguage=en 7. Thames Valley Chamber of Commerce (2002) Economic and Monetary Union BCC Brief October 2002 http://www.thamesvalleychamber.co.uk/memberservices/8_1.asp 8. Thomas Eife The truth is that policymakers could have avoided these misperceptions Europe’s World http://www.europesworld.org/EWSettings/Article/tabid/78/Default.aspx?Id=8eedc261-8edc-4691-b7f7-8b02194cd2c6 9. Veronika B Horniakova (2006) Ardous Road to Euro Zone http://www.czech.cz/pdf.aspx?id=5879 Read More