The Euro: Implications for the United States-Answers to Key Questions
(Letter Report, 03/01/2000, GAO/GGD/NSIAD-00-105).
Pursuant to a congressional request, GAO provided information on the
euro, focusing on: (1) what the euro is and why Europe is moving to it
now; (2) what the potential effects of the euro on the dollar are; (3)
what the potential monetary policy and exchange rate effects of the euro
are; (4) what the euro's implications for U.S. trade and investment with
Europe are; and (5) what the implications of the euro for international
economic policymaking are.
GAO noted that: (1) the euro is the new currency being used by 11 of the
15 countries that are members of the EU; (2) the euro is the most
significant and far-reaching part of the larger initiative known as the
European Economic and Monetary Union (EMU); (3) EMU is the effort by EU
countries to more closely link their economic policies to achieve
greater political and economic integration; (4) these countries believe
the euro supports the broader political goals of greater European
economic and political integration; (5) regarding the four EU countries
not in the Euro Area: (a) the United Kingdom does not plan to join the
euro area until it has achieved greater economic synchronization with
the rest of the EU; (b) the majority of the Danish public supports
adopting the euro, and the government plans to hold a national
referendum on eventual membership; (c) in Sweden, the ruling party has
come out in favor of joining the Euro area, but it has not yet set a
date for a national referendum on the issue; and (d) Greece wanted to
join the euro area but could not meet the economic requirements; (6)
most experts maintain that there are many reasons to believe the euro is
sustainable; (7) several of the analysts GAO spoke with believe that the
comparative status of the dollar and euro as international currencies
may be affected by potential developments in the euro area payments and
securities settlements infrastructure; (8) although there are certain
economic benefits that derive from the public and private international
roles of the dollar, the importance of such benefits is uncertain; (9)
in the euro area, monetary policy is decided upon and implemented by the
European System of Central Banks (ESCB); (10) the ESCB has appeared to
be focused on price stability in numerous public statements; (11)
although the Federal Reserve System has a track record of cooperating
and coordinating with some of the central banks in the ESCB, it has
little experience dealing with the European Central Bank as its a new
institution; (12) over the longer term, the credibility of the value of
the euro currency will likely depend primarily on the performance of
euro area economies and their economic policy mix; (13) after its
introduction in January 1999, the euro steadily declined in value; (14)
some experts have said that the largest effect of the creation of the
euro will be the transformation of financial services in Europe; and
(15) the reduction of foreign exchange activity in currencies replaced
by the euro was regarded by banks as the main negative consequence of
the EMU.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: GGD/NSIAD-00-105
TITLE: The Euro: Implications for the United States-Answers to
Key Questions
DATE: 03/01/2000
SUBJECT: International economic relations
Foreign trade agreements
International trade
Investments abroad
Foreign exchange rates
International trade regulation
Tariffs
Economic policies
International relations
Economic analysis
IDENTIFIER: European Union
Euro
Trans-European Automated Real-Time Gross Settlement
Express Transfer System (TARGET)
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United States General Accounting
Office
GAO
Report to the Chairman
Subcommittee on Domestic and
International Monetary Policy,
Committee on Banking and
Financial Services, House of
Representatives
March 2000
GAO/GGD/NSIAD-00-105
THE EURO
Implications for the United
States- Answers to Key Questions
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Contents
Page 5 GAO/GGD/NSIAD-00-105
Preface 1
Chapter 1 8
What is the
Euro?
Chapter 2 20
How Could the
Euro Affect
the Dollar As
An
International
Currency?
Chapter 3 32
What Could Be
the Effects of
EMU on
Monetary
Policy and on
Exchange
Rates?
Chapter 4 41
What are the
Implications
of EMU for
Financial
Markets,
Financial
Institutions,
and Their
Regulation?
Chapter 5 54
What are the
Implications
of the Euro
for U.S. Trade
and Investment
with Europe?
Chapter 6 63
What Are the
Implications
of EMU for
International
Economic
Policymaking?
Appendixes Appendix I: 66
Objectives, Scope,
and Methodology
Appendix II: Glossary 68
Appendix III: 73
Bibliography
Tables Table 1.1: 1999 9
Population and GDP
of the Euro Area and
the United States
Table 1.2: Euro and 10
National Currency
Conversion Rates
Table 1.3: Euro 11
Membership
Requirements
Table 1.4: Chronology 19
of Selected Events
Surrounding the Euro
Figures Figure 1.1: Members 9
of the European
Monetary Union and
the European Union
Figure 2.1: Cross- 22
Border Assets of
Banks in Industrial
Countries by
Currency (1985-1998)
Figure 2.2: 23
International Bond
and Note Issues
Outstanding by
Currency (1985-1998)
Figure 2.3: Official 28
Foreign Exchange
Reserves by Currency
Denomination (1985-
1998)
Figure 3.1: Dollar- 40
Euro Area Exchange
Rate, January 1996 -
February 2000
Figure 4.1: 43
Announced New Issues
of International
Bonds and Notes
(January - September
1998 and 1999)
Figure 4.2: Size of 45
Euro Area Versus
United States
Financial Markets
(End- 1995)
Figure 5.1: U.S. 55
Merchandise Trade
With Euro Area
Countries (1994-
1998)
Figure 5.2: U.S. 56
Service Trade With
Euro Area Countries
(1994-1998)
Figure 5.3: 57
Composition of U.S.
Merchandise Trade
with the Euro Area
by Sector, 1998
Figure 5.4: U.S. 60
Direct Investment
Position in Euro
Area Countries 1998
- Historical Cost
Basis Data
Figure 5.5: Sectoral 61
Composition of U.S.
Direct Investment
Position in Euro
Area 1998 -
Historical Cost
Basis Data
Abbreviations
BIS Bank for International
Settlements
ECB European Central Bank
EMU Economic and Monetary
Union
ERM Exchange Rate Mechanism
ESCB European System of
Central Banks
EU European Union
FDI foreign direct
investment
HICP Harmonized Index of
Consumer Prices
IMF International Monetary
Fund
Preface
Page 2 GAO/GGD/NSIAD-00-105
On January 1, 1999, 11 of the 15
countries in the European Union
(EU) adopted the euro as a common
currency.1 On the same date, the
new European Central Bank (ECB)
took control of monetary policy
in these these 11 countries. This
strengthening of economic
integration in Europe is
generally viewed as a way to
foster greater political
integration in addition to
achieving economic benefits for
member countries. Monetary union
has created in Europe a new,
large economic entity that could
become a powerful force in world
economic and financial markets.
Its emergence has raised
questions about how the United
States will be affected, in areas
ranging from the dollar's role as
an international currency to the
effects on U.S. trade and the
relative attractiveness of the
United States to foreign
investors.
For example, over the past half
century, the U.S. dollar has been
the primary world currency for
business transactions, holdings
of currency reserves at central
banks, and in private portfolios.
Concerns have been expressed
about whether the euro will
change the dollar's role in these
areas and, if so, what the
implications will be for the U.S.
economy. With regard toOn the
policy frontmaking, the advent of
the euro has implications for
U.S. monetary policy sincbecause,
although suchmonetary policy is
determined primarily by domestic
economic conditions, the Federal
Reserve does take international
conditions into account when
setting monetary policy.
Some experts have said that the
largest effect of the creation of
the euro will be the
transformation of financial
services in Europe. For example,
the,y predicting, for example,
that European stock and bond
markets will become more
integratedexpand over time to
roughly the size of tand could
rival those in the United States.
Because Europe is an important
trading and investment partner of
the United States, there has been
considerable interest in whether
the introduction of the euro
could affect trading and
investment patterns. A key
determinant of any potential
effects is the euro's influence
on economic growth in Europe.
AlthoughWhile the euro can
potentially benefit growth, it
also brings policy challenges to
national governments and the
European Union, such as the
difficulty of fitting one overall
monetary policy to diverse
economies. Thus,and conclusions
on itsthe euro's growth effects
may remain tentative for some
time.
The advent of the euro has
implications for how
international economic policies
are set and implemented, such as
bringing about some changes in
representation at G-7 -7 meetings
on economic policy.2 Whether
this deeperdeeper European
economic integration could affect
the balance of power in economic
policy deliberations, such as
trade negotiations with the
United States, has been of
interest to U.S. policymakers.
We undertook this review of
the implications of the euro for
the United States at the request
of the Chairman of the
Subcommittee on Domestic and
International Monetary Policy of
the House Banking Committee.
