The Impact of the Euro Since Its Launch - Dissertation Example

? The Impacts of The Euro Introduction of euro was the biggest economic experiment and tracking the impacts of this experiment is highly important to know whether the experiment succeeded. This report considers the impact of the euro over the status of US$ as a reserve currency, Foreign Direct Investment in the Eurozone, international trade, inflation, interest rates and monetary policies. There have been different views of different economists regarding the mechanisms of the impacts euro has had on different economical phenomenon. This report also analyzes the views presented by some economists on the economic factors mentioned above. The report also shows whether the impacts have been positive or negative and what changes have the euro brought to the economic environment of the member countries of Eurozone. Finally after the analysis of the literature from economists and analysts, the conclusions regarding the impact of euro would be derived. Table of Contents Table of Contents iii References xiv The Impacts of the Euro 1. Introduction The Euro is one of the stable currencies in the world. It is the official currency of the eurozone which consists of 17 member states of the European Union. The euro was initially introduced as an accounting currency on 1 January 1999. The notes and coins for the euro were brought into circulation on 1 January 2002. In the period between the introduction of the currency and the advent of its notes and coins, the preceding currencies’ notes and coins were accepted, however such currencies were fixed against the euro. The significance of the currency on a global scale can be determined by the fact that it has become second largest reserve currency in the world. Apart from that, it has also become second most traded currency all over the world after the US $. According to the statistics released by European Union, more than €800 billion were in circulation as at June 2010. The euro has surpassed US$ in the combined value of notes and coins in circulation all over the world. According to the estimates released by IMF, eurozone is the second largest economy in the world. Many US economists had criticized the idea of a currency such as euro. According to such economists, euro was bound to be a failure and it would not last for so long (Jonung, 2010). However, euro surpassed everyone’s expectations and in a very short period of time, it evolved to be one of the most powerful currencies in the world. Most economists were against the idea of monetary unification however the success of euro proves that monetary unification is an evolutionary process. From these facts and figures, it can be inferred that euro has become one of the most powerful currencies in the world and it has significant impact on the global economy. 2. Euro as Reserve Currency In order for a currency to be a favoured reserve currency, it must have well developed financial markets. The euro was formed after the unification of 17 currencies of the member states of the European Union. The unification strengthened the euro financial markets and it lowered the macro-economic risks of the countries in eurozone. This was one of the reasons why euro became one of the biggest reserve currencies all around the world. It inherited its reserve status from the currencies that dissolved into euro. Before the introduction of euro the overall share of US$ as reserve currency was 70.9% which dropped to 64% in the year 2008. On the other hand, the inherited proportion of the euro as reserve currency was 17.9% in the year in which it was introduced, i.e., 1998. One of the reasons behind the euro’s status of one of the most reserve currencies is due to German Mark. The proportion of euro as reserve currency increased to 26.5% in the year 2008. The euro has significantly affected the status of US$ as a reserve currency. Most economists are also debating the possibility of the euro replacing the US$ as the most held reserve currency. According to David Roche, global strategist at Independent Strategy, the euro will become world’s preferred reserve currency because Europe has a better growth strategy as compared to the US. This argument provides even more strength to the possibility of the euro becoming the most held reserve currency. According to Roche, American strategy of growth is increasing the taxes in order to meet the deficit in the budget however the strategy of Europe is to shrink the spending. Americans have to suffer higher taxes and resulting inflation at the same time, however the strategy of the eurozone which is significantly controlled by Germany is right and it will help Europe recover faster than the rest of the world. This scenario will affect the position of the euro in a positive manner and it will add further strength to the currency. According to Galati and Wooldridge (2006), there are four factors that play an important part in determining the favourableness of a currency to be a reserve currency. First factor is the share of the country in international trade. If a country is active in international trade, other countries are most likely to use the country’s currency as a monetary medium of carrying out transactions (Frankel, 2000). In this manner, the currency will have greater circulation throughout the globe and the number of non-resident users of the currency would increase. Another factor that determines whether the currency would be suitable for a reserve currency is the macroeconomic stability. According to Hartman and Issing (2002), the development of the international role of a currency depends mainly upon the stability of its price. If the currency can be confided upon with regard to the stability of its value, it has greater chances of being used as a unit of account internationally (Eichengreen and Mathieson, 2000). According to some economists, the reserve value of a currency diminishes if a steep inclination in inflation occurs. Therefore, stability in the value of a currency is highly important. This argument can be linked to the argument of Roche who said that the strategy of Europe to shrink its spending in order to meet the deficit would be helpful in increasing the stability of euro. Due to limitation on spending, the inflation would not rise and the value of euro will remain stable. This is one of the reasons why euro is becoming a preferred reserve currency. The third factor that determines the favourableness of a currency to be reserve currency is the development of financial markets. If the financial markets of a country are well developed and more liquid as compared to other countries, other