by Sara Eisen
Figure 3-4 10-Year Bond Spreads Compared to German Bonds
Source: Reuters EcoWin
EMU Reform
The eurozone is currently under particular strain because the global debt crisis and the financial difficulties of some member states have revealed the weaknesses of the EMU.
All of the weaknesses that were exposed during the debt crisis led to a loss of market confidence in the entire eurozone. In order to regain this confidence, the European governments have to address these deficiencies. The Heads of State and Government of the eurozone and their finance ministers have already taken crucial decisions in this regard that will lead to a comprehensive reform of the current rules and architecture of the EMU:
1. Strengthening budgetary surveillance. One of the most important decisions has been to strengthen the supranational surveillance mechanism for national budgetary policies within the framework of the Stability and Growth Pact (SGP), an agreement adopted in 1997 to enforce budget discipline among nations that use the euro.
• As often discussed by experts, this was achieved “to take better account of the debt criterion” of the pact (Le Cacheux and Touya, 2007). Debt reduction will be mandatory for every member country of the eurozone. Up until now, it was possible to initiate an “excessive deficit procedure” against a eurozone country only if its government deficit was too great, that is, more than 3 percent of GDP. In the future, the European Commission will also be able to launch the procedure:
–If a balanced or almost balanced budget is not achieved in the medium term.
–If a country’s total debt is too large. In the future, member states with a debt-to-GDP ratio of more than 60 percent will be required to reduce the amount of excess by one-twentieth a year until their debt amounts to only 60 percent of GDP.
• Sanctions will become effective earlier. With the new obligation to have a balanced or nearly balanced budget in the medium term, sanctions will be part of the “preventive arm” of the SGP, that is, they will apply even if the general government deficit is not more than 3 percent of GDP. If the necessary corrective fiscal policy measures are not applied adequately, a country will have to make an interest-bearing deposit amounting to 0.2 percent of GDP, which could, in further steps, be transformed into a non-interest-bearing deposit and eventually into a monetary penalty. Sanctions as part of the “corrective arm” of the SGP will now take effect more quickly as well, that is, when the government deficit is already larger than 3 percent of GDP and/or when overall debt is not being reduced adequately.
• Sanctions will be increasingly automatic. In the past, it was too easy to block sanctions, and the European Commission was unable to defend the SGP against the national interests of the member states (Heipertz and Verdun, 2010). This deficit has been adjusted significantly. In the future, sanctions will automatically apply unless a large majority in the council halts the process (by means of a “reverse majority”).
• Sanctions will become more comprehensive. In the medium term, it will be possible not only to impose fiscal and monetary penalties, but to deny EU resources to a member state on a greater scale than has currently been the case. Payments from certain EU funds are to be tied to sustainable fiscal policies.
2. Strengthening macroeconomic coordination and surveillance. European governments have reacted to experts’ warning that “the current institutional framework [of the EMU] for cooperation is not enough to avoid the accumulation of imbalances” within the eurozone (Ortiz Martínez, 2009). With the newly agreed-upon Euro Plus Pact, European governments are showing that from now on, they are resolved to coordinate their economic policies and to concentrate on improving the competitiveness of their countries and of Europe as a whole. From this point onward, the countries participating in the pact will agree each year on common objectives, which will then entail concrete national commitments. While the pact is first and foremost meant to foster the competitiveness of all member states and to address macroeconomic imbalances; it is meant to strengthen the long-term sustainability of public finances by, among other things, anchoring a debt brake in national laws or constitutions, adapting the pension systems to national demographics, and placing a limit on early retirement schemes. With the introduction of a new procedure for macroeconomic surveillance, an alert mechanism will monitor the measures under the Euro Plus Pact in order to detect, prevent, and, if necessary, correct excessive macroeconomic imbalances. Both budgetary and macroeconomic surveillance will, in the future, be coordinated and intensified within a European planning and reporting cycle called the European semester.
3. Strengthening the surveillance and regulation of financial markets. As “[t]here is an emerging consensus on the need to strengthen cooperation between the supervisory authorities responsible for major cross-border institutions and to promote a more convergent and consistent application of regulations” (Papademos, 2009), European governments have established a new European system of financial supervision, the European Financial Stability Facility (EFSF), to make the financial sector sounder and more resilient. The newly created European Systemic Risk Board (ESRB) will monitor the stability of the financial system as a whole, warn about impending systemic risks, and issue recommendations on how to eliminate those risks. Three new European supervisory authorities in the fields of banking, insurance, and securities will work together with national supervisory authorities in the surveillance of institutions and markets. Various measures have been put in place to strengthen financial institutions, of which the Basel III international bank capital rules are of particular importance because they force financial institutions to maintain more and higher-quality capital buffers. Member states are also called upon to introduce instruments and procedures for restructuring failing banks, the collapse of which would pose a systemic risk to the banking sector. Recapitalization should preferably take place via the private sector, with supplementary capital being provided by governments if necessary.
