Watch out! The Euro Area is getting more assertive

By: Wolfgang Münchau

It looked like a really lousy forecast. When the euro was launched in 1999, I predicted that it would appreciate against the dollar, that it would challenge the dollar as a leading reserve currency and that the Europeans would pursue their economic interests on the world stage more effectively.

After the launch of the euro, the exchange rate weakened, the dollar’s global role strengthened and the eurozone made absolutely no efforts to pool its policy interests. And I stopped making forecasts.

But today, almost nine years later, it may all be happening. The adjustment in the bilateral euro/dollar exchange rate is already under way and likely to be persistent.

The international role of the euro has clearly increased. In the global bond markets, the euro has effectively challenged the dollar’s predominance. The euro’s share of global foreign exchange reserves is close to 26 per cent, against the dollar’s 65 per cent. The still formidable gap is very likely to narrow in the coming years.

The news last week that the United Arab Emirates and Qatar are considering dropping the dollar peg is another important development, the significance of which cannot be overestimated. If this happens, it may well mark the unravelling of a regime known in the policy jargon as Bretton Woods II. Under this regime large parts of the world have tied their currency to the dollar and allowed America to run a large current account deficit by reinvesting their dollar surpluses into the US. The rapid decline in the dollar’s effective exchange rate gives countries an incentive to loosen the peg, as domestic inflation rises. Eventually, they may end up rebalancing their foreign-exchange portfolios. This has not happened in a big way yet. But it also means that the euro’s role as a global currency has only one way to go – up.

There are two further factors that would support a stronger role for the euro. The first is that global investors will want to hedge their dollar exposure and diversify, as the perception of the relative strengths of the eurozone and US economies is changing. The eurozone economy looks a little healthier today than it did a few years ago and the US looks less robust as a result of the credit crisis. Second, when the euro was launched almost nine years ago, eurozone bond markets were fragmented and inefficient relative the US’s. That is no longer the case.

With the euro’s international role rising, my third prediction may eventually also come true, though we are still quite a long way from the effective representation of the eurozone’s global policy interests. Of course, not much has changed in terms of the eurozone’s presence in multilateral financial institutions, such as the International Monetary Fund. Member states are jealously guarding their national seats.

But there has been one important development. Next week, the eurozone will dispatch its three most senior policymakers – Jean-Claude Trichet, president of the European Central Bank, Jean-Claude Juncker, chairman of the eurogroup of finance ministers, and Joaquín Almunia, the European economics commissioner – on an official trip to Beijing. Whatever you think about that visit and its chances of success, this is the first time the eurozone has sent its top team on a politically delicate foreign mission. This is a big deal for the Europeans.

It is always easy to ridicule such attempts – for example, to poke fun at the relatively large size of the delegation. Yes, it takes three Europeans to replicate the role of a single American, the US Treasury secretary; and, yes, it means that when you call the eurozone from outside, you need three telephone numbers instead of one. But who cares? It is a monetary union, not a state.

This trip will probably not make a huge impact in the short run. The Chinese will not revalue the renminbi just because a Luxembourger tells them to, even when flanked by a Spaniard and a Frenchman. But this is the start of a new process.

In the past, the policy dialogue between China and Europe focused entirely on trade and investment. When European politicians, such as Gerhard Schröder, former German chancellor, visited China, they talked mainly about trains and cars. When the Americans go to China, they talk about the exchange rate and the global economy. The trio’s trip is the first big attempt at a high-level macroeconomic dialogue.

Apart from the rise in the euro’s global role, there is a more subtle explanation behind this shift in European thinking. The eurozone is a large economy consisting of 13 members that are mostly small, open economies. Unfortunately, eurozone policymakers are only slowly making the full transition from a small to a large economy mindset. Just witness the increasingly absurd economic policy debate in France. All this talk about active exchange rate management is evidence that the country’s policy elites, including President Nicolas Sarkozy, are still trapped in the small-economy past.

Large economies differ not only in size but, more importantly, in structure. Small economies are obsessed with their relative competitiveness while large economies, such as the US, have a naturally greater interest in the global economy.

It will be a long time before the eurozone manages to represent its interests effectively. Mistrust, unfortunately, still governs relations among member states, and between member states and the central bank. But the trio’s diplomatic mission is a step in the right direction.

 

Send your comments to munchau(at)eurointelligence.com

Copyright The Financial Times Limited 2007

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