countries are most likely to put the currency of the country with well developed financial markets to use for the purposes for intervention (Eichengreen, 1998). In case of euro, the presence of independent central bank helps in maintaining the value of euro against the political pressures which are usually in favour of depreciating the value of a currency in order to accelerate external trade. The fourth factor is network externalities. A currency status as reserve currency depends upon the extent of its usage. If a currency is used more, the transaction cost of the currency would be less and it would be more liquid. All these factors make the currency feasible for new users, thus the possibility of the currency to be held as reserve currency increases even further. In case of euro, the currency is widely used therefore it is highly feasible for new users. Therefore the currency is highly favourable for being a preferred reserve currency (Rey, 2001). Thus, keeping the above argument in view, it can be inferred that the euro has the potential of replacing US$ as the highest held reserve currency in the world. However, according to some economists, this process can be slow and it might take so many years depending on the global economic activity. The growth in the reserve ratio of the euro as against US$ is the evidence of the increasing favourableness of the euro. Apart from that, the four factors that are needed for a currency to be suitable for being reserve currency are also present in euro therefore it can be concluded that the euro has had a significant impact of the US$ in terms of its reserve currency status. 3. Impact on International Trade According to Rose (2000), the impact of the usage of a common currency on trade is highly significant. The paper suggested that the accumulated effect of a common currency on trade would be that the trade would rise by 235%. However, later papers by economists denied such estimates and provided some realistic estimates that were the rise in trade by 10% (Baldwin and Taglioni, 2006). Although there is significant difference in both the estimates but one thing that is common is the increase in trade. Thus, it can be inferred that use of a common currency among different countries can boost international trade by a significant degree. The same argument can be applied on the euro phenomenon. The euro is used by all the countries in the eurozone, thus it is a common currency of a number of countries and apart from eurozone euro is used in so many other international markets as well (Robert, 2003). Therefore euro has significantly helped in improving international trade in that region (Allington, 2005). There are a number of reasons why a common currency like euro would boost international trade. One of the reasons is the convenience in export because a common currency decreases the costs of shipments and the firms derive more profits (Richard, 2005). This decrease in the cost of shipments would induce more local firms to initiate international trade and thus the international trade would increase due to the use of common currency (Robert et al, 2003). Thus, euro has made it more convenient for the countries in eurozone to conduct international trade and it has also created opportunities for these countries to conduct trade with other countries that use euro for trade purposes. 4. Impact on Investment Statistics suggest that the overall increase in the Foreign Direct Investment in the eurozone has increased by 5% after the introduction of the euro. The euro has made it easier for entities to access financial markets in Europe therefore the investment in the territories using euro has become relatively easier. Statistics suggest that the investment done within the eurozone member countries increased by 20% during the initial four years after the introduction of euro. Multinational entities have also increased their investment in the eurozone due to the increase in the investment rates. The euro has also had an impact upon the accessibility of the financial markets in eurozone for corporations outside eurozone; therefore it has become easier for corporations to make investments in the eurozone. The most significant impact that euro has had is on the investment in companies that are cantered in countries that had weaker currencies former to the euro. Introduction of euro has helped such companies attract international investment. However, the companies that are cantered in countries that had well established currencies before euro have not been affected significantly by the introduction of euro. 5. Impact on Interest Rates Studies suggest that the introduction of euro lowered the interest rates in the member countries and it created an environment of long term credit. This is also said to be one of the primary benefits for the countries that adopted euro to be their currency. The decline in interest rates increased the market value of the entities operating in the member countries. It has been observed that the interest rates declined significantly in the countries that had weaker currencies former to the euro as compared to those countries who had well established currencies. This effect is the same as that of investment. The decrease in interest rates also increased the lending activity and it resulted in the growth of local housing. The ultimate effect of this growth was the increase in demand causing increase in the inflationary pressures (Lane, 2006). Although the initial impact of the euro on the interest rates in eurozone was positive, the recent economic conditions have affected the eurozone as well. According to a report issued by European Central Bank (ECB), the increase in oil prices would affect the GDP of eurozone. Rise is oil prices would lower the GDP of eurozone, thus the more the increase in oil prices, the lower the GDP of eurozone. Therefore it can be inferred that the impact of euro has been positive on all the economic phenomena but it is not isolated from the global economic factors. Therefore change in any global economic factors can have a significant impact over the economic development of eurozone and it can also hamper the impact of euro on the interest rates in the eurozone. 