4. Establishing an institutional emergency and crisis management mechanism. All of these measures will make it quite unlikely that the euro countries will face financial problems in the future that are on a par with those seen in recent years. However, if, despite all of these precautionary measures, another sovereign debt crisis does occur in the EU, a robust institutional crisis management mechanism will be in place thanks to the establishment of the European Stability Mechanism (ESM), which will replace the existing temporary EFSF in July 2013. This new institution will be well equipped to assist countries whose illiquidity threatens the stability of the eurozone as a whole. The ESM’s toolbox will consist of loans (provided on condition of strict economic reform and adjustment programs), the right to intervene in primary and secondary markets, the ability to recapitalize financial institutions of systemic importance, and precautionary programs. It will also have clear rules and mechanisms for worst-case scenarios, namely, a euro country’s insolvency.
Most experts argue, “[t]he Greek crisis demonstrates the inadequate macroeconomic crisis management framework in the EU and the need to establish a more orderly sovereign debt restructuring process” (Kern, 2011). This is exactly what European governments have taken care of with the construction of the new stability mechanism. The ESM will allow for orderly restructuring in the event of insolvency by regulating when debt restructuring becomes necessary and by choosing which procedure is needed. Standardized debt restructuring clauses (collective action clauses, introduced in all new sovereign bond contracts of the eurozone issued for a period of more than one year) will assist in fostering an early dialogue between the debtor and the bondholders, as well as prevent individual creditors from blocking negotiations on specific debt restructuring models.
The eurozone is facing serious problems. Achieving reform in Greece, Ireland, and Portugal, while at the same time preventing contagion from spreading to other eurozone countries, is a challenge of tremendous proportions. However, there is no reason to have doubts of its success because European governments
have agreed on a comprehensive set of measures to address the institutional shortcomings of the eurozone’s past. If they are successful in implementing these measures effectively, the euro and the eurozone will have a bright future—a future within a multipolar currency system.
The Future: A Stable Multipolar Currency System
The financial crisis has placed a massive burden on our economies, and several countries continue to face huge challenges in terms of putting their houses back in order. It has now become clear that past growth dynamics in the world economy and its regional subsystems, including the euro area and the EU, were not always based on sound economic fundamentals. Especially in the run-up to the financial crisis, the growth dynamics in advanced countries were distorted by unsound leverage in private- and public-sector balance sheets. At the global level, uneven macroeconomic policies and exchange-rate regimes led to the buildup of significant macroeconomic imbalances. The persistence of these imbalances, giving rise to instabilities in the global financial system, has been one of the motivations for the G-20 to place the reform of the international monetary system at the top of the international agenda. Europe has actively supported this policy focus and has an ongoing, strategic interest in being part of the process of shaping a new international monetary and financial order.
The international monetary system is currently still largely focused on the U.S. dollar as the dominant international reserve currency. While the sustainability of the “twin deficits” in the United States and exchange-rate policy in key emerging markets have been the subject of debate for a long time, adjustment so far has been slow. Despite some hope of renewed resilience in growth and adjustment, the risks of crises are still looming. Along with the substantial increase in international capital flows over the last 20 years, balance of payments crises have grown significantly, too. Although the focus is currently on Europe, and on the peripherals in the eurozone in particular, the sovereign debt crisis has also reached the United States. Eichengreen (2005) has argued that the dominance of the U.S. dollar as an international reserve currency is not insulated from the risk of a sharp reversal, especially if the U.S. current account deficit and fiscal position are not brought to more sustainable levels. For a long time, a key issue has therefore been how the international monetary system can be reformed to avoid the rise of global imbalances and make the system more stable and resilient.
First, we should evaluate whether the euro can close ranks further with the U.S. dollar as an international reserve currency. To answer this question, it is useful to start by examining some of the fundamental preconditions for a currency to secure the status of an international reserve currency.
Preconditions for Reserve Currency Status
According to Lim (2006), there are five factors that facilitate international currency status: large economic size, the existence of a well-developed financial system, confidence in the currency’s value, political stability, and network externalities. Additional features of the current international monetary system and requirements for currencies to assume reserve status are large-scale current and financial account convertibility, a high degree of capital mobility, surveillance of economic policies, and cooperation on monetary policy making at regional or multilateral levels (Bénassy-Quéré and Pisani-Ferry, 2011).