Specifically, our objectives were
to answer the following
questions: (1) What is the euro
and why is Europe moving to it
now? (2) What are the potential
effects of the euro on the
dollar? (3) What are the
potential monetary policy and
exchange rate effects of the
euro? (4) What are the
implications of the euro for
financial markets and
institutions and their
regulation? (5) What are the
euro's implications for U.S.
trade and investment with Europe?
And (6) What are the implications
of the euro for international
economic policymaking?
In this report, we attempt to
provide the information in a
clear, concise, and easily
understandable manner for a
nontechnical audience. -makers.
This document addresses a wide
range of questions that have been
asked about the implications of
the euro for the United States.
For readers who are interested in
more detailed information on the
topics covered here, we also
include a bibliography.
If there are any questions
regarding this report please
contact Tom McCool at (202) 512-
8678 or Susan Westin at (202) 512-
4128.
Thomas J. McCool
Director, Financial Institutions
and Markets Issues
General Government Division
Susan S. Westin
Associate Director, International
Relations and Trade Issues
National Security and
International
Affairs Division
topics netary Fund.
_______________________________
1 The 15 members of the EU are
Austria, Belgium, Denmark,
Finland, France, Germany, Greece,
Ireland, Italy, Luxembourg, the
Netherlands, Portugal, Spain,
Sweden, and the United Kingdom
(U.K.). Denmark, Greece, Sweden,
and the U.K. have not adopted the
euro.
2The G-7 consists of seven major
industrialized countries that
consult on general economic and
financial matters. The seven
countries are Canada, France,
Germany, Italy, Japan, the United
Kingdom, and the United States.
Chapter 1
What is the Euro?
Page 15 GAO/GGD/NSIAD-00-105
Q. What is the single European
currency and how did countries
qualify for membership in the
euro area?
A. The euro is the new currency
being used by 11 of the 15
countries that are members of the
European Union (EU). (See fig.
1.1.) The euro area comprises
these 11 countries. The euro area
countries have a population
slightly larger than the
population of the United States
and economies with a combined
gross domestic product (GDP)
about 75 percent the size of the
GDP of the United States.1 (See
table 1.1.)
Figure 1.1: Members of the
European Monetary Union and the
European Union
Source: European Commission
documents.
Table 1.1: 1999 Population and
GDP of the Euro Area and the
United States
Population GDP
United 272 million $9.1
States trillion
Euro area 291 million $6.7
trillion
Sources: European Union, Central
Intelligence Agency, Census
Bureau, and Bureau for Economic
Analysis
When the euro was launched
on January 1, 1999, the 11
countries in the euro area locked
their exchange rates to the euro,
redenominated their national debt
into euros, surrendered control
of monetary policy to the
European Central Bank (ECB), and
began using the euro in
electronic transactions.
Citizens of countries that
have adopted the euro still use
their national currencies, such
as the German mark or French
franc, in daily transactions.
However, the values of these
currencies are legally tied to
the euro and do not fluctuate in
relation to one another. Thus,
the euro represents units of
national currencies. For example,
x1 equals approximately 1.96
German marks (see table 1.2 for a
complete list of currency
values). This legal linking to
the euro allows financial
transactions between countries
and new issues of national debt
to be denominated in euros. Euro
coins and currency are to replace
the national coins and currency
by June 2002 at the latest, at
which time the old currencies are
no longer to be used. According
to the EU, most countries are
planning to have national coins
and currency replaced by the end
of February 2002.
Table 1.2: Euro and National
Currency Conversion Rates
X1 equals Valuea National
approximate currency
ly.
Belgian
40.34 francs
German
1.96 marks
Spanish
166.39 pesetas
French
6.56 francs
Irish
0.79 pounds
Italian
1,936.27 lira
Luxembourg
40.34 francs
Dutch
2.20 guilders
Austrian
13.76 schillings
Portuguese
200.48 escudos
Finnish
5.94 marks
aAll values rounded to two
decimal places. Exact euro values
require the use of six figures.
Source: European Council
Regulation 2866/98, December 31,
1998.
The EU set out a number of
requirements to qualify for
membership in the euro area.
Countries had to be members of
the EU and comply with four
general economic criteria: price
stability, a sustainable
government financial position,
exchange rate stability, and
convergence of long-term interest
rates. Table 1.3 spells out these
criteria in more detail.
Table 1.3: Euro Membership
Requirements
General criteria Specific
requirements
Price stability Annual rate of
consumer price
inflation must
be within 1.5
percent of
average annual
consumer price
inflation from
the three
countries with
the lowest
inflation rate
as measured by
the Harmonized
Index of
Consumer Prices
(HICP).
Sustainable General
government government
finances deficit must be
no more than 3
percent of GDP
and show
progress towards
lowering general
government debt
to 60 percent of
GDP.
Exchange rate National
stability currency
participates in
the Exchange
Rate Mechanism
(ERM) and
observes the
normal margins
of the exchange
rate mechanism
without severe
tensions or
devaluations for
2 years.
Long-term Long-term
interest rate interest rates
convergence must be within 2
percent of the
average rates
from the three
countries with
the lowest
inflation rates
as measured by
the HICP.
Source: Treaty on European Union.
The various institutions of the
EU, including the European
Commission, the Council of the
European Union, the ECB, and the
European Parliament, have
different roles in determining
which countries qualify for
membership.2 On the basis of
their respective determinations
and recommendations, on May 3,
1998, the Council of the EU
confirmed that 11 countries would
adopt the euro beginning in 1999.3
Q. What is the relationship
between the euro and European
Economic and Monetary Union
(EMU)?
A. The euro is the most
significant and far-reaching part
of the larger initiative known as
EMU. EMU is the effort by EU
countries to more closely link
their economic policies to
achieve greater political and
economic integration. EMU
continues the EU's efforts to
achieve a fully integrated single
market in goods, services, labor,
and capital within the EU. The
requirements for EMU are spelled
out in the Treaty establishing
the European Community, as
amended in 1992 and 1997
(hereafter referred to as the
Treaty), and further refined in
decisions made by the Council of
the EU.4 In general, EMU
requires countries within the EU
to implement economic policies
that ensure stable prices, sound
public finances and monetary
conditions, and a sustainable
balance of payments.
The euro is the most significant
aspect of the monetary union.
The membership requirements for
the euro area and the provisions
related to the ECB are subsets of
the EU's treaty provisions and
legislation pertaining to EMU.
For example, the requirements for
membership in the euro area
described above are spelled out
in the portion of the Treaty
related to economic and monetary
policy; protocols to the Treaty;
and subsequent Council decisions,
regulations, and resolutions.
EMU also has a number of
provisions that are not directly
related to the euro. For example,
EU member states must coordinate
their national economic policies
and provide information to the EU
on their national economies.
Representatives from EU member
states also meet periodically to
discuss approaches to economic
issues and other matters of
common concern. For example, in
recent years, EU leaders have met
to coordinate national policies
on job creation, taxes, and
European security and defense
policy. Those EU countries that
have not adopted the euro still
have to abide by most of the
other requirements of EMU.
Despite EMU and the euro,
governments still retain a high
degree of regulatory and
legislative control over large
sections of their economies,
including their labor markets,
tax codes, and welfare
legislation. National
governments are also responsible
for implementing fiscal policy.
However, countries' ability to
use fiscal policy is restrained
by EMU. The Stability and Growth
Pact, adopted by the EU in 1997,
clarified how the surveillance of
national fiscal policies will be
carried out in the EMU
environment. The Pact requires
countries to have budgets close
to balance or in surplus in order
to avoid breaching the 3 percent
of GDP deficit ceiling, except
during extreme recessions.5 For
countries that have adopted the
euro, failure to do so could
result in sanctions from the EU,
ranging from public criticism to
fines of up to 0.5 percent of
annual GDP. In addition, all
countries are required to submit
annual plans to the EU showing
how they will reach this goal.
Q. What is the rationale for the
euro?
A. Government leaders from euro
area countries cite a variety of
political and economic reasons
for adopting the euro. In
general, these countries believe
the euro supports the broader
political goals of greater
European economic and political
integration. Some leaders also
hope that the creation of a more
robust European Union will
enhance Europe's global position
in the world relative to the
United States.
From an economic perspective, the
introduction of the euro
eliminates potentially costly
fluctuations among values of
national currencies within the
euro area. It also fosters
integration of goods, services,
and financial markets. Europeans
also hope the stringent economic
requirements to join the euro
area and sustain EMU will provide
discipline to national budgets
and encourage structural change
in their economies. In
particular, some experts believe
these requirements, which impose
economic restrictions on national
monetary and fiscal policy, could
pressure countries to liberalize
labor markets and make other
structural changes in their
economies that would allow labor
and capital to move more easily
among firms, industries, and
member countries.6
Individual countries have
additional and varying national
reasons for joining the euro. For
example, German political leaders
stressed that adopting the euro
would demonstrate Germany's
commitment to remaining closely
tied to the rest of Europe.7
French politicians noted that the
euro and EMU could bolster
Europe's global influence and
ensure that France had a direct
voice in European monetary
policy.8 Italian leaders
stressed the increased economic
credibility their country would
gain by joining the euro area.
