European single currency - Essay Example

The Euro: European Single Currency The idea of a European common currency had been in the drawing board since 1993, but the Euro as EU's common currency went into circulation in 1999 and was considered as a major step towards European integration. The ratification of the Maastricht treaty in November of 1993 was responsible for the creation of the European Monetary Union or EMU and adopted the Euro as their common currency (European commission, n.d.). When the Euro was introduced into EMU on January 1, 1999, it became the new official currency of the 15 member countries thereby replacing their old national currencies like Deutschmark of Germany and Franc of France. The Euro was introduced first as a virtual currency for payments not requiring hard cash and for purposes of accounting. The old national currencies of member countries were used for cash payments and is considered as sub-units of euro. The European commission revealed that the real euro currency in bank notes and coins appeared in January 2002. The European commission reported that the primary responsibility of the EMU is to ensure the price stability of goods and services in all the member countries by maintaining an annual inflation rate of less than 2%. The European commission added that although Denmark and United Kingdom are members of the European Union, Euro is not their currency as they agreed on the 'opt-out' clause of the Maastricht treaty thereby exempting them from participation. The European commission further added that many of the newest members like Sweden has to satisfy yet the conditions set by the treaty on Euro adoption as the single currency. The European commission revealed that the conditions set among other things, involve maintaining budget deficit of less than 3% of their GDP, a debt ratio of less than 6% of GDP, inflation of less than 2% and interest rates comparable to EU average. To date, about 320 million citizens of EU use Euro as their business transaction currency and reportedly enjoy the benefits. Experts forecasted that the benefits will be more widely distributed as other EU member countries adopt Euro as their currency. The EU member states is a part of Economic and Monetary 2 Union or EMU and is considered as an stage geared to economic integration based on a single market. The European commission reported that the economic as well as monetary integration of the EU simulates the history of the Union. In 1957, when the EU was founded, they concentrated on establishing a common market. In the course of time, it was felt that closer cooperation related to economic and monetary matters were needed for the common market to progress and flourish further. The European commission revealed that when the euro was adapted as the single currency of the EU, the monetary policy is being managed by the European Central Bank (ECB) which was established for that sole purpose, and the corresponding central banks of the member countries. Together, they formed the Eurosystem Fiscal Policy on tax and spending and remain as responsibility of individual member countries. They adhere to follow the agreed procedures on public finances accounting known as Stability and Growth Pack. The member countries also retain their responsibility for creating their own structural policies related to labour, capital markets as well as pensions. They however agree to coordinate them with ECB to ensure higher chances of achieving goals related to stability, employment and growth. Having adopted a single European currency has many benefits and these were the motivations for the creation of the Euro. An Economics teacher form Oxford University named Tejvan R.Pettinger (2008) enumerated the benefits that can be derived from having only one European currency system. They are as follows: Reduced transaction Costs 1. There will be no more cost involved in currency exchanges; this will benefit tourists and firms trading in the Euro area (Eudey 1998, 14). According to the author, this benefit amounts to 1% of GDP. Salvatore in 2002 reported that this 1% of GDP is equivalent to almost $30 billion a year (The Euro, the European, pp. 154). Accumulated savings were so gigantic due to the transaction costs reduction related to currency exchange by firms doing import and export to or from different country members. 3 1. Price Transparency With only one common currency, it will be much easier to compare prices among countries. This benefit is usually maximized among firms sourcing for raw materials to produce cheaper priced goods. A good example of this is the price of new cars which is much higher in UK than EU Euro trading countries. UK is still using its own pound sterling as currency. This a proof that a single currency market can result to considerable price differences. 2. Eliminating Exchange Rate Uncertainty Volatility of exchange rate due to different currencies can destroy profitability of exports. This discourage investments as it undermines confidence in business. With a single currency, business confidence will be more focused and this will result to higher trade and growth of economy. Coupled with elimination of the need for currency exchanges, the problems which are normally associated with volatility of exchange rate between member nations were also eliminated. The only left uncertainty problem will be the fluctuations between the euro, the dollar, yen, and other important national currencies outside the European Monetary Union . Exchange rate fluctuations were considered as another form of transaction cost because they can transform trading among companies from different countries more risky. If a manufacturing company in one country and a firm that exports in another make a deal for the products of the manufacturer, the exchange rate volatility can pose a risk problem in the trade. Experience will tell us that, if one currency falls in value compared to the other, then the manufacturer could get far less for his product than he should have, or the importer may incur a much higher cost than was originally agreed upon .The elimination of this risk will help greatly the international trade, thereby, offering more business investment opportunities like inward investments to all EMU countries. 