Sound fiscal and structural policies are needed to provide international investors with what they need most: a large and elastic supply of safe assets. The fact that the supply of euro-denominated safe assets can shrink at precisely the time when demand for such assets is rising has not been lost on investors.
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It is likely a dominant factor keeping the euro from having a stronger international role. We know that the journey towards a true European safe asset, one that does not vanish on rainy days, will be long and full of perils. They reduce transaction costs, making the currency more attractive for international financing and settlement, and — as more liquid markets mitigate rollover risk — they are perceived as safer by investors. This is not just theory. Recent research shows that capital market depth was critical in helping the US dollar to catch up with, and then overtake, the pound sterling in the first half of the last century.
Financial deepening was by far the most important contributor to the increase in the share of dollar-denominated international bonds issued between and Its impact dwarfed that of economic size or credibility. European capital markets appeared to be becoming more integrated, and hence deeper, prior to But this impression was based more on price convergence than on real cross-border integration.
You can see this clearly on Slide 6, which shows composite indicators of euro area financial integration produced by the ECB.
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The quantity-based indicator remains at about half of its pre-crisis peak, and at very low levels in absolute terms. Source: ECB.
Notes: The price-based composite indicator aggregates ten indicators covering the period from the first quarter of to the fourth quarter of , while the quantity-based composite indicator aggregates five indicators available from the first quarter of to the third quarter of The indicators are bounded between zero full fragmentation and one full integration.
Increases in the indicators signal greater financial integration. For a detailed description of the indicators and their input data, see ECB , Financial integration in Europe, Frankfurt am main. The latest data are for the third quarter of But the underlying reasons for it are structural.
Capital markets in Europe are still fragmented along national lines, since various legal and institutional barriers hinder the creation of a single pool of liquidity. This is precisely why policymakers have now put their weight behind the capital markets union CMU project. But progress remains too slow.
The ECB has been complementing these efforts by upgrading its payment system infrastructure, which contributes to market integration and, in turn, to the depth and liquidity of euro area securities markets. In time, these systems may offer international market participants easier access to our currency. But empirical evidence supports the view that the US dollar benefits from a substantial security premium. Nations that depend on the US security umbrella hold a disproportionate share of their foreign reserves in dollars.
Predicted share of the US dollar in the foreign exchange reserves of selected countries.
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Source: Eichengreen, B. Mehl and L. Note: The figures show the predicted shares of the US dollar in the foreign reserve holdings of five countries which depend on the US security umbrella. Actual US dollar shares are shown as blue bars. The actual dollar shares are based on publicly available estimates for the year Korea , Germany , Japan , Saudi Arabia and Taiwan ; see Eichengreen et al. You can see this on Slide 7: a model restricted to economic factors — the yellow bars — under-predicts, by a wide margin, the dollar reserves of countries dependent on the United States for their security.
A model including their NATO membership — the red bars — comes much closer to the actual shares. This is not a new phenomenon. But it has a clear implication for policymakers. Europe already exerts global leadership in regulatory, competition and trade domains. This is what I would now like to discuss. As I see it, the monetary policy relevance of an international currency has probably increased over time, on account of both the evolution of the international monetary system itself and the way central banks implement monetary policy today, in particular at the zero-lower bound.
More specifically, I see three broad implications for the conduct and transmission of our monetary policy, all of which we would need to understand and take into account when defining the appropriate stance for the euro area. This is in part mechanical: the more the domestic currency is used for trade invoicing, the less the pass-through to import prices in the face of fluctuations in the exchange rate.
This holds not only over the short run, when prices are sticky, but also over the long run when they are adjusted by producers. The tight correlation between domestic currency invoicing and exchange rate pass-through is evident in the euro area. Exchange rate pass-through to import prices vs. The estimation sample spans the time period from the first quarter of to the last quarter of The share of euro invoicing reported on the x-axis is the average over the sample period.
The black line is a fitted regression line. Exchange rate pass-through to euro area import prices in response to a monetary policy shock. Source: ECB calculations based on Casas et al. The degree of pass-through, in turn, has a strong influence on the transmission of shocks, which has differing implications for monetary policy. On the one hand, lower pass-through means that import prices are better shielded from exogenous exchange rate shocks, and monetary policy can focus more on domestic sources of inflationary pressures. On the other hand, the effect of domestic monetary policy on import prices is more limited when pass-through is low.
You can see this on the right-hand chart, which plots simulations from a calibrated model of the exchange rate pass-through. Clearly, increased local currency pricing would, in principle, attenuate an important lever of monetary policy. But it is also true that, in the euro area, exchange rate pass-through has already notably declined over the past two decades, mainly due to the declining share of commodity imports and the increasing role of global value chains.
Today, the pass-through to final consumer price inflation may be less than a third of what it was at the beginning of the century. Sources: Eurostat and ECB staff calculations. The cumulated impulse response is based on the updated estimation of Hahn over a year rolling window from the first quarter of to the first quarter of Each point on the dark blue line refers to the end point of each year rolling sample, with the first sample referring to the period from the second quarter of to the first quarter of and the last sample to the period from the second quarter of to the first quarter of The second way in which an international currency is relevant for monetary policy is its effect on interest rates.
In principle, international currency issuers enjoy greater monetary autonomy. Central banks in small open economies, for example, are typically more heavily exposed to foreign spillovers in setting interest rates than those presiding over an internationally dominant currency. But international currencies are not isolated from foreign spillovers.
Greater external demand for euro area securities, for instance, can increase the influence of foreign factors on domestic monetary and financial conditions. For example, in periods of global stress, investors rush to the safety and liquidity of dollar-denominated securities, thereby compressing term premia. These effects, however, are typically temporary and policymakers can hence afford to look through such volatility. Other effects may prove more durable, however. The past experience of the Federal Reserve highlights these challenges. It is well documented that the large demand for US securities by foreign central banks in the run-up to the financial crisis contributed to the decline in longer-term US interest rates, thereby in part offsetting the parallel tightening efforts by the Federal Open Market Committee.
In other words, the effects of such purchases by foreign central banks do not fundamentally differ from those of domestic central banks which purchase assets as part of their efforts to stimulate the economy — quantitative easing. It is not that these effects are completely absent in the euro area today. As the second most important reserve currency, demand from foreign central banks can also be expected to have affected euro area financing conditions.
But there is a difference, and it is due to a distinctive feature of the euro area which I have already highlighted: the lack of a single safe asset. We have seen foreign demand driving a wedge between sovereign bond yields in the euro area. The implication is that efforts to improve the stability of our currency union could be expected to lead to a more even distribution of reserve demand effects across the euro area.
This, by itself, would benefit the transmission of our monetary policy. The final monetary policy implication of a stronger international role for the euro is that spillovers and spillbacks through international trade and finance would probably be larger. The first is that the increased use of the euro as an international funding currency would amplify the so-called international risk-taking channel of monetary policy, which operates through international bank leverage.
Strong link between US dollar movements and international dollar lending. Notes: Growth in US dollar lending refers to quarterly changes in cross-border loans and deposits in US dollars of BIS reporting banks; NEER stands for nominal effective exchange rate positive changes indicate a dollar appreciation.
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Second, if the euro were used more for trade among third countries, a depreciation of the euro would make all euro-denominated exports cheaper, from euro area and non-euro area firms alike. This would cause an increase in global trade with potentially positive spillbacks. The flipside is that central banks in smaller economies, not least in emerging market economies, could turn more frequently to the ECB for currency swap lines when the tide turns — i. The ECB would then be called on to increase its activities as an international lender of last resort.
Any extension of the global network of currency swap lines would, however, have to be based on sound monetary arguments.