Greece did not meet the criteria
for membership in the euro area
in 1998 but, according to the EU,
it may do so in spring 2000 when
its performance will be assessed
again. The U.K., Denmark, and
Sweden chose not to adopt the
euro.
Q. Why are four EU countries not
in the euro area?
A. Although the U.K. meets the
fiscal, inflation, and interest
rate criteria for the euro, it
has not tried to join the euro
area, in part, because political
leaders and the public have not
been willing to give up the
British pound and control over
monetary policy. In 1991, the
British negotiated a provision in
the Treaty exempting the U.K.
from the euro.9 Support for the
euro in the U.K. remains low,
with one January 2000 poll
showing that those opposed to
joining the euro area outnumber
those in favor of joining by
about two to one. The U.K. does
not plan to join the euro area
until it has achieved greater
economic synchronization with the
rest of the EU.10 The government
has also pledged that any
decision to adopt the euro must
be ratified by the public in a
national referendum before going
into effect.
In 1992, voters in Denmark
rejected the proposed amendments
to the Treaty that had been
negotiated in Maastricht. This
created a political crisis within
the EU because all EU member
states had to approve the
proposed amendments before they
could go into effect. Thus,
Denmark could have entirely
stopped EMU. To avoid this, the
EU exempted Denmark from having
to join the euro area. Danish
voters approved the amended
treaty in 1993. Currently,
according to public opinion
polls, the majority of the Danish
public supports adopting the
euro, and the government plans to
hold a national referendum on
eventual membership.
Sweden joined the EU in January
1995. Two years later the
Swedish government decided Sweden
should not join the euro area
because of lack of popular
support. However, unlike Denmark
and the U.K., Sweden does not
have a special opt out clause in
the Treaty. To avoid membership
in the euro area, the Swedish
government ensured it would not
meet the exchange rate criteria
for membership. The ruling party
has since come out in favor of
joining the euro area, but it has
not yet set a date for a national
referendum on the issue.
Greece wanted to join the euro
area but could not meet the
economic requirements. The Greek
government, backed by a solid
majority of the population who
support joining the euro area,
plans to reapply in March 2000 in
an attempt to gain membership in
2001.
Q. Is the euro sustainable?
A. Most experts maintain that
there are many reasons to believe
the euro is sustainable.
Adopting the euro has been a top
political priority of the euro
area governments. Although ruling
political parties have changed
during this time, political
support for the euro has not,
even though some countries had to
implement sometimes painful
economic policies to join the
euro area. Many experts told us
that the current political
leaders in the euro area
countries and the EU will not
allow the euro to fail.
However, some analysts have
observed that the euro's
sustainability will not be known
until it has been tested by
stress or even an economic
crisis, especially a crisis that
affects member countries
differently . If the public
believes that their country is
suffering additional economic
harm from the euro, there could
be greater pressure on political
leaders to back away from their
support for the euro. Some
experts have also pointed to the
euro's potential for creating
greater political and economic
strains among national
governments. For example,
national leaders will no longer
be able to use monetary policy or
reductions in exchange rates to
soften the impact of economic
shocks. In addition, the EMU
requirement to maintain a roughly
balanced budget places some
limits on the ability of national
governments to spend more money
to provide fiscal stimulus during
economic downturns.
As a practical matter, it would
be very difficult for a country
to withdraw from the euro area.
Many experts believe that the
economic disruptions of leaving
the euro area and recreating a
national currency could outweigh
the possible benefits of
regaining a national currency and
national monetary policy.
Politically, there are no
provisions in the Treaty for a
country to voluntarily withdraw,
nor are there processes for
removing a country against its
will. If a country left the euro
area, it would violate the Treaty
and likely trigger a political
crisis within the EU.
According to experts, failure to
maintain the euro area would have
far-reaching consequences for
Europe and the rest of the world.
Most agree that only a major
economic or political crisis
could bring down the euro area.
The collapse of the common
currency would create economic
uncertainty in Europe with likely
spillover effects onto the rest
of the global economy.
Politically, failure of the euro
area would be a major setback for
the EU. According to many
analysts, it would bring EU
enlargement to a halt and
undermine the credibility of
other EU initiatives.
Table 1.4: Chronology of Selected
Events Surrounding the Euro
Date Event
March Six European countries sign the Treaty
1957 of Rome, establishing the European
Economic Community (EEC).
January Council adopts first regulations
1962 establishing common market in
agriculture.
July 1968 Customs union completed, common external
tariff established, and freedom of
movement guaranteed for workers within
the EEC.
February The 12 members of the European Community
1986 sign the Single European Act. The act
extends the powers of the Community and
establishes framework for a single
market.
June 1989 European Council calls for negotiations
on treaty revisions necessary for the
introduction of EMU and the euro based
on plan developed by governors of
central banks and Commission President
Delors.
February Maastricht Treaty signed by EU heads of
1992 state and government.
1992-1993 Treaty ratified by EU member states.
1993-1997 Countries reduce inflation and cut
budget deficits to meet euro membership
criteria.
1994 European Monetary Institute created as
the precursor to the ECB.
June 1997 EU adopts the Stability and Growth Pact.
May 1998 Council of the EU announces
participating countries.
January ECB begins operations as a central bank.
1, 1999 Irrevocable fixing of conversion rates
to euro. National debt converted into
euros.
By The euro notes and coins are to be
January introduced among the participating
1, 2002 countries.
By June National currencies are to be withdrawn,
2002 and only euro notes are to be legal
tender.
Source: European Union.
_______________________________
1GDP refers to the total value of
goods and services produced in an
economy in one year.
2The European Commission proposes
policies and legislation, is
responsible for administration,
and ensures that provisions of
the treaties and the decisions of
the EU institutions are properly
implemented. The Council of the
EU is composed of ministers or
heads of state and government
representing the member states.
The European Parliament comprises
626 members, directly elected in
EU-wide elections for 5-year
terms.
3The European Monetary Institute,
the ECB's precursor, participated
in the 1998 decisions. The ECB
will participate in future
decisionmaking on euro area
membership.
4Decisions made by the Council of
the EU are legally binding on all
EU member states. Most decisions
are made by majority vote, but
some require unanimity.
5This provision was added to
ensure that countries could
increase spending during mild
economic recessions and still not
exceed the 3 percent of GDP
deficit limit set by the Treaty.
6Some examples of potential
structural changes include
reforming labor laws to make it
easier to hire, train, and fire
workers; allowing greater labor
mobility across the EU; and
reforming pensions to reduce
fiscal burden and allow
portability across countries.
7The political negotiations over
the euro took place in the later
1980s and early 1990s, at
precisely the same time Germany
was reunifying. Other countries
in Europe were concerned that a
larger Germany could dominate the
continent.
8Before the euro, the German
Bundesbank (Germany's central
bank) was viewed as, de facto,
setting monetary policy for the
rest of Europe. Because the
German economy was so much larger
and the mark was viewed as the
strongest currency, other EU
countries who had entered the ERM
felt pressure to follow the lead
set by the German central bank.
9Modifications to the Treaty on
Europe must be approved by all
member countries. The U.K. would
not approve the changes necessary
to implement the euro unless it
was allowed to opt out.
10The U.K. government says that
monetary union membership is
contingent on five tests: (1)
compatibility of the U.K.
business cycle with the rest of
Europe, (2) ability to react to
problems with sufficient
flexibility, (3) impact on
foreign direct investment in the
U.K., (4) impact on national
financial services, and (5)
implications for growth and
employment.
Chapter 2
How Could the Euro
Affect the Dollar As
An International
Currency?
Page 21 GAO/GGD/NSIAD-00-105
Q. What is an international
currency?
A. An international currency is
one that is used for payments and
finance outside the issuing
country's borders. In the case of
the U.S. dollar, for example, a
sizeable amount of international
trade that never crosses our
borders is invoiced and paid for
in dollars. Banks outside the
United States take deposits and
make loans in dollars. Dollar-
denominated bonds are issued
outside the United States. U.S.
dollar currency notes circulate
in substantial amounts in some
foreign countries, sometimes for
illicit purposes. In addition to
these uses, which largely involve
private sector entities, foreign
central banks hold dollars as
part of their official reserve
holdings.