To date, the U.S. dollar has dominated the international scene on account of its fulfilling almost all of these criteria. Yet, when viewed historically, the U.S. dollar’s assumption of its current dominant reserve currency status was the outcome of a gradual process of overtaking the pound sterling between the two World Wars. Despite the difference in terms of economic, political, and military power, the reserve status of the pound sterling had succeeded in outpacing that of the dollar for many years beforehand, with the primary reason being network externalities, particularly large demand-side and supply-side economies of scale. This is explained by the fact that with larger and more frequent use of the pound sterling worldwide, transaction costs decreased, and the individual utility of trade in terms of this currency increased. Inherent network externalities produced a situation of inertia, which helped the pound sterling to remain in its dominant position longer than the fundamentals would have indicated. Once the U.S. dollar assumed reserve currency status, it built network externalities of its own.
The hegemonic dominance of the U.S. dollar in the international monetary system has remained mostly undisputed in the years since the abolition of the Bretton Woods system. The unparalleled stable and liquid market in the United States means that the U.S. dollar has remained the currency of choice. Based on the historical experience of the relationship between the pound sterling and the U.S. dollar, however, the dominant role of the dollar as the key international reserve will not necessarily remain unchallenged. Future shifts between evolving new reserve currencies and the U.S. dollar are possible. Eichengreen and Flandreau (2009) showed that despite network externalities and the inertia of a dominant currency (the pound sterling), the U.S. dollar was able to become the world’s leading currency in just one decade.
The main challenge facing the euro, the yuan, and other emerging-market currencies in becoming international reserve currencies is developing deeper domestic financial markets through which positive network externalities and a wider use of reserves in private-sector transactions can arise. In the current G-20 process, work is being undertaken on the deepening of local currency bond markets and the improved management of volatile global capital flows. Especially for those emerging-market economies that wish to enhance the absorption of capital flows, the focus will, therefore, have to be placed on ensuring the robustness of their domestic financial institutional setting (Prasad, 2011).
Current Trends in the Reserve Status of the Euro and the U.S. Dollar
The transition to a multipolar currency system is already well on its way. The euro has made its mark on the international financial system. While the euro has gained only slightly in terms of banks’ international assets (see Figure 3-5), the share of euro-denominated international bonds outstanding has risen from 25 percent in 1993 to more than 45 percent in 2011.
Figure 3-5 Banks’ Foreign Currency Assets and Outstanding International Bonds and Notes
Source: Bank for International Settlements
U.S. monetary policy can still have a potentially large impact on foreign private and official market participants’ investment choices, thus influencing global wealth and liquidity (IMF, 2011a). The ongoing importance of the United States as a global financial investment destination can be seen when comparing U.S. dollar asset holdings. While foreign banks hold some US$5,400 billion of assets in the United States, U.S. banks hold only assets worth US$2,500 billion abroad, which is the largest net investment position difference in the world, according to IMF spillover analysis (IMF, 2011b). This means that the U.S. dollar retains a strong position in international finance.
Can the U.S. Dollar Be Challenged?
Some economists argue that despite the existence of an international financial market that has grown enormously and decreased transaction costs, positive network externalities are still working to the benefit of the dominant currency today (Meissner and Oomes, 2008). Some take the argument further, stating that the optimum would be to have just one international main reserve currency (McKinnon, 2005). It is, however, far from clear whether any multipolar currency system will finally converge toward unipolarity. Eichengreen and Flandreau (2009) argue that several currencies were already in use to varying extents as international reserve currencies before World War I (namely, the pound sterling, the French franc, and the German mark) as well as between the wars (the pound sterling and the U.S. dollar). Furthermore, today’s global market is sufficiently liquid and transaction costs are low, which means that multiple currencies can reach the scale necessary for network externalities to have an effect. As Mateos y Lago and colleagues (2010) outline, alternative currencies—fully substitutable for the U.S. dollar—could “overcome the network extern
alities that strongly push all actors to converge to a dominant currency.”
Is There a Role for the Special Drawing Right?
The Special Drawing Right (SDR) was created in 1969 by the International Monetary Fund to support the Bretton Woods fixed-exchange-rate system as a supplementary reserve asset (IMF, 2012). Its role since then has, however, been limited. Yet the debate among academic economists continues to focus on the question of whether the SDR could become a true international reserve asset and a possible substitute for the U.S. dollar or gold to support the expansion of world trade and financial development. Most recently, the question of the future role of the SDR has been taken up by the G-20 in the context of work on the reform of the international monetary system in the run-up to G-20 summits. While strengthening the SDR is a long-term process, progress has been made in exploring a criteria-based path under which the SDR basket of currencies at the IMF could be broadened, in particular with regard to the possible inclusion of the yuan. Technical as this may seem, it may prove to be another step toward a multipolar currency system. The G-20 working group on reforming the international monetary system has emphasized that this process would contribute to the internationalization of currencies as a market-driven process, and that the process would also imply countries increasing their degree of exchange-rate flexibility and relying less on capital control measures, moving toward a more liberalized flow of capital into and out of countries.
