Euro Impacts Essay, Research Paper

INTERNATIONAL UNIVERSITY

SOFIA

The Euro as a single currency

The Impacts of its Introduction

Liberalizing trade is nothing new to the world, but we have never witnessed such a vast economic integration between sovereign countries like the integration carried out in the European Union. Customs duties between European countries started to come down steadily in the early 1950s and were abolished in 1968 with the introduction of a customs union and the implementation of the common external tariff. The official proclamation of the single market on 1 January 1993 marked the ending of non-tariff barriers to trade between Member States.

European Monetary Union will make it possible to complete European economic integration. The introduction of a single currency will mean price transparency, that is prices of goods can be directly compared on the markets of the participating Member States, which will merge into one market. Obstacles to trade such as the transaction costs, which add up to 0.4% of the EU GDP per year, and the exchange risk, will be eliminated. The competitive positions of companies can no longer be established by exchange-rate movements but will reflect productivity, inflation and cost differentials. This should permit a better allocation of capital and of available resources. The member countries will also be able to save administrative costs used for hedging operations. Over and above its positive effects on price stability and public finances, the single currency will make it possible to complete the single market and increase the benefits, which have already flowed from it.

Monetary Union will create an area within which national financial markets will become an integrated, wider and more flexible market. Financial institutions and financial centers will face new competitive conditions. The size of a specific national market will lose its significance. Competition will increase and could lead to greater harmonization across the euro area.

The introduction of the euro will have a great impact on the financial sector. This is because of three main reasons:

? The European System of Central Banks will be operating the single monetary policy in euro. So, it will be necessary for financial institutions to be able to operate in euro.

? Governments will issue all new debt in euro. Therefore, financial institutions, payment systems and clearing systems will have to be prepared to operate in euro from the start of monetary union..

? Businesses and citizens may decide to use financial products denominated in euro at any time during the transition period. A financial institution that fails to provide such services would run the risk of losing business.

The introduction of the euro will have important implications not only for the Union and its Member States but also for their partners. But while it will be a major event for international monetary relations and the international monetary system, there will be no abrupt change; nor is it likely to be destabilizing.

In order to prepare for the euro, and once it is in place, Member States need to follow sound economic policies based on low inflation, healthy public finances and stable monetary conditions. These rules of good economic management are the recipe for low interest rates, strong investment growth, and therefore high growth and job creation. Firms across the world – and not just in Europe – will benefit from these improved growth prospects. The strength of Europe as a trade partner will open new prospects for exporters in the rest of the world. Foreign companies especially will benefit, because there will be only one market to penetrate rather than 15. Therefore, the costs of doing business in Europe will go down significantly, fostering competition and lowering prices across the Union

The international role of the euro will probably become evident first in the European zone of influence, that is in those countries which have close economic and trade ties with the European Union. In that zone, in areas such as the countries of Central and Eastern Europe, a gradual shift has already taken place out of dollars to the Deutsche Mark and later on to the euro into DM, and it can be expected that this phenomenon will be reinforced. Gradually its role will grow at world level, as markets realize that the euro is a stable currency. The size of EMU and the integration of its financial markets imply that the euro will become a major world currency. Countries, which are less developed will be likely to use the euro as an official reserve currency.

It is to be expected that the introduction of the euro will induce portfolio shifts in favor of euro-denominated assets. These are likely to become more attractive for international investors for a combination of reasons:

? The sheer size of the euro area gives rise to the development of deep and liquid markets in financial euro instruments.

? The policy-mix in the euro area are stability-oriented. Monetary policy is stable, with an independent European Central Bank committed to price stability, and fiscal policy is stable, based on the Union’s strong commitment to budgetary discipline. The euro represents an attractive store of value.

This will increase the competitiveness of the European companies worldwide.

The mechanism of the interest rates represents an important aspect in the financial system of the union. The European Monetary Union will decrease the interest rates, due to the following factors:

? The stability of the euro will be guaranteed by an independent central bank. Countries, members of the Monetary Union will benefit from low interest rates, because the inflation will decrease as well as the risk.

? The member countries desire price stability, which is possible with lower interest rates and inflation.

? The growth will be more stable, which will ensure lower interest rates and the investments will increase which will increase growth and so on.

? The liquidity of the financial markets in euro is expected to become greater, which will lead to lower interest rates.

There is already a good example of the statements above. For the last decade, long term interest rates have fallen in Europe by more than 3 % on average and short term interest rates by more than 6 %. The difference in long term interest rates of the major euro currencies has virtually disappeared.

There is a concern that replacing one or more currencies by a single currency will increase inflation, as low prices are rounded up. The decimalization in United Kingdom and Ireland did not result in higher prices. The change of the European currencies with the euro should have low effect on inflation or the inflation may even go down because of the competition. It will be easier for producers and consumers to compare prices. This will result in higher competition because consumers could go and purchase a good, where its price is lowest. So, companies, which offer at higher prices will have to decrease them or increase the quality of goods.

The introduction of the euro, however, faces some criticism, which in most cases does not prove to be appropriate or connected to the euro. The high rate of unemployment, which exists in most EU states is rather structural than connected to the euro. The macroeconomic stability, which will follow with the implementation of the euro is likely to decrease the unemployment.

There is a risk of overvaluating the euro, due to the big optimism, connected to the currency. This might have some negative effects on the financial markets (e.g. the price of the euro fall recently, which led to some skepticism about the stability of the currency). It is essential for member states to follow a policy of price stability and it should be noted that the euro is a “young” currency and such fluctuations in its exchange rate are expected at the beginning.

There is a possible scenario that financial market speculation might derail the EMU until 2002, when the national currencies and the euro will co-exist. The reason for this is that the currencies of the member states have different weight. Some of them like the German Mark and the British Pound are very strong, while currencies like the Greek Drahma are weak. The demand for the strong currencies will increase, while the demand for weak currencies will decrease. Having in mind that there is currently a fixed exchange rate among them, a disbalance in the financial market might follow. This is wrong however because of two reasons. First, the period of co-existence between the euro and the national currencies of euro-area member states is not a trial period in which withdrawal is an option. This is a transition period in which the problems associated with the changeover to the euro will be resolved. Second, the national currencies of the EMU members are no longer independent. They are fixed to the euro. A speculation between currencies of the member states is pointless because this is equal to speculation with a currency of the same type.

The introduction of the euro in 1999 was an event, anticipated for a long time. Following, the euro has faced some problems due to the transaction period, but there is a strong belief that these problems will be easily overcome as the young currency accumulates power. Now that, the euro has become the official currency of the European Union (with some exceptions) there will be no more national currencies of the member states. In this way, we become witnesses of the highest level of integration among independent nations in the world history, when the European Union is expected to become the leader in the world economy.

Bibliography

1. Kreinin, International Economics, 1991, Harcourt Brace Jovanovich

2. Cecchini, The European Challenge, 1992, Wildwood House

3. European Central Bank’s web site: http://www.ecb.int

4. EMU official web site: http://www.emu.int