Q. How could the euro change the
dollar's use as an international
currency by the private sector?
A. The dollar is used by the
private sector in a variety of
ways. The dollar is the primary
transaction currency in
international trade. Presently,
the dollar plays a dominant role
in invoicing around the world,
especially for primary
commodities like oil. In1998, it
was estimated that the dollar
served as the payment currency
for about 48 percent of world
trade, although the U.S. share of
world trade was about 18 percent.
This provides an incentive for
companies engaged in
international trade to maintain
working balances in dollars. In
the EU's view, the use of the
euro in trade invoicing (not
counting intra-euro area trade)
is likely to exceed the sum of
the currencies that have been
replaced by the euro. This is
due in part to economies of scale
in the use of currencies leading
to lower transaction costs and
better availability of hedging
instruments.
The dollar is also the primary
currency of international
banking. Bank for International
Settlements (BIS)1 data show that
at the end of 1998, about 41
percent of international bank
assets2 were denominated in U.S.
dollars (see fig. 2.1); however,
the U.S. banks' share of
international bank assets was
about 11 percent. This shows that
the dollar is used by non-U.S.
banks as well as U.S. banks.
The dollar's 41-percent share of
international bank assets in 1998
was well below its 63-percent
share in 1985. At the end of
1998, the largest portion of the
"all other currencies" category
was the national currencies of
euro area members, which
accounted for about 31 percent of
international bank assets.
Figure 2.1: Cross-Border Assets
of Banks in Industrial Countries
by Currency (1985-1998)
Source: BIS.
A large share of international
bonds and notes is issued in
dollars.3 (See fig. 2.2.) BIS
data show that at the end of
1998, about 45 percent of
international bonds and notes
outstanding was denominated in
dollars. Less than half of these
have been issued by U.S.
borrowers, who accounted for 20
percent of the total outstanding.
The largest share of bonds and
notes issued in currencies other
than the dollar was issued in the
national currencies of euro area
members. These currencies
accounted for about 28 percent of
the total at the end of 1998.
During the period 1985 to 1998,
the dollar share of international
bonds and notes outstanding
fluctuated between a high of
about 57 percent in 1985 to a low
of about 35 percent in 1995.
Figure 2.2: International Bond
and Note Issues Outstanding by
Currency (1985-1998)
Source: BIS.
In some foreign countries, U.S.
dollar currency notes circulate
in substantial amounts.4 In these
countries, the dollar is used as
a substitute for local cash
transactions-particularly in
countries where hyperinflation or
social disorder undermines the
public's faith in the local
currency. In mid-1998, it was
estimated that about 60 percent
of the $441 billion dollar notes
in circulation-about $265 billion-
-were held outside the United
States. Many of these dollar
notes are used in underground
economies, and it is widely
believed that some of these
dollars are used as a medium of
illicit exchange.
Holdings of paper currency by the
public, whether inside or outside
the United States, serve as a
form of interest-free financing
for the U.S. government. Using an
interest rate of 5 percent, the
foreign holdings of dollar notes
yield a seigniorage of about $13
billion a year. That is, the
U.S. government saves $13 billion
annually because foreigners hold
currency instead of interest-
paying bonds. If euros were to
become more widely used for
similar purposes, outside the
euro area there would be a
decreased demand for dollars, and
it is possible that the U.S.
government would lose some
earnings it receives through
seigniorage.
A variety of factors will
determine whether the emergence
of the euro will have a
significant impact on the
international role of the dollar.
Euro area companies may be in a
stronger position than before to
require that the euro be used in
their transactions in order to
avoid exchange rate risk. The
analysts we spoke with told us
that those nonindustrial
countries that had been
conducting their cross-border
transactions in the currencies of
the member countries of the euro
area are expected to do so in
euros. Those developing
countries closely linked to the
United States would continue to
use dollars.
Over the longer term,
several of the analysts we spoke
with believe that the comparative
status of the dollar and euro as
international currencies may be
affected by potential
developments in the euro area
payments and securities
settlements infrastructure. The
U.S. dollar is supported by
systems that allow money and
financial assets to be moved with
great speed, efficiency, and
reliability. In the euro area,
each country still has its own
separate systems for wholesale
payments. The ECB has established
a new wholesale system for cross-
border euro payments called Trans-
European Automated Real-Time
Gross Settlement Express Transfer
System (TARGET), which links the
comparable systems of each member
central bank. TARGET must be
accessed through the national
systems, which are not yet
harmonized. Nonetheless,
progress is being made in dealing
with euro area-wide payments and
securities infrastructure. The EU
expects lower transaction costs
to result from this process.
Through the first 10 months of
1999, TARGET carried 69 percent
of euro payments value.
Moreover, providers of securities
infrastructure services announced
a wide range of plans involving
integration of their systems
through links or cross-border
alliances. Lower transaction
costs are not only related to
official payments systems and
securities settlement systems,
but also to economies of scale
for enterprises, banks, and in
the foreign exchange markets.
Responses of investment managers
to the euro as an investment and
financing currency will depend on
the euro's competitiveness with
the dollar as an international
currency.5 The decisions of
these private agents will be
influenced by factors that make
euro-denominated investments
attractive, such as the
prospective ECB monetary policy
stance, the inflation rate in the
euro area, the perceived
riskiness of the rate of return
on euro-denominated assets, and
economic growth in Europe.
Economic size favors neither the
dollar nor the euro because the
economies are similar in size.
Relative confidence in the
currencies is likely to depend
upon both economic performance
and the monetary policy stances
taken by the respective central
banks. Both the Federal Reserve
and the ECB have pursued stable
monetary policies aimed at low
inflation. Officials in the
United States and Europe stressed
that the dollar's international
role will not be challenged if
the underlying strength of the
U.S. economy remains
fundamentally sound.
It is possible that the euro
could eventually affect the
dollar's position as the premier
international currency. However,
most analysts we spoke with and
documents we reviewed maintained
that the euro is not likely to
cause a sudden decline in the
dollar's use as an international
currency in the near future, and
any shift away from the dollar
will be gradual. Some experts
argue that the euro is not likely
to displace the dollar's
international role because of
inertia in the use of
international currencies and that
at best, the euro will complement
the dollar. There are, however,
other experts who argue that the
euro will compete with the dollar
for a substantial share of its
international role. An
intermediate view is that the
euro's gains will not necessarily
come at the expense of the dollar
because increased use of the euro
may not decrease the use of the
dollar in absolute terms.
Q. How could the euro change the
dollar's use as an international
currency for official purposes?
A. Central banks around the world
hold large amounts of currency
reserves, and a large portion of
these reserves is denominated in
dollars. Central banks hold
foreign currency reserves for use
in case they wish to intervene in
foreign exchange markets to
prevent the exchange rate of
their domestic currency from
falling against foreign
currencies.6 From 1985 through
1998, the dollar's share of
official foreign exchange
reserves ranged between about 44
percent and 57 percent, the peak
year being 1998. (See fig. 2.3.)
At that time, the euro area
national currencies and the
European Currency Unit (ECU)7
accounted for about 15 percent of
official currency reserves .
Figure 2.3: Official Foreign
Exchange Reserves by Currency
Denomination (1985-1998)
Source: IMF.
Another official international
role for a currency is as a base
against which other countries
might "peg" their exchange rates.
Countries peg their exchange
rates by tying the value of their
currency to the currency of
another country-typically the
currency of its largest trading
partner. The value of the pegged
currency rises or falls
simultaneously with the value of
the currency to which it is tied.
Several dozen smaller countries
around the world peg their
currencies to the dollar, the
euro, other currencies, or a
basket of currencies. A country
that pegs its currency to another
is likely to keep most of its
foreign exchange reserves in that
other currency.
Some Eastern European countries,
which have pegged their
currencies to the German mark in
the past, now peg their
currencies to the euro. The euro
has replaced the former national
currencies of the French franc
and the Portuguese escudo as a
pegging currency. The EU expects
more countries to peg their
currencies to the euro in the
future, in some cases upon
accession to the EU. Experts we
spoke with expect the countries
that pegged their exchange rates
to the dollar before the advent
of the euro to continue to do so
because it makes economic sense
for them.
Most Latin American and Asian
countries have closer trade
relations with the United States
than with Europe, and thus it
seems likely that these countries
will continue to use the dollar
as a reserve currency. However,
it also seems likely that the
euro would be used by countries
that intend to peg their exchange
rates to the euro or to intervene
in currency markets in the euro
for other purposes.
