Free DP Download 23 January 2020 - THE EURO IS PUNCHING BELOW ITS WEIGHT AS AN INTERNATIONAL CURRENCY: New research explains why

Thursday, January 23, 2020

Ethan Ilzetzki, Carmen M. Reinhart, Kenneth Rogoff           
CEPR DP No. 14315 | 16 January 2020

Twenty years after the euro was launched, its role as an international currency is no greater than the German Deutschemark and the French franc, which it replaced. A new CEPR study by Ethan Ilzetzki, Carmen Reinhart and Kenneth Rogoff demonstrates the currency’s distant second status behind the dollar, notes the emerging threat of China’s renminbi as a competitor in the world monetary system, and explains why the euro punches so far below its weight.

The authors’ central explanation for the euro’s lagging role is the shortage of safe euro-denominated assets, which is partly due to the highly fragmented financial markets in the Eurozone. For example, an asset issued in Italy or Greece isn’t viewed as a close substitute for German bonds. Indeed, the Eurozone functions more like economic archipelago than a unified financial and economic zone. 

The Eurozone’s limited unity, particularly in the post-crisis decade, has also posed difficulties for monetary policy. The study finds evidence that the European Central Bank (ECB) was slow to find its own voice and its 20 years can be divided into a ‘Bundesbank-plus’ period and a ‘whatever it takes’ period.

The first decade showed a slow transition from the European Exchange Rate Mechanism with stable German inflation as its goal. In this period, the ECB’s implicit policy rule put a far greater weight on German inflation than on inflation in the Eurozone as a whole.

The second period has been characterised by zero and negative interest rates, and an expanding ECB arsenal of credit facilities to European banks and sovereigns. Lack of ECB policy clarity makes the nature of the euro hard to assess and therefore a less attractive currency to use as an anchor. This may be an additional factor limiting the euro’s international reach.

Figure 1: Evolution of Anchor Currencies: Dollar and Euro (Number of countries weighted by their share in world GDP, 1975-2015)

Note: The figure shows the share of countries anchored to the US dollar (top, green line) and to the euro (post 1999) and German Deutschemark and French Franc (pre 1999) (bottom, blue line). The thin lines exclude the US from the dollar bloc and current Eurozone members from the euro bloc. It weighs the anchored countries by their share in world GDP. The vertical lines show the date of euro adoption. 

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