4. Inflation can be effectively checked 4 The ECB is setting the inflation rate target among member countries to be lesser than 2% and should be maintained at all times. Countries with traditionally high rates of inflation will be benefited as its rate will be neutralized by other country members with traditionally low inflation rates. 3. Euro could emerge as a global trading currency The globalresearch.ca revealed that as early as 2003, "Russia, the world's second largest oil exporter, is giving serious consideration to trading its black gold in euros, a switch that would surely set dominos in motion () and, ultimately, knock the dollar off its global throne". This situation is not far from happening nowadays specially with the appreciation of Euro and the continues depreciation of the American dollar and considering that more than half of Russia's trade in oil is with Europe. 4. Inward investment increase Investment form countries outside the Euro zone may increase due to lower transaction cost in the EU area. Very recently, according to the author, Nissan warned UK that it will lose its inward investment should it prefer to be out of Euro. The website coprovasevropauzudelala.cz (2007) reported that in their analysis of a single market currency, business will be encouraged to effectively carry sound investment decisions mainly due to reduced uncertainties. The website added that hedging operations which are designed to protect companies from volatility of exchange rate can be eliminated. It is a common knowledge that in finance, hedging is taking out of an investment to reduce or eliminate the risk in another investment. It is a strategy aimed at minimizing the risk of exposure to an unwanted business risk while still allowing some room for the business to profit from the investment activity. (Brookes et.al, 2001, 3). The coprovasevropauzudelala.cz. (2007) further said that the practice of cross- border payments in foreign currency which slows the business transaction process will likewise be nullified. Furthermore, the web site revealed that management of several currency 5 accounts which make internal accounting more complicated will be eased. 5. Single financial market: benefits for savers and borrowers A single currency market opens up huge opportunities and attractive climate for both capital providers such as savers and investors and capital users in the likes of private and corporate borrowers and equity capital issuers to engage in profitable transactions. Likewise, the euro provide a single uncomplicated market for financial operators like banks, investment and pension funds and insurance companies to actively participate in the business process. In addition, the website said that the existing small and fragmented capital markets in respective countries evolve into a deeper, larger and more liquid and stable financial markets. On the part of the savers, the benefit is from a wider choice of investment offers and saving opportunities while the investors can have more elbow room to spread the risks and improve confidence for riskier more profitable ventures. The borrowers both corporate and private as well as equity users benefit from enhanced funding opportunities as money is readily available in a favorable and healthy capital markets. 6. Macroeconomic framework: benefits of a single currency to the economy as a whole The website coprovasevropauzudelala.cz. (2007) reiterated that the EMU is fundamentally based on a sound and healthy macroeconomic structure with favorable price stability condition and sound public finances as checked by European System of Central Banks (ESCB) to avoid member countries from acquiring excessive deficits and debts in relation to their GDP as set by ECB. Low interest rates is also a character of sound macroeconomic climate. The Euro zone is encouraged to operate in less than 2% inflation condition thereby controlling government debt and increase the size of securities market for euro and promoting liquidity. Price stability, sound financial management by the government, low interest rates and creation of employment are the ideal conditions for increased business activities and these conditions should be found in Euro zones. 6 The website further added that a good market economy like in the Eurozone can provide protection form external shocks. Due to the size of the Euro area and the fact of localization of its trade within the zone, the Euro area is now better equipped to withstand external economic shocks like exchange rate fluctuations vs. American dollar and other major currencies compared to the case under their national currencies. This stability made it possible for a number of transactions to be euro-invoiced. The decision of the Euro zone countries to adopt Euro as their single currency in place of their old national currencies although provided a number of advantages is not also devoid of problems as proven by experiences of the ECB since 1999. For a more sensible analysis, let's take first the existing facts at present in the Euro zone. The website economicshelp.org (2008) reiterates that Euro is the single currency of the Eurozone area, a common monetary policy is in placed and a common interest rate is set by the ECB applicable to whole Eurozone area. In addition, the website reminds that the Growth and Stability Pact which was