Before the inauguration of the
euro, there were questions about
whether the European System of
Central Banks (ESCB)8 and other
central banks around the world
might sell large amounts of their
dollar reserves. Prior to EMU,
the central banks of the present
members of the euro area needed
part of their reserves for
possible intervention in the
currency markets in case of
instability between their
currencies. Once EMU converted
the intrazone trade and capital
flows into domestic-currency
transactions, such intervention
was no longer necessary, and it
was thought that the pooled
foreign currency reserves of the
ESCB might exceed the potential
reserve needs of EMU.9 The ECB
reported that in 1999 some of the
national central banks did reduce
the proportion of foreign
reserves in their balance sheets.
Nonetheless, such actions were
not sizeable; between the end of
January and the end of October
1999, the combined foreign
exchange reserves of the euro
area only dropped from $234
billion to $223 billion. The
impact of reduction in excess
reserves would be small relative
to the stock of U.S.
international assets and
liabilities. Moreover, statements
from both the ECB and the U.S.
Treasury indicated that dramatic
or abrupt changes in the currency
reserves of the central banks
were unlikely.
A shift in the type of reserves
held by developing countries may
have more of an effect on the
value of the dollar than a shift
by industrialized countries. As
of March 1999, International
Monetary Fund (IMF) data show
that developing countries held 58
percent of global foreign
currency reserves, and developed
countries held 42 percent of
global foreign currency reserves.
As of the end of 1998, 57 percent
of developing country currency
reserves was dollars, and 64
percent of developed country
currency reserves was dollars.
The ECB expects the euro to
inherit the reserve currency
roles of the respective euro area
former national currencies and to
be the second most used
international reserve currency.
Most analysts maintain that the
advent of the euro is not likely
to cause a sudden decline in the
use of the dollar as a reserve
currency in the near future.
Central banks have traditionally
refrained from abrupt and large
changes in the level and
composition of their foreign
reserves. Over time, official
sector preferences for currency
use could change, and the euro
could eventually replace part of
the dollar's role as a reserve
currency, but experts we spoke
with expect any change to be
gradual. As the euro achieves
depth and liquidity, over time
central bankers may see it as an
increasingly desirable currency
for diversification purposes.
Ultimately, the ability of the
euro to become a major reserve
currency will depend on the
confidence that both foreign
central banks and international
investors have in it as well as
on its usage in international
trade and finance.
Although there are certain
economic benefits that derive
from the public and private
international roles of the
dollar, the importance of such
benefits is uncertain. Some
analysts believe that these roles
provide, in addition to economic
benefits, important political
benefits to the United States
that are worth maintaining. Other
analysts believe the importance
of a country's currency has
little to do with the well-being
of its citizens over the long
run, as attested by the
experience of many successful
economies whose currencies do not
have major international roles.
_______________________________
1BIS is an organization of major
central banks that is based in
Basel, Switzerland. It is the
principal forum for consultation,
cooperation, and information
exchange among central bankers.
2International bank assets are
assets of banks located in 24
major industrialized countries or
off-shore centers.
3International bonds and notes
include both domestic currency
issues in a given country by
nonresidents of that country
(e.g., dollar bonds issued in the
United States by foreign
entities) and foreign currency
issues in a given country by
either residents or nonresidents
(e.g., dollar bonds issued in
London by either a U.S. company
or a British company).
4See C. Randall Henning,
Cooperating with Europe's
Monetary Union, Institute for
International Economics,
Washington, D.C.: May 1997.
5See "The International Role of
the Euro," ECB Monthly Bulletin,
August 1999.
6The foreign exchange markets are
where domestic currency is
exchanged for foreign currency.
When one country experiences an
increase in demand for foreign
currency relative to its domestic
currency, the exchange rate of
the domestic currency will fall.
A central bank can "intervene" or
try to influence this by selling
foreign currency and buying its
domestic currency.
7The European Currency Unit is a
composite basket of currencies in
which each currency is weighted
according to its share in intra-
European trade, its percentage
share of EU gross national
product, and the relative
importance of each country's
foreign exchange reserves. As of
January 1, 1999, the ECU was
converted into the euro on a one-
for-one basis.
8ESCB comprises the ECB and the
central banks of all EU member
countries.
9Note that the creation of the
euro did reduce the ESCB's
currency reserves somewhat,
because the portion of each
national central bank's reserves
that had been in other members'
currencies was converted into
domestic currency upon creation
of the euro. In January 1999, the
euro area foreign exchange
reserves dropped by $32.8
billion, possibly reflecting this
effect.
Chapter 3
What Could Be the
Effects of EMU on
Monetary Policy and on
Exchange Rates?
Page 38 GAO/GGD/NSIAD-00-105
Q. What is monetary policy?
A. Monetary policy is the set of
central bank actions that adjust
the supply of money and credit
conditions in the economy to
achieve a set of policy goals.
Important monetary policy goals
include price stability, economic
growth, and keeping output near
its potential and, thus,
unemployment low. An additional
objective is to manage credit
conditions to facilitate a
smoothly functioning economy.
Monetary policy is designed to
affect economic variables such as
interest rates and the level of
output and employment in the
short run in ways compatible with
long-run policy objectives.
An "easy" monetary policy lowers
unemployment and increases output
over the short run through faster
monetary growth and possibly
lower interest rates. However,
these effects may not last over
the long term, and such a policy
also tends to raise the rate of
inflation and decrease the value
of the currency on international
markets. In contrast, a "tight"
monetary policy raises interest
rates and lowers inflation,
possibly at the cost of higher
short-term unemployment. Such a
policy can also increase the
value of the currency on
international markets. A tension
exists in monetary policy
decisions between the desirable
goals of low unemployment and low
inflation.
Q. How is monetary policy set and
implemented in the euro area?
A. In the euro area, monetary
policy is decided upon and
implemented by the European
System of Central Banks (ESCB),
which consists of the ECB and the
central banks of all EU members.1
The Governing Council of the
ECB-composed of the 6-member
Executive Board plus 1
representative from each of the
11 euro area member central
banks-formulates monetary policy,
and the Executive Board
implements monetary policy
through the national central
banks. A central way monetary
policy is conducted is through
open market operations--the
buying and selling of approved
securities.2
According to the Maastricht
Treaty, the ECB's primary goal is
price stability, which the ECB
has operationally defined as less
than 2 percent per year of
inflation in consumer prices. In
contrast to the German
Bundesbank, the leading European
central bank, which had aimed for
a specific rate of growth of its
money supply, the ECB's stated
policy is to be more flexible and
consider other indicators in
making monetary policy decisions.
Specifically, the ECB has set
forth a "two-pillar" strategy for
conducting monetary policy, which
includes (1) a reference value
for money supply growth of 4 �
percent annually in the broadly-
defined money supply measure, M3;3
and (2) a broad-based assessment
of the outlook for inflation
generally.
A fundamental question
surrounding the introduction of
the euro was whether the ECB
would pursue a relatively strict
monetary policy and maintain low
inflation over the long run in
the face of potential pressures
to pursue an easy monetary policy
to lessen (short-run)
unemployment. Those who raise
this question cited several
factors including that almost two-
thirds of the ECB's Governing
Council are representatives of
national central banks that have
only recently become independent,
and more liberal member
governments may come into power
and pressure the ECB for a more
expansionary monetary policy.
In its brief history, the ECB has
appeared to be focused on price
stability in numerous public
statements. To date, inflation
has remained modest, generally
not exceeding 2 percent per year,
and broader measures of the euro
money supply have grown
moderately, although above the
reference value rate .4 One
issue continues to be how the ECB
will conduct monetary policy when
economic conditions differ
significantly among member
countries--if, for example, the
economies of some countries, but
not others, are depressed by
external or internal events.
Q. How could the euro affect
monetary policy in the United
States?
A. Conducting U.S. monetary
policy is the responsibility of
the Federal Reserve System (the
Fed), the central bank of the
United States. Congress has
defined the primary objectives of
national economic policy as
economic growth, a high level of
employment, stable prices, and
moderate long-term interest
rates, and the Fed is required to
pursue these goals.5 As a
practical economic matter,
tensions can arise in the pursuit
of these goals. In general, low
inflation has been a clear
priority of U.S. monetary policy
over the past 15 years.
Open market operations are the
principal means of conducting
U.S. monetary policy. They are
the responsibility of the Federal
Open Market Committee, which
comprises all 7 members of the
Board of Governors of the Fed
plus the presidents of each of
the 12 (regional) Federal Reserve
banks.6 After considering the
current and expected state of the
economy and its future prospects,
including domestic and foreign
economic activity, output,
inflation, wage inflation,
interest rates, money supply
growth, consumer spending, and
securities markets, the committee
decides upon what it considers an
appropriate open market policy
for the New York Federal Reserve
Bank to implement. Meetings
occur eight times a year.
