The global financial markets have been dominated by the ongoing debt crisis within member countries of the European Union (EU), and particular attention focused on the Eurozone. The purpose of the Eurozone was to foster monetary integration of the member states with the introduction of the common currency - the Euro. The aim of a common currency is to enhance trade in goods and services among member states since exchange rate risk would be diminished. The Euro not only increased intra-regional trade among member states but it has stimulated international trade as well. The common currency has significantly benefitted financial activity over the years, influencing the currency, bond and equity markets. In spite of the benefits derived from the introduction of the euro, it also highlighted some flaws within the Eurozone, namely the lack of fiscal and political union, which has been exposed within the last year. This article seeks to illustrate the trends in the financial markets since the euro was introduced.
The Euro Dollar
Since the introduction of the Euro dollar in 1999, it has become a major currency in the foreign exchange markets. Figure 1 tracks the performance of the euro against the US dollar (USD), Pound sterling (GBP) and the Japanese Yen (JPY). Compared to the USD, the euro has had numerous fluctuations, arguably so, given the strength of the USD in the world economy. After the euro's introduction in 1999, there was a slight depreciation against the USD largely due to the higher growth rates in the US relative to the EU and relatively higher interest rates in the US. However, this was reversed in 2002, when the appreciation coincided with the introduction of euro notes and solidified the euro's position as a medium of exchange and a store of value. Subsequent to this, major changes were attributable to developments in the global markets as globalization of the world economy greatly increased.
Against the yen, the euro fluctuated. The main reason for the depreciation in 2008/2009 was due to the financial crisis which began in the US and spilled over to Europe and the rest of the world. As a result, investor confidence fell in both the US and Europe and, at the same time, Japan's economy was relatively strong and its outlook was improving. Combined, these factors led to a surge in the demand for the Japanese yen. The same occurred in 2010, where subsequent to the Japanese earthquake and tsunami, the flood of yen back into Japan, together with domestic policy, lead to the depreciation of the euro against yen.
The euro has remained relatively stable against the pound sterling, largely due to the fact that these economies are major trading partners, as the UK is a member of the European Union. There was some appreciation of the euro against the pound though, which was attributable to the speculation in the markets and lower interest rates in the UK relative to Eurozone countries (especially since 2008).
The Euro as a Reserve Currency
The USD has been and continues to be the world reserve currency. It is widely accepted as a measure of exchange in all trading markets due to its strength and stability. The euro, following its introduction in 1999, has rapidly increased in terms of reserves, especially in comparison to the Japanese yen, pound sterling and Swiss francs. As a relatively large trading bloc, member countries have increased their holdings of the euro, however, this has also been the case of its major trading partners. The euro facilitates trade not only in physical goods and services, but is also crucial to the financial markets. A large number of transactions, particularly debt issuance, are conducted in euro currency and as such holdings of the euro have increased.
Globally, the composition of the Euro as a reserve currency has increased since its inception. Figure 2 shows an increase from 18% in 1999 to 26% in 2010. This has been largely due to the well-developed financial markets, confidence in the currency (backed by the strength of the European Central Bank ) and the impact it has had on output and trade. When the financial crisis emerged, the US economy contracted and the USD depreciated against most currencies. It was at this point that there was speculation that the euro may become the next reserve currency. However, the debt crisis that surfaced in 2010, eroded this speculation and the ever spiraling crisis, has solidified the USD as the world reserve currency, despite its challenges.
Having illustrated the trends against major currencies, the overarching picture is that the euro is a widely held currency among most financial markets and has a significant impact in the world economy today.
Global Capital Markets
A source of strength for the Eurozone area is the increase in the activity in the financial markets, namely banking, bonds and equities. A key driver of the use of the euro, apart from trade, has been the ease of access and general attractiveness as a source of funding. There has been an increase in the use of euro denominated debt since the euro was introduced, evidenced by the surge from 2003, where it surpassed that of US debt issuances, to present day (see Figure 3). Although there was some slowing in the trend since 2008, euro denominated debt outstanding remains high. Money market activity (see Figure 4), has also been dominated by the euro currency, cementing the Eurozone as a key place for raising short term capital and earning moderate return on investments. A strong impetus for this has been the relatively stable Eurozone economies, backed by the strong monetary framework enforced by the ECB. The policy rate set by the ECB has proven to facilitate stable prices within the region, which has buoyed the currency and confidence within the Eurozone. Interest rates have been relatively high (when compared to other developed markets) and have thus lent support to the increased capital market activity in the region. At present at 1%, the policy rate is still attractive among developed markets, where the US rate is near 0% and the UK it is at 0.5%.
The equity markets also experienced an increase in activity subsequent to the introduction of the euro. Volumes traded (Figure 5) steadily rose as with other areas within the financial markets. Particularly for countries within the Eurozone, equity financing was relatively attractive as the removal of barriers allowed for the free movement of capital within the region. FDI activity, which also increased since the introduction of the euro, also supports the increased market activity on the Euro Stoxx index. Clearly, the trends show the increased influence the Eurozone has had on the financial markets.
Prior to the global financial crisis in late 2008, yields within the Eurozone were relatively low, with spreads between them only marginal. When the euro was introduced, member countries became privy to relatively low means of financing (due to low interest rates), so debt financing among member states increased. However, as economic growth slowed in most countries, deficit financing was used to spur growth. Over time, the accumulated debt led to a surge in indebtedness and raised concerns about debt servicing capacity, notably so in the so called 'PIIGS' of the region. Consequently, this led to numerous sovereign rating downgrades and consequently yields in these troubled countries rose, especially in Greece (Figure 6).
The challenge facing the Eurozone, and by extension the global markets is because of the potential contagion effect that the debt crisis poses. In the case of Greece, its debt is held by a number of other member states and by a number of European banks as well. If it were to default, there will likely be a ripple effect across the region, possibly the world. Thus far, Greece has received its second bailout and with a newly formed government, austerity measures will likely be implemented to curtail fiscal imbalances and the debt levels. However, the questions remain; what guarantee is there that this will not happen again? Who will be next to request a bailout? Does the region have an unlimited supply of funds to plug this never ending leak? These issues, among many others currently face member states of the Eurozone and the rest of the world is keenly looking on. The bold step that it made to attempt monetary integration has indeed yielded great benefit, however, it also exposed some imperfections. What may be required is yet another bold step - a move toward a fiscal and political union. Whether members of the EU are willing to make this step is left to be seen.
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