agreed among country members set a cap on government borrowings, debt and related fiscal policy. The website also revealed that in reality, as of the third quarter of 2008, several member countries violated the cap on government borrowings. This was the root of the problem Eurozone is now facing. First, according to the website, the Eurozone has a common monetary policy and this involved setting a common rate of interest for the whole zone. The interest rates set by ECB by experience is not appropriate for regions which were growing more rapidly or much slower than the Eurozone average. As an example, if the French economy suffers recession, it would opt to lower interest rates to stimulate demand. In reality however, France cannot lower its interest rate because it no longer has the flexibility to do so as the interest rate was set by the ECB applicable to all member countries. As a result, France will be stuck in recession as their only alternative of cutting rates is not allowed. Recession is viral due to the fact that trading is exclusively done within the Eurozone area only, at the end of the day, the economies of member countries heavily trading with France will also suffer recession. 7 The second problem with Euro is that the Eurozone is not an optimal currency area unlike in the case of US. The website added that it is a common practice in US among its citizen to transfer from one state to another if the employment attractiveness in his place is declining. If NewYork is in recession, people can easily move to neighboring New England and be employed there. In the case of Eurozone, they cannot just do as what can be done in US as the member countries have their own language and culture which is a barrier for cross country development and employment. An Assistant Professor in economics from Romania, Giobanu, G (2008), said that the Organization for Economic Cooperation and Development and the European Union that labour mobility or "escape hatch" (p.7) in Eurozone countries is two to three times lower than the US. The website also consider the limitation in fiscal policy as another problem. With a common monetary policy being implemented in the Eurozone, it is of prime importance to have more or less the same level of national debt in relation to GDP. This is so because a country with large debt to GDP ratio will find hard time finding a buyer of its national debt. At present, this is big problem of Mediterranean Eurozone like Italy, Greece and Spain. At present Italy's national debt-GDP ratio is 1 meaning the national debt of Italy is over that of its GDP. The advantage of offering insulation against external shock in the Eurozone is also a disadvantage. In as much as the insulation is there, there is lesser incentive or reason for a country to implement structural changes and assume greater fiscal responsibility. The problem even get more heavier considering the fact that devaluation is not an option among the Eurozone countries. In effect, the website added that the Eurozone is locked into whatever happens with Euro. The currency has been appreciating sharply over the other major currencies in recent months. The Eurozone countries must be happy with the development due to the fact that their currency is becoming stronger and that means stability within Eurozone. The other side of the coin reveals that appreciation of the Euro result to making their products more expensive. To illustrate this point, a wine from Italy will be more expensive than a US wine because one will spend more dollars to match its price in 8 Euro. This hurt mostly those Eurozone countries involved in exporting and tourism. The main problem is under the Eurozone policy, devaluation is not an option for individual countries. The website revealed that under normal situation, if the currency of a country is appreciating, the economic intervention should be devaluation to make the export products cheaper. It is now an accepted fact that the Euro has been appreciating over the other major currencies. The Yahoo Forex Education Center reported that "the euro to dollar exchange rate is the price at which the world demand for US dollars equals the world supply of euros. Regardless of geographical origin, a rise in the world demand for euros leads to an appreciation of the euro". This goes to prove that the continuous appreciation of Euro nowadays is a reflection of investors confidence on the economic stability of the Eurozone market and it will have an effect on the major trade currencies. Effect of Euro Appreciation to the U.S. Dollar The XE universal currency converter (2008) revealed that the current Euro-dollar rate is 1.43 Meaning, 1US dollar is equivalent to 1.43 Euro. It can be recalled that in mid 1990s the euro- dollar rate was 1.40 (euroactive.com 2002) and even went down to about 0.98 in 1999 during the time of the Euro launch as single currency of the Eurozone. It is now a common knowledge that when an economy of a certain country is stable, its currency appreciates. The appreciation of Euro is a mirror effect of the depreciation of the US dollar (Gallati and Ho, 2001). Due to the excellent business investment climate being seen by international investors in Eurozone areas, they prefer investing their capital in the area and setting aside in the meantime investing in US. Dollar. It is a fundamental theory in investment economics that one should put his investment in areas with less risk and that is the Eurozone. The mad scramble for available Euro elevate the demand for the currency. Injecting the economic law of supply and demand, this lead to appreciation of the Euro. On the other hand, the demand for sluggish dollar as currency for investment and international trade became low because the 9 attention was focused on the bullish Euro. The over-all effect