The Board of Governors oversees
two other tools of monetary
policy. The discount rate- the
rate at which banks and other
deposit-taking institutions can
borrow from their Federal Reserve
Banks-is changed from time to
time to reinforce open market
operations. Reserve
requirements-the schedule by
which these institutions must
keep reserves as cash in their
vaults or as deposits in accounts
at the Fed-are rarely changed.
Although the Fed determines U.S.
monetary policy primarily on the
basis of domestic economic
conditions, the Federal Reserve
also takes international
conditions into account insofar
as they influence U.S. domestic
objectives. For example,
increases in the price of oil, an
international commodity, can
significantly affect the U.S.
inflation rate and has influenced
U.S. monetary policy. Similarly,
following the Russian default in
1998, the Fed started to ease
U.S. monetary policy by lowering
short-term interest rates in
September to offset the downward
effect on U.S. economic growth of
increasing weakness in foreign
economies. Monetary policy does
affect exchange rates; however,
according to Fed officials, in
recent years the Fed has not
intervened in the foreign
exchange market, except to combat
disorderly markets during brief
periods.
Although the Fed has a track
record of cooperating and
coordinating with some of the
central banks in the ESCB, it has
little experience dealing with
the ECB as it is a new
institution. Thus, how those
interactions will affect U.S.
monetary policy is yet to be
determined.
Q. How can exchange rates vary?
A. Exchange rates vary due to a
variety of influences-current and
expected monetary, fiscal, and
structural policies, as well as
cyclical and other economic
forces. Exchange rate movements
can be characterized in terms of
longer term trends and shorter
term fluctuations around those
trends, termed volatility.
Generally, the more that two
countries' fundamental economic
conditions or macroeconomic
policies differ, the greater will
be the trend movement of their
common exchange rate, other
things being equal. Volatility
reflects market participants'
reactions to new information on a
variety of changing economic as
well as other conditions. Actual
or expected intervention by the
central banking authority in the
foreign exchange market to
maintain the exchange rate can,
in certain cases, reduce
volatility.
Q. What is the recent history of
exchange rate variations among
euro area members?
A. Although exchange rates among
continental European countries
have been relatively stable in
recent years, governments have at
times experienced difficulties in
defending currency values, with
the latest currency crisis
occurring in 1992-93. Governments
of EU member states have tried to
lessen exchange rate variability
among their countries for some
time, due to the high degree of
trade and investment among them.
Some central banks have
intervened in foreign exchange
markets and increasingly
governments have coordinated
macroeconomic policies to reduce
exchange rate fluctuations. A
common view is that large
fluctuations in currency values
result in increased costs to
businesses to cover the risks of
conducting international
transactions, although the effect
of such costs on trade volume is
not clear.
Q. How could the euro affect
exchange rates with other
currencies?
A. The euro's effect on the
volatility of the euro area's
external exchange rate with
respect to other currencies-e.g.,
the dollar-has been subject to
debate among international
economists. Some economists have
argued that the euro will be more
volatile against other currencies
than were the major national
currencies of euro area members,
and others have argued that
volatility will be less.
Reasons given for higher expected
volatility are (1) during the
initial period of the euro there
will be greater uncertainty about
how the ECB will conduct monetary
policy, a rapidly changing
financial environment in Europe,
and unknown shifts by
international investors and
central banks; and (2) the ECB
may be less concerned about
exchange rate fluctuation than
the individual central banks had
been before EMU because creation
of the large, single-currency
zone reduces the share of GDP
that is influenced by these
fluctuations.
One reason given for possible
lower volatility is that the
monetary policy of the euro area
is likely to respond to business
conditions across the euro area
and not a particular country.
These conditions can vary across
countries. Thus, interest rates
in the euro area, reflecting more
heterogeneous business
conditions, could fluctuate less
than they would have for one
country, leading to less
fluctuation in capital flows
between the euro area and the
rest of the world, and less
fluctuation in the euro exchange
rate, other things being equal.
Over the longer term, the
credibility of the value of the
euro currency will likely depend
primarily on the performance of
euro area economies and their
economic policy mix.
Q. How has the euro-dollar
exchange rate varied?
A. After its introduction in
January 1999, the euro steadily
declined in value, going from
$1.17 to about $1.02 by July 1.
Its value recovered somewhat
after that but declined again,
dropping below $0.98 by the end
of January 2000, a more than 16-
percent depreciation since
January 1999 . Because the euro
was launched at a point when the
values of euro area currencies
against the dollar were
relatively high compared to the
previous 2 years, it is difficult
to know at this point the
significance of this decline.
One factor behind the
depreciation against the dollar
may be the relative strength of
the U.S. economy, which led to an
increased demand by foreigners
for U.S. stocks and bonds and
increased foreign direct
investment in the United States.
Some analysts also believe that
slow progress in restructuring
economies in some euro area
countries has also lowered the
market's confidence in the euro.
Figure 3.1 shows recent trends in
the dollar-euro area exchange
rate.
Figure 3.1: Dollar-Euro Area
Exchange Rate, January 1996 -
February 2000
Note: Values before January 1999
reflect a synthetic euro based on
trade-weighted averages of the
exchange rates of the 11 euro
area countries. Beginning in
January 1999, values reflect
observed dollar-euro exchange
rates.
Source: Department of Commerce.
Future movements of the dollar-
euro exchange rate are likely to
depend upon the macroeconomic
policies of the United States and
euro area countries, their future
relative economic growth, how
quickly euro area countries
restructure their economies, and
other forces affecting these
economies.
_______________________________
1The four EU member states that
are not part of the euro area
have a special status; they are
allowed to conduct their national
monetary policies and do not take
part in decisionmaking nor in
implementation of the common euro
area monetary policy.
2Other tools of monetary policy
include setting (1) the interest
rate of the Marginal Lending
Facility, through which eligible
financial institutions may borrow
overnight from ESCB; (2) the
interest rate in the Deposit
Facility, through which ESCB
accepts overnight deposits from
eligible financial institutions;
and (3) financial institutions'
reserve requirements.
3The most common measures of
money are M1, M2, and M3. M1 is
the narrowest measure and
includes the most liquid assets--
currency held by the
(nonfinanacial institution)
public and checking account-type
balances at financial
institutions. M2 is a broader
concept, and includes, for
example, certain time deposits.
M3 is the broadest measure; in
addition to M2, it includes other
assets such as large time
deposits, and marketable
liabilities of financial
institutions.
4From December 1998 through
January 2000, M3 grew almost 6
percent.
5These laws include The Federal
Reserve Act of 1913, which
established the Federal Reserve
System; The Employment Act of
1946; and The Full Employment and
Balanced Growth Act of 1978, also
known as the Humphrey-Hawkins
Act, after its original sponsors.
6At any one time only five
presidents may vote, one of whom
is the head of the New York
Federal Reserve Bank.
Chapter 4
What are the
Implications of EMU
for Financial Markets,
Financial
Institutions, and
Their Regulation?
Page 42 GAO/GGD/NSIAD-00-105
Q. What are the implications of
the European Monetary Union (EMU)
for financial markets,
institutions, and their
regulation?
A. EMU is a major step in the
economic unification of Europe,
which began with the Treaty of
Rome in 1957. As with the
nonfinancial aspects of
unification, EMU is intended to
strengthen Europe economically by
achieving the benefits of
economies of scale. From the U.S.
perspective, key questions about
EMU focus on financial markets,
banking, and financial
regulation.
Q. How could the euro affect
financial markets in Europe and
the United States?
A. Financial markets serve
investors and users of capital
better when the markets have
sufficient size and liquidity to
allow large sums to be traded
without destabilizing prices. By
substituting a single currency
for numerous currencies that
could fluctuate against each
other, EMU and the euro are
intended to add to the depth,
liquidity, and competitiveness of
capital markets in the euro area,
and to lower trading costs for
borrowers. Although EMU does not
by itself make one uniform and
unified market, the establishment
of the single currency removes an
important impediment to the intra-
euro area capital flows: i.e.,
exchange rate risk. Some experts
have said that the largest effect
of the creation of the euro will
be the transformation of
financial services in Europe.
They predict that European stock
and bond markets will become more
integrated over time and could
rival stock and bond markets in
the United States. The
introduction of the euro may
eventually create the largest
single-currency financial market
in the world.1
Various structural differences
still exist in the euro area
financial markets. The
development of Europe-wide
private securities markets has
thus far been inhibited by long-
standing regulations for issuing,
dealing, and trading securities;
by elements of tax systems that
encourage bank financing; and by
differences in market practices
and in securities and settlement
systems. With the introduction of
the euro, European financial
markets could become less
segmented and market practices
could be more uniform.
