The euro as an international currency: implications for exchange rate policy

Speech by Lorenzo Bini Smaghi ,Member of the Executive Board of the ECBEuro50 Group meeting50 YEARS AFTER THE TREATY OF ROME: STRENGTHENING THE ECONOMIC LEG OF EMU,2-3 July 2007, Rome, Italy

Eight and a half years after its introduction, the euro is now well established as the second world currency. The European Central Bank (ECB) recently published its sixth annual “Review of the international role of the euro”, which provides a detailed description of the euro’s use in the various segments of the financial market and in international trade.

What is the implication of this development for the conduct of economic policy, especially exchange rate policy, in the euro area? My instinctive answer would be to say: “none”. The fact that the dollar is the major world currency does not seem to affect the conduct of the US monetary, fiscal or exchange rate policies. It certainly affects the transmission channels for external shocks and therefore the analytical models used by the central bank, but not its overall policy objectives. Why should then the euro area be different?

Let me try to answer this question by first examining the institutional set-up supporting the exchange rate policy of the euro.

The Treaty establishing the European Community clearly specifies the competences of the European Central Bank and the Eurogroup, in Article 111. These provisions are not expected to be changed by the next Intergovernmental Conference leading to the preparation of the Reform Treaty.

The Eurogroup, which meets once a month and is composed of the finance ministers of the euro area, defines the exchange rate regime of the euro, in a procedure that also involves the ECB and the European Commission. Given the very clear procedure established in Article 111, which requires qualified majority in the Eurogroup on a proposal by the European Commission or the ECB, it is clear that any orientation would have to be based on an agreement between the Eurogroup and the ECB.

The current exchange rate regime of the euro is free-floating, like those of the other currencies of the major industrial countries. Within such a regime, the Eurogroup may formulate “general orientations” for the exchange rate policy of the euro, orientations which should be without prejudice to the ECB’s primary objective of price stability. No orientation has been formulated so far. The European System of Central Banks (ESCB) holds and manages the foreign exchange reserves of the Member States and has responsibility for intervening in the foreign exchange markets. ^[1]

This division of labour is different from that prevailing in the United States or Japan, where the respective finance ministries have responsibility for both defining the exchange rate regime and implementing intervention in the foreign exchange markets.

The structure in place in the euro area is in my view a more efficient one. Experience over recent years suggests that, to be able to influence exchange rates in both directions, policy action needs to satisfy at least three requirements. It needs:

The structure in place in the euro area is best suited to satisfying these three requirements.

First, as is widely shown in the literature, intervention is unlikely to have a lasting effect in the foreign exchange markets unless it is expected to be followed by domestic policy action, especially concerning interest rates. This suggests that any foreign exchange intervention at odds with domestic monetary policy would be unlikely to succeed in influencing the exchange rate. To be effective, foreign exchange intervention has to be conducted in close cooperation with the monetary authorities. Giving responsibility for foreign exchange intervention to the central bank might be the best way to ensure such consistency.

When there isn’t full consistency between foreign exchange policy and monetary policy, either intervention is not effective in influencing market exchange rates or it has to become so massive that it ultimately alters the conduct of domestic monetary policy. This might be the case especially when intervention is aimed at counteracting a trend appreciation of the exchange rate, leading to the accumulation of huge amounts of foreign exchange reserves that cannot be easily sterilised.

The second condition for an effective foreign exchange policy is that it be conducted in concert with the main external partners. A unilateral policy is unlikely to affect markets in a lasting way, unless it leads to a subordination of domestic policy objectives to external objectives, as would occur in the case of massive intervention. Successful episodes of intervention in the foreign exchange markets have been the result of agreements between the major currencies, in particular within the G7, such as for instance the Plaza or the Louvre accord, or the agreement between the monetary authorities of the three major currencies in the autumn of 2000.

The third condition is that whatever policy is decided among the main partners, it should be well communicated to the markets. This is the reason for G7 statements accompanying episodes of intervention. Statements are also at times made with a view to influencing the markets. The effectiveness of such statements depends on the existence of market expectations that effective action can be implemented to induce a market correction.

The three above-mentioned conditions are best met if both the finance ministry and the central bank are involved in the definition of the policy. Effective communication and coordination with the external partners require that the finance ministry be involved, while the need to ensure consistency with domestic policy action requires that the central bank be involved. If one of the two parties disagrees with the course of action, or is seen by the markets as not being fully involved, the effectiveness of the policy might be impaired. There are numerous examples in the recent past to confirm this view.

In the euro area foreign exchange policy is ultimately decided by the Eurogroup and the ECB, in accordance with the respective competences that I mentioned above. This has not only been prescribed by the Treaty; it has also worked in practice. The position of the euro area at the G7 meetings, or at meetings with the US and Japanese authorities, has been defined jointly over the last eight years by the two institutions. The Presidents of the Eurogroup and the ECB have represented the euro area at the G7 meetings where the world economic outlook and exchange rate issues have been discussed. All G7 communiqués since 1999 have been signed by both parties.

The same coordination has taken place at the level of the deputies, ^[2] where the more frequent contacts and monitoring of financial market developments take place and the communiqués are prepared.

In autumn 2000, intervention in the foreign exchange markets was undertaken under the responsibility of the ECB. However, the Eurogroup President was informed ahead of time and the Eurogroup was involved in the preparation of the communication that accompanied the intervention. To ensure effectiveness, the communication was agreed with the US and Japanese authorities.

The experience of 2000 and since then shows that the euro area can act promptly in the markets, with the appropriate involvement of the Eurogroup and the ECB, within the context of the current flexible exchange rate regime. There has been no need for orientations or guidelines to achieve such a level of efficiency.