of the euro appreciation over the U.S. dollar will be felt by consumers in the U.S. The on line version of the Boston news in March 2008 reported that European Union businesses were feeling the pain of the Euro appreciation over the dollar as it makes the euro zone exports more expensive for buyers in America. According to Boston News Online, "The rising euro makes German cars and French Champagne () increasingly expensive for the EU's major trading partner, the United States. If the euro remains strong () it also could discourage American tourism in Europe" (U business 4th par). About tourism, Carr (2008), a reporter writing for About.com said that a year ago, a week hotel accommodation in Paris costs US1,862.00, today it cost US$2,185. According to her, an automatic loss of $233.00 is down the drain and that means less money on trinkets, passes for museums, fashionable clothes and a nice dinner too. The reporter further said that if the trend continues, it will mean less American tourists will visit France and other European countries including the Vatican. The accent of the Euro over the US dollar was forecasted in 1997, two years before the launch of the Eurozone single currency. The forecast was made by C. Fred Bergsten, the Director of the Institute for International Economics (foreignaffairs.org 1997). According to the Director, the introduction of the Euro as the official single currency of the European Common Market (now a single market known as Eurozone) will mean the birth of the first real competitor of the American dollar since the time it overtook the British pound sterling as the international currency. The director forecasted that about $1 trillion of international investment can be taken out from the US dollar by Euro. Europe could try exporting its unemployment by initially undervaluing the Euro as what really happened. It can be recalled that the value of Euro in 1999 was 0.98 to a dollar and then gradually appreciate to 1.40 in 2002 (euroactive.com 2002). Protectionist battle could break out according to the director. That is really what is happening now. The Director further said that the Euro will not cause instability in the world market but it will contribute to volatility. This is the reason for the 10 depreciation of the US dollar and volatility in the US domestic market. The director further said that the global roles of the EU and the US are nearly identical. The EU accounts for 31% of world output and 20% of the world trade. The US provide about 27% of global output and 18% of global trade. The US accounts for 40 to 60% of world finance while the European currencies combined a share of 10 to 40%. The forecast of the Director further revealed that even the initial EMU members of nearly half a dozen, they would constitute an economy about two thirds the size of US and almost equal that of Japan. Combining the EMU and Japan will topple down the US. According to the Director way back in 1997, "The dollar will probably remain the leading currency indefinitely. But the creation of the euro will narrow, and perhaps eventually close, the present monetary gap between the United States and Europe". The dollar and the Euro will likely account for each of them about 40% of global finance and the remaining 20% will be shared by Yen, Swiss franc and other minor currencies. Based from the collected information, the over-all effect of Euro appreciation over that of US dollar will be unfavorable trade balance in favor of the Eurozone. The reason for this is the fact that commodities coming from Eurozone countries going to the US will be priced higher than before making it less attractive to American consumers. On the other hand imports of Eurozone coming from the US will increase due to the fact that it will be much cheaper now than before. This is because of the appreciation of the Euro over the American dollar. On the export-import scene between US and Eurozone, the latter will be less competitive due to the fact that the price of their products will be much higher than what the consumer outside the Eurozone can afford. Due to uncompetitive ness, a slow down in production may be decided by the European Central Bank in the near future and an intervention of Euro appreciation maybe needed to prevent over heating of the economy. If the appreciation of the Euro over that of other currencies will not be abated, economic 11 implosion may result and this will be fuelled by internal unemployment. This scenario may be prevented if the Eurozone is just trading raw materials among themselves. If they import most of their raw materials, due to Euro appreciation, it will be more expensive and this will lead to slow down in production which will lead to unemployment and higher inflation. The effect of Euro Appreciation on British Pound Sterling The XE universal currency converter (2008) revealed that the current Euro-Pound exchange rate is 0.791 meaning 1 Euro is equivalent to 0.791 British Pounds. This may look promising at first glance but according to Pettinger (2008), the British pound is progressively losing to the Euro since 1999 when the latter was introduced. The reason for this is that the UK growth is slowing down. The IMF due to sliding economy of UK has slashed its growth forecast and there is a possibility of a recession by the end of 2008. The strength of the Euro over the pound sterling made the latter the choice currency for investment in the Eurozone region over the pound sterling. A wise investor will not choose a weak currency as pound sterling as it is in the path of sliding down. This contributed a lot to acceleration of the decline of the sterling value vs. the Euro. The housing market in UK is a major determinant of consumer confidence, economic growth and spending. The rate of house price falls have speeded