Nonetheless, the first year of
the euro was marked by a surge of
activity in euro-denominated
international debt securities.
In the first 9 months of 1999,
announced new issues of such
securities almost doubled
compared to the amounts for the
pre-EMU currencies in January-
September 1998. As shown in
figure 4.1, in the 1999 period,
the euro-denominated share of
international securities issues
climbed, and that of dollar-
denominated announced issues
dropped. The inauguration of the
euro was an important factor in
the strength of euro-denominated
issues: according to BIS, the
merger of euro area currencies
can broaden the range of
investors who might be interested
in investing in some bond issues
and also resulted in a pooling of
investment demand. One reason for
this increased bond issuance in
1999 was an upsurge in merger and
acquisition activity in the euro
area, according to an IMF
official. One financial services
industry official told us that
part of the surge in euro issues
last year may have reflected
temporarily favorable terms
offered by underwriters competing
to establish market share.
Figure 4.1: Announced New Issues
of International Bonds and Notes
(January - September 1998 and
1999)
Source: BIS.
Just as dollar-denominated debt
issues have been issued by non-
U.S. entities, euro-denominated
issues have been issued by non-
euro area entities. Countries
such as Brazil, Argentina, South
Africa, and Canada have launched
euro issues in significant
amounts; according to the ECB,
this was in order to rebalance
the currency composition of their
foreign debt. Moreover, U.S.-
based companies have issued euro-
denominated debt. Nonetheless,
there is a stronger "home-
currency bias" for euro-
denominated issues; BIS data show
that less than half of
outstanding dollar-denominated
issues have been issued by U.S.
entities, but 68 percent of euro-
denominated issuance has been
raised by euro area borrowers.
Most of the rise in international
debt securities issuance in 1999
has come from European companies,
a growth that BIS ascribes to the
euro.
Not only was there an increase in
the total amount of euro-
denominated funds raised in 1999,
there was also a broadening of
the type of European companies
that were able to tap this
market. Previously, corporate
securities issuance in Europe had
been primarily by the highest-
rated and best-known companies;
other companies were more
dependent on financing from
banks. Changes in investor
strategies stemming from the
merging of currencies, however,
facilitated the entry of lower
rated borrowers into the
international bond market.
Because EMU will permit investors
to more accurately assess and
price corporate risk, higher
yielding debt issued by small to
medium sized or highly leveraged
companies will become more
attractive. The emergence of a
European junk bond market is
widely predicted.
An opening of securities issuance
to less-than-highest-rated
companies may lessen some
borrowers' dependence on bank
loans. This would move Europe
toward a more U.S.-style
financial system, where financial
markets are a more important
source of finance than bank
lending. Figure 4.2 shows the
comparative shares of securities
and bank financing in the euro
area countries and the United
States in 1995. In the United
States, combined stock market
capitalization plus outstanding
debt securities amounted to $17.9
trillion, compared to bank assets
of $5 trillion.2 In the euro
area countries, the comparative
sizes were reversed, with bank
assets of $12 trillion exceeding
combined stock and debt
securities of $9 trillion.
Figure 4.2: Size of Euro Area
Versus United States Financial
Markets (End- 1995)
Source: IMF.
The faster growth of euro-
denominated activity on the
international financial markets
does not appear to have been at
the expense of U.S. entities. As
noted, U.S.-based borrowers have
issued euro-denominated debt.
Moreover, the move toward a more
unified financial market in the
euro area has presented
opportunities for U.S. financial
services companies. These
companies, through their
experience at home, have
developed considerable expertise
in such activities as securities
underwriting and mergers and
acquisitions. Notwithstanding
shifts in the currency
composition of issues in 1999,
data for the first 9 months of
1999 show that U.S. investment
banks increased their share of
international bond underwriting
to 45 percent, up from 41 percent
in 1998. European underwriters
had about a 40-percent share in
the 1999 period.
Q. What impact might the euro
have on the market for U.S.
Treasuries?
A. By eliminating currency risk
on cross-border transactions, the
introduction of the euro has
reduced the cost of issuing and
investing in euro area government
securities. Some analysts have
questioned whether the U.S.
Treasury bond market might be
challenged by a euro-denominated
government bond market of bonds
issued by euro area
countries-especially in an era
when the United States is issuing
less debt. This question arises
because existing euro area
national government debts that
were previously denominated in
national currencies and all
future issues are now denominated
in the single currency. The
totals of euro area government
debt exceed the amount of
publicly issued U.S. Treasury
debt.
Nonetheless, since the conversion
of government debt to the euro,
interest rate differentials still
exist between the different
governments' debt. One analyst
has compared these interest rate
differentials to the different
interest rates of U.S. state and
municipal bonds. Although there
has been some convergence of
interest rates, these
differentials reflect, among
other things, the respective
credit standing of each
government's debt, which still
depends on that country's ability
to service its debts in the
future. There is no common
taxing authority in the euro area
and no statutory guarantees of
one country's debt by another.
Each euro area member has
different financial needs, fiscal
policies, and regulations.
Interest rate differentials may
also depend on issuing
techniques, clearance and
settlement procedures, and legal
procedures. Thus, the government
bonds are not deemed to be
fungible, and there are still as
many different government bond
markets as there had been
previously. Treasury officials we
spoke with believe that the
possibility of a unified euro-
government bond market competing
with the U.S. Treasury market is
unlikely at the present time.
According to the EU, although the
euro area government bond market
is not yet unified, greater
harmonization is being promoted
through extensive consultations
that take place among national
debt offices on instruments and
issuing techniques and practices.
A European debt agency has been
proposed to issue debt
instruments on behalf of national
governments. Such a supranational
debt agency would require a
costly process of revision and
amendment of European treaties.
Q. How could the euro affect
banking in Europe and the United
States?
A. Banks operating in the euro
area, including U.S. banks, are
facing a number of possible
effects stemming from the
establishment of EMU.3 The
reduction of foreign exchange
activity in currencies replaced
by the euro was regarded by banks
as the main negative consequence
of EMU. Creation of a single-
currency area removes one
deterrent to banks in any one
euro area country from conducting
banking in another euro area
country, namely the risk of
adverse moves of exchange rates.
Because the disappearance of
national currencies reduces the
home currency advantages that
banks in euro area countries had
vis-�-vis banks in other euro
area countries, the introduction
of the euro can be expected to
trigger a further increase in
cross-border competition and
operations of banks. This
increased competition could put
downward pressure on
profitability.
Faced with the potential for
greater competition and the need
to increase efficiency and reduce
costs, banks in the euro area
countries have embarked on a wave
of mergers and acquisitions in an
attempt to enhance their size and
competitiveness. In terms of the
nominal value of deals, bank
mergers in the euro area
surpassed those of the United
States by some 70 percent in
1999. Thus far, however,
consolidation activity has mostly
been within national borders, in
part because national authorities
have appeared reluctant to
approve major foreign ownership
roles in their domestic banking
systems. That is, although the
market shares of foreign
institutions have recently shown
a gradual increase in a number of
countries, the euro area banking
sector is still fragmented along
national lines. The need to
become familiar with conditions
in the various national markets
and the difficulty of developing
pan-European banking products
have constituted barriers to
cross-border banking activity. In
addition, the EU believes there
are sound economic and practical
reasons, such as language
differences, for consolidation
taking place first on a national
level.
All banks operating in the euro
area, as well as banks in London
and elsewhere, that had accounts
in euro area national currencies
report that they have had to
expend substantial sums adding
new systems for recording and
managing activities in the new
currency. Moreover, banks'
earnings may be reduced by the
disappearance, culminating in
2002, of revenues generated from
customers' foreign exchange
trading between the national
currencies.
In addition, there could be a
more fundamental adjustment of
banks' role in financing in the
euro area in the future. As shown
in figure 4.2, the euro area's
financial markets are dominated
by bank financing, followed by
debt security financing, with
stock markets least important. In
contrast, the financial markets
in the United States are
dominated by debt securities
financing, followed by stock
market financing, with bank
financing least important.
As noted in the above discussion
of financial markets, EMU is
expected by many experts to
bolster the capacity and
efficiency of euro area capital
markets. This development would
allow a broader spectrum of euro
area companies to raise money by
issuing securities, making the
companies less dependent on
borrowing from banks. According
to the EU, corporate bond
issuance in euro in 1999 was
about four times as great as bond
issuance in euro area member
national currencies in 1998.
