Question

What are the implications of adopting the Euro for domestic Fiscal policy?

Answer 1

Financial markets play a key role in the transmission mechanism, as they influence to a large extent the effectiveness of the transmission mechanism of monetary policy. As indicated in Section 2, an enhanced international role of the euro may contribute to the creation of a broader, deeper and more liquid financial market in the euro area. It will be characterised by lower transaction costs, further integrated bond and to some extent equity markets, and possibly an enhanced role of direct finance with a larger role of private debt securities and equity markets. The impact of the international role of the euro on the transmission mechanism will also be determined by the impact of these features on the various channels of the transmission mechanism.

The impact of the internationalisation of the euro on the transmission mechanism: general aspects

1. Quicker adjustment of market interest rates to official interest rate changes and more competition in banking

Should the internationalisation of the euro stimulate the development of a financial structure more dominated by direct finance, interest rates and wealth effects could gain more relevance in the transmission mechanism, because financial market prices tend to react more rapidly to official interest rates than retail deposit and lending rates. Furthermore, facing increased competition, banks may have to adjust their rates more promptly by changing interest rate spreads.

One can argue that it may become easier for domestic banks to attract funds from outside the euro area, for example through the issuance of certificates of deposit, or to securitise their assets, for instance mortgages. However, the ECB will continue to have sufficient control over short-term euro rates. Thus, banks would have to borrow in foreign currency if they would like to avoid higher rates, thus incurring exchange rate risks. Consequently, it is unlikely that the sensitiveness of banks’ assets and liabilities to monetary policy actions will be significantly affected by availability of funds from non-residents.

Naturally, the internationalisation of the euro does not change the asymmetric information problem that is at the root of the “special” role of banks. Thus, if the problems of screening and monitoring borrowers are not significantly affected by the internationalisation of the euro, small firms and households will continue to be constrained in their access to the (euro) capital markets. By contrast, for larger firms access to external finance will tend to be easier and less costly. Consequently, the internationalisation of the euro may accentuate the differences in the ways in which the different sectors of the economy react to changes in monetary policy. Additionally, for small firms and households, the international role of the euro is unlikely to be, in itself, a factor fostering major breaks in existing borrower-lender relationships.

2. Higher interest rate sensitivity of the economy

It also seems that the main factors that determine the strength of the interest rate channel in the transmission mechanism are largely independent of the internationalisation of the euro. For example, increasing long-term borrowing at fixed rates by euro area firms might reflect expectations of price stability or stem from structural changes in euro area capital markets resulting from Stage Three of EMU.¹⁵

The internationalisation of the euro, however, may have an indirect effect on the interest rate channel. For example, if third countries successfully peg their exchange rates to the euro, there will be a stronger impact of changes in euro area interest rates on interest rates outside the euro area. This in turn will have an impact on economic activity in these countries. Through its effect on euro area exports to these countries, the interest rate channel will be reinforced, depending on the importance of the trade relations of the euro area with the countries that tie their exchange rates to the euro.

The transmission process of monetary policy via feedback effects through third countries will also be influenced by the role of the euro as an international investment currency and by the respective net asset position of other countries. For example, if a foreign country uses the euro mainly for the denomination of short-term or floating debt, higher euro short-term rates would tend to dampen demand in that country. This effect will be compounded if borrowers or banks in these countries rely heavily on the euro, whereas their assets are denominated in their local currency, in particular if the latter significantly depreciates against the euro. The indirect impact of these developments on euro area developments would again mainly depend on the degree of trade relations of the euro area with the respective country.

(iii) Weaker exchange rate channel

An extensive use of the euro as invoice currency and as currency of denomination and settlement in commodity markets could make the euro area HICP less sensitive, in the short run, to US dollar exchange rate movements. Under these circumstances commodity price movements would convey a better signalling of relative price changes for euro area producers and consumers and may help focus attention on the more fundamental and persistent factors underlying price trends. A widespread use of the euro as currency of denomination in commodity markets or as invoice currency could also influence the effects of exchange rate changes on the current account. If euro area exports and imports are increasingly invoiced in euros, the short-term effects of exchange rate changes on the trade balance should in general be reduced.