6. Impact on Inflation According to Brachinger (2006), the actual impact of the euro on inflation in the eurozone was negligible but the consumers, especially in Germany, perceived it to be high. This perception of the consumers proved to be detrimental for the economy and it defeated the purpose of the euro to an extent. The difference between the actual and perceived inflation is highly important in a number of respects (Del Gionavvne & Sabbatini, 2005). Before the introduction of euro, the actual inflation and the inflation perceived by the consumers coincided closely but just after the bank notes and coins of euro were introduced, consumers started perceiving that the introduction of euro has caused a significant hike in the prices. This perception was developed due to the rise in prices of only a few but important things including food. Since all the consumers buy food products on a regular basis, the increase in the prices of food products led them to believe that the euro has caused a hike in prices of all the products, however the truth was the opposite. In order to analyze the situation, certain surveys were conducted. It was inferred that there was a slight hike in the prices of some products and the prices of other products fell cancelling each other’s effect. Thus, the net effect of the introduction of euro on the inflation was negligible. The difference between the actual inflation and perceived inflation was different in the member countries. In Finland and Belgium, the perception gap was low; however in Italy and Greece it was significantly high. This perception gap was at its highest in the year 2003 and it started to decline afterwards. In Germany, the perceived inflation and actual inflation coincided again in the year 2005. Therefore, it can be inferred that the overall impact of euro on the inflation in eurozone was not significant, however the perceived inflation created the inflationary pressure. Since eurozone is not isolated from the global economic scenario, therefore it is also affected by the rise in global inflation triggered by the rise in oil prices. 7. Impact on Monetary Policies Before the introduction of euro, each member country of the eurozone had its own fiscal and monetary policies in accordance with the economic conditions of the country. There were differences in the policies of these countries. However, the introduction of euro brought a significant change in the monetary arrangement of all the member countries in the European Union. The creation of a single common currency for twelve out of fifteen members of the European Union was not an insignificant decision; therefore it affected the monetary policies of all the countries in the European Union. After the introduction of the euro, the authority of determination of the monetary policy for the member countries of eurozone was passed onto the European Central Bank (ECB). The European Central Bank is the authoritative figure that determines a common interest rate for all the member countries in the eurozone. The main policy of the bank is to keep the inflation from growing by a significant degree. The ECB seeks to keep the Harmonized Index of Consumer Prices of below 2%. European Central Bank has set up a convergence criteria in order to maintain its monetary policy. The convergence criteria that must be met by the countries wishing to join the eurozone are; the prices must be stable, that is, the inflation rate must not be higher than the average inflation of the three member countries with lowest inflation; the exchange rate of the currency must be stable as against other currencies in the European Union; the government must not have a debt exceeding 60% of its GDP and the annual deficit must not exceed 3% of GDP; and the interest rates must be comparatively lower. Thus, it can be said that the introduction of euro had a positive impact on the monetary policies of the member countries of eurozone. With a common monetary policy, there are equal opportunities for economic growth in these countries along with the attempts to keep the inflation rate at minimum. 8. Conclusion Introduction of a common currency in the European Union has been one of the biggest economic experiments. The introduction of euro has had impacts on almost all the economic aspects of the member countries of the eurozone since its launch. Apart from the member countries, euro has had significant impacts on global economy as well. Before the introduction of the euro, US$ had significant share as the global reserve currency, but after the launch of the euro, it significantly lost that share to the euro which became the second most held reserve currency in the world. The euro also had an impact on the international trade. The use of a common currency made it easier for the firms within the eurozone to conduct trade among themselves. In this manner, euro accelerated the trade activity within the eurozone. This was because of the reduction in the transaction costs because of the use of common currency. The cost of shipments also declined and the firms began to export goods to other countries. The introduction of euro also had an impact upon the Foreign Direct Investment in the eurozone. The overall investment increased by a commendable degree. The companies in the countries that had weaker currencies before the launch of euro benefited the most from this scenario and most of the investment was directed towards such companies. The euro also affected the interest rates in the eurozone. The transfer of authority to determine the monetary policy of all the member countries of the eurozone helped the countries have lower interest rates. This scenario spurred the economic activity in the member countries along with keeping inflation at bay. However economic scenario of eurozone is being affected by the global economic factors such as increasing oil prices. The introduction of euro did not have any significant impact on the inflation in the member countries in the eurozone however the gap between the perceived inflation and actual inflation widened. The actual inflation was calculated to be far less than that perceived by the consumers. The perception spurred due to the hike in prices of some goods which were set off by other goods. Therefore the net effect remained negligible but the consumers considered the hike in prices of some goods as the hike in the rate of inflation. Ultimately, the introduction of euro made it possible for the member countries of the eurozone to have a unified authority to determine the monetary policy. Therefore the monetary policy is decided by European Central Bank. The goal of the institute is to keep the inflation rate low without hampering the economic growth. References Allington, Kattuman, Waldmann. (2005) ‘One Market, One Money, One Price?’ International Journal of Central Banking, December 2005, pp 73-115. Baldwin, R. and Taglioni, D. (2004) ‘Positive oca criteria: Microfoundations for the Rose effect’, COE/RES Discussion Paper Series No. 34. Brachinger, H. 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