up and it may reached 20%, this will lead to slow down in the coming months and ultimately to lower interest rates. The low interest rate target was approved by the IMF to arrest the progressive decline of the British pound and achieve the new growth target. Currently, the UK is exposed heavily to mortgage lending to finance British housing. A higher percentage of disposable income in UK is tied up with mortgage payment. Reduction 12 in house prices where the capital is invested will naturally result to economic dislocation as what is happening now in UK. The most important reason for the decline of pound sterling is the fact that Euro has now become the choice of investors and bankers nest to the US dollar. The weakening US dollar has now been set aside in favor of the Euro. It is quite obvious that sterling is now relegated to third choice by the investor-bankers. There is abundant supply of British pound and dollars but nobody wants to put their investment risk in them. Instead, the Investors prefer to invest in Euro and so the demand for Euro skyrocketed. The law of supply and demand comes in. The Effect of Euro Appreciation on Gulf Cooperation Council Countries It is a known fact that the GCC countries are the world's source of oil. The GCC countries is composed of Kuwait, UAE, Saudi Arabia, Oman and Qatar. These countries depend exclusively on oil as source of revenue and imports for their prime commodities needs. A reporter of newspaper Middle East, Pamela Ann Smith in June 2008 revealed that while the currencies of the GCC countries have depreciated along with the US dollar, the depreciation is even much higher when compared with Euro, thus making Gulf imports more expensive. Statistics of import by GCC countries provided by The Middle East and Riyadh based investment bank NCB capital revealed that 26% of the total import amount in 2006 came from Eurozone compared to only 10% from the US. Europe is now the Gulf's most preferred supplier. Exports to GCC countries from EU is worth $100 billion a year. The GCC import much of its machinery and equipment requirements as well as expatriate services from Europe. Due to dependency of the GCC economy on import, significant appreciation of Euro against any local currency is doubly worrying. Coupled with the problem is the fact that oil is still being priced in US dollars which is weaker than Euro. In addition to demand for European goods, majority of the oil magnates prefer vacationing in Europe than any other place in the world. This shows that the GCC countries is at he mercy of the Euro for fits 13 existence. Summary and Conclusion We have known that Euro was introduced in January 1999 as the single currency unit of European Common Market or the Eurozone. Membership to the Economic zone require changing the countries' currency with Euro and the debt-GDP ratio should not exceed 6%. The inflation rate across the Eurozone is set at lesser than 2% and country members have the option to make their own macro and micro structural programs to meet the agreed inflation rate across the region. The most outstanding benefit from a single currency market is the reduction of transaction cost being incurred by investors and businessmen if they prefer to invest in the Eurozone. The savings can reached 1% of the zone's GDP or about $30 billion a year. The elimination of exchange rate uncertainties associated with mixed currency investment is completely eliminated. Nine years of operation resulted to almost setting aside the US dollar as the international trade currency. The reason for this is the healthy economic performance of majority of the member countries and neutralized the not so excellent performance of a number of member countries. Due to the economic stability of the Eurozone, together with the sluggish US dollar owing to a recession from home brought about by the unfavorable economic conditions and the housing mortgage crisis in Britain, the Euro became the preferred choice currency for investment and reserve. Further to this, the demand for Euro heightened as most of the investors would like to exchange their currencies for Euro and reinvest in Eurozone where the risk is so manageable. Coupled with demand for Euro, its value appreciated very sharply leaving the dollar and pound sterling behind. Due to the fact that Eurozone is the preffered source of products by the Americas and Middle East countries, the Euro appreciation is now becoming a major problem. Loss of competitiveness by exporters, manufacturers and cross boundary traders set in due to more expensive products they offer as a result of Euro value appreciation. Something need to done to arrest the mercurial appreciation of Euro in time, otherwise, economic implosion may result. 14 Works Cited Bergsten, C. (1997). The dollar and the euro [on line]. August 1997.Foreign Affairs.org. Council on Foreign Relations. Available from: [Accessed 16 September 2008] Boston.com (2008). U businesses: strong euro hurts [on line]. 6 March 2008. Associated Press. Available from : [Accessed 17 September 2008] Brookes, A., Hargreaves, D, Luca, C and White, B. (2001). Can hedging insulate firms from exchange rate risk [on line]. 2001. Reserve Bank of New Zealand. Available from: < http://www.rbnz.govt.nz/research/bulletin/1997_2001/ 2000mar63_1brookeshargreaveslucaswhite.pdf > [Accessed 16 September 2008] Carr, K. (2008). Tracking the Euro vs. Dollar and Budget Tips [on line]. In: The Euro Gains onDollar. 1 April 2008. Available from: < http://gofrance.about.com/cs/travelplanning/a/dollargains.htm > [Accessed 17 September 2008] Ciobanu, G and Ciobanu, A. (2008). 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Yahoo! 7 Pty Limited. Available from: < http://au.biz.yahoo.com/forex- 16 education/dollar-euro.html> [Accessed 18 September 2008) Read More