More recently, the euro area participated, together with the United States, Japan, China and Saudi Arabia, in the multilateral consultations on global imbalances organised by the IMF. These consultations have led the participants to make public policy commitments with a view to facilitating a smooth adjustment of these imbalances.

What still needs to improve? Communication, especially during the process of preparing the common positions.

At present euro area positions are prepared, prior to G7 or IMF meetings or on other occasions, at meetings of the Eurogroup, in which the ECB participates. These meetings are well prepared at the technical and deputy level, but the publicity surrounding them often leads to conflicting signals. Some finance ministers are often tempted to make public statements about exchange rate issues before a Eurogroup meeting starts, often in an attempt to influence the meeting. Since these statements are at times contradictory, the strength of the final outcome risks being undermined. Furthermore, since the effectiveness of the message ultimately depends on agreement with the euro area’s two main partners, i.e. the United States and Japan, revealing in public individual positions tends to weaken the negotiating position of the euro area. This was apparent for instance in early 2007, prior to the Essen G7 meeting, when some euro area finance ministers expressed concern and dissatisfaction with the level of the euro exchange rate, especially vis-à-vis the yen, while other ministers indicated that the exchange rate of the euro was appropriate. These differences of opinion did not ultimately contribute to a strengthening of the yen.

To sum up, it is my opinion that the euro area is fully equipped to manage its own currency, which is the second largest in the world. But better discipline is required in the preparation of the euro area’s position to ensure that a consistent message is sent to its partners.

Is this enough to ensure that the euro area can play a role in the international monetary system equal to its economic weight?

In a world of perfectly flexible markets, with no distortionary policies and no barriers to trade in capital, goods and services, being equipped with the instruments necessary for managing one’s own currency might be sufficient. In such a world we would not need the WTO, the IMF or bilateral policy relations to discuss trade and financial issues.

The real world is different, as is well known. It is not only characterised by many distortions and policy failures; it is also increasingly integrated and interdependent. This implies that economic policy should address not only domestic issues but also international issues. Just to give an example, the exchange rate regime implemented by some Asian countries, such as China, has an impact on economic developments in the euro area, as it does on economic developments in the United States or other industrial countries. Engaging the Chinese authorities, as well as the other major authorities, in discussions aimed at improving the respective policies has become an essential feature of policy cooperation in the era of globalisation.

The question is whether the euro area is sufficiently well equipped to participate in all these international fora to foster policy cooperation in a way that maximises its own interests. The answer is positive as regards some fora, such as the G7, G3 or the IMF multilateral consultations, where specific policy issues are discussed, but not necessarily for all fora, especially when it comes to bilateral relations.

What is the reason for this? Part of the reason comes from the fact that the EU is quite a complex construction, with differing degrees of integration depending on policies and on countries.

Monetary and exchange rate policies are certainly an area where the euro area can speak with one voice and implement a single policy, although the main objective of monetary policy is a domestic one, i.e. price stability.

Fiscal policy is in the hands of the individual countries, although constrained by the Stability and Growth Pact. It would be difficult to imagine fiscal policy being used by the euro area in a coordinated way to achieve an international objective, although this might be the case if, by chance, international and domestic objectives were to coincide.

Structural policies are also in the hands of the individual countries. The Lisbon strategy provides a framework for common objectives and a monitoring procedure. It is, however, a process established at the level of the EU, not of the euro area. In recent years, and more recently in the multilateral consultation process, structural reforms have been part of the main commitment made by euro area countries to contribute to the smooth resolution of global imbalances. In fact the countries have made substantial progress towards reforming their economies, but much remains to be done. The process is independent of the international cooperation framework.

On trade issues, the countries speak with one voice, but at the EU rather than the euro area level. On financial policies the issue is even more difficult, as competences are spread between national governments, the European Commission and the various Lamfalussy Committees. The same applies to international financial institutions such as the IMF and the World Bank, where the euro area countries are spread out over eight constituencies.

These various policy areas are not necessarily related to one another and have to be conducted independently, based on the principles of efficiency and respect of the institutional set-up. When it comes to international policy cooperation, however, the ability to bring around the table all the dimensions of a country’s or an area’s economic policy may increase the likelihood of finding solutions. This is the approach that has been followed for instance in the high-level dialogue that takes place twice a year between the United States and China. This dialogue tackles all sorts of economic policy issues, related not only to the exchange rate but also to trade, finance, aid and industry. It is not yet clear whether this type of forum will deliver the expected synergies and results. However, it cannot be denied that Europe, and in particular the euro area, would have quite some difficulties in implementing such an approach.

These difficulties do not arise so much from fundamental differences of opinion on the substance of the matters under discussion. On most of these issues the EU or euro area countries have to in any case reach some common position for internal purposes. This is the case for trade, finance and even for development aid, as Europe is among the world’s largest donors. To be sure, these are all areas where it is much easier to find agreement than in other foreign policy matters. The problem is purely institutional and organisational. It can be resolved only by defining the mechanisms and procedures through which the euro area can achieve common positions on international economic policy issues and represent them in international fora.

I conclude with one last reflection.

The argument - that I personally find to be a pretext but - that has often been put forward by several observers, including policy-makers, that the main reason for progress not having been made in the international representation of the euro area, especially in international financial institutions such as the IMF, is that more political integration is required to support such a move. The recent European Council Presidency Conclusions launching the Intergovernmental Conference for the Reform Treaty have made progress in further political integration, by confirming the role for a High Representative of the Union for Foreign Affairs and Security Policy.

Could this decision also represent a way forward in the field of the external representation of the euro area?