Furthermore, retail banks in most
euro area countries are
relatively inefficient. Financial
systems in Europe are "over-
banked" in that complex ownership
structures have prevented exit
and entry, retarded innovation,
and perpetrated mispricing of
financial services. 4 The
introduction of the single
currency is thought likely to
accelerate the transformation of
European finance by eliminating
home currency advantages that EU
banks have had in their local
deposit-taking and lending
activities.
The impact of these developments
on U.S. banks would vary with the
business focus of each bank. All
U.S. banks operating in Europe
presumably faced extra costs from
upgrading their accounts and
management systems to accommodate
the euro. But the disappearance
of revenues from foreign exchange
trading among national currencies
would affect only those banks
active in this business.
Similarly, the possibility that
some groups of companies will be
able to raise money by issuing
securities, thus borrowing less
from their banks, would not
necessarily affect all U.S. banks
operating in Europe, only those
that have been lending to these
groups of companies. On a broader
level, however, if subsequent
mergers in Europe eventually lead
to stronger, more efficient
financial institutions, U.S.
banks would face increased
competition. This would affect
U.S. banks doing business in
Europe; and it could also make
some larger European banks more
formidable competitors worldwide,
including in the U.S. market
itself.
Q. How could the euro affect the
regulation of financial services
companies in the United States
and Europe?
A. Monetary union in Europe
does not mean that new financial
regulatory and supervisory
structures have been created.
Creation of the ECB did not
entail any transfer of
supervisory powers to the ECB.
Euro area countries continue to
regulate financial services at
the national level supplemented
by EU directives.5 At the
national level there are a
variety of regulatory
arrangements. In some cases, bank
supervisory functions are
combined with monetary policy
functions within the central
bank. Other countries assign
supervisory responsibility to
another agency. There are
considerable differences in the
regulation of bank activities and
their ownership structure across
EU countries. Other nonharmonized
regulatory differences include
taxation, subsidies, supervisory
reporting, on-site inspections,
provisions for bank liquidation
and restructuring of banks, and
other factors. Unless further
harmonization takes place,
banking regulations will continue
to grant considerably different
powers to banks in each country.
One important restriction on
intra-euro area cross-border
investment has been made
irrelevant by the euro. The EU
has a matching rule that
liabilities in a foreign currency
must be 80-percent matched by
assets in the same currency. That
is, fund managers must invest in
assets denominated in the same
currencies as the liabilities
they back. This rule applies to
investments of pension funds and
insurance companies. With the
advent of EMU, insurance
companies will be able to invest
their assets in any country of
the euro area as long as their
liabilities are denominated in
euros. Asset allocation will move
away from domestic equities and
bonds to those from all EMU
participant countries.
The implementation of
several EU directives and the
Basel Accord on capital adequacy6
have not fully harmonized capital
standards. The EU is currently
conducting a review of its
capital adequacy standards. In
the meantime, capital standards
differ somewhat across EU
countries owing to the different
lists of items that banks can use
to meet capital requirements.
Likewise, supervisory practices
vary in terms of procedures for
examinations and inspections,
disclosure of regulatory
reporting, lending limits, and
limits on bank activities abroad.
One important issue has been
ambiguity about mechanisms for
resolving banking crises. The
Maastricht Treaty is silent about
lender of last resort
responsibilities. There is no
central authority with the
explicit mandate to ensure market
stability over the EMU financial
system. Situations could arise in
which the ECB would have to act
decisively and quickly. The euro
area central banks, the ECB, and
bank supervisors would have to
cooperate and share information.
According to the EU, the ECB has
made it clear that it is
satisfied with the organization
of lender of last resort
activities. However, work remains
to be done in the area of crisis
management involving central
banks, supervisory organizations,
and Ministers of Finance.
Although there is an EU
requirement for all EU countries
to develop deposit insurance
systems, the structure of deposit
insurance is far from harmonized.
Deposit insurance administration
is the responsibility of the
government in five EU countries,
of the banking system in six, and
of both in the remaining four.
Funding is to be provided before
the occurrence of a bank failure
in 10 of the 15 EU countries and
after the occurrence of a failure
in the remaining countries.
Deposit insurance premiums are
risk-based only in two euro area
countries, and the basis on which
the premium is calculated varies
considerably across the EU. The
extent of coverage is uneven
ranging from a low of $12,000 in
one country to full coverage in
another euro area country. This
lack of harmonization could be a
concern for regulators if it
triggers regulatory competition
between national banking systems
with funds flowing towards
countries offering the most
protection.
_______________________________
1The market value of bonds,
equities, and bank assets issued
in EU countries, not euro area
countries, amounted to more than
$27 billion at the end of 1995.
This is larger than the number
for North America (See
International Capital Markets:
Developments, Prospects, and Key
Policy Issues. IMF, Nov.1997).
2Market capitalization is the
value of outstanding shares of
securities listed on exchanges.
It is calculated by multiplying
share price by number of
outstanding shares.
3Other fundamental forces have
also led to changes in the
financial system, including
financial liberalization,
innovation, technological
progress, and diversification of
savings and investment
portfolios.
4See Folkerts-Landau, David, D.J.
Mathieson, and G.J. Schinasi.
"EMU: Systemic Implications and
Challenges," International
Capital Markets: Developments,
Prospects, and Key Policy Issues.
Washington, D.C.: IMF, Nov. 1997.
5Directives are measures passed
by the European Commission that
EU member national governments
are required to adopt through
their own national legislation.
Current EU directives allow
freedom of establishment of cross-
border service provision and have
substantially harmonized
prudential regulation, including
solvency ratios and large
exposures.
6The Basel Accord, developed
under the auspices of BIS, is a
risk-based capital standards
framework for internationally
active banks.
Chapter 5
What are the
Implications of the
Euro for U.S. Trade
and Investment with
Europe?
Page 55 GAO/GGD/NSIAD-00-105
Q. What are the current levels
and composition of trade between
the United States and the EU?
A. The amount of U.S. trade with
euro area countries has grown
rapidly in recent years. (See
fig. 5.1.) In 1998, euro area
countries were the second largest
U.S. trading partner, behind
Canada, accounting for 15 percent
of U.S. trade. Although the
United States has in recent years
had a trade deficit with the euro
area countries in terms of
merchandise (goods) trade, the
service sector has seen a
surplus. (See fig. 5.2.)
Figure 5.1: U.S. Merchandise
Trade With Euro Area Countries
(1994-1998)
Source: U.S. Department of
Commerce.
Figure 5.2: U.S. Service Trade
With Euro Area Countries (1994-
1998)
Note: Estimated service trade
data are for 13 countries. These
data include U.S. service trade
with Greece and Denmark in
addition to the 11 euro area
countries. Thus, these data may
overstate to some extent the
amount of U.S. service trade with
euro area countries.
Source: U.S. Department of
Commerce.
Germany is the United States'
largest trading partner among
euro area countries, followed by
France and Italy. The composition
of U.S. trade with euro area
countries, by sector, is similar
to that of overall U.S. trade.
Among nine aggregate sectoral
groupings, trade in the top two
accounted for about 60 percent of
all U.S.-euro area trade. These
top categories are machinery and
transport equipment, followed by
chemicals and related products.
(See fig. 5.3.)
Figure 5.3: Composition of U.S.
Merchandise Trade with the Euro
Area by Sector, 1998
Source: U.S. Department of
Commerce.
Q. How could the euro affect U.S.
trade?
A. The introduction of the euro
is not expected to have a
significant direct impact on U.S.
trade with the euro area or with
the rest of the world. However,
it may indirectly affect future
U.S. international trade if it
affects the economic growth of
the euro area or its
competitiveness. If euro area
economies grow faster due to the
introduction of the single
currency, Europe's demand for
U.S. exports could rise. That
effect could, however, be offset
to some degree if the euro leads
to European producers becoming
more efficient, and thus more
competitive in international
markets. Both of these effects,
however, could be dampened by
corresponding exchange rate
adjustments between the euro and
other currencies.
In addition, the euro could
potentially affect the relative
attractiveness of U.S. exports to
non-European markets if European
producers competing with U.S.
exporters in those markets become
more efficient producers.
Although the overall trade
effects are generally believed to
be small relative to overall U.S.
trade, those business sectors in
which U.S. trade with Europe-or
U.S. firms' competition with
European producers in third-party
markets-is concentrated could see
more significant impacts.
Q. How could the euro affect
economic growth in Europe?
A. EMU and the euro's effects on
economic growth in Europe will
not be known for some time
because they depend largely on
economic policy decisions to be
made in the years ahead. On the
positive side, a common currency
may to some extent reduce costs
of doing business. More
transparent pricing can enhance
competition. These factors can
benefit economic growth. In
addition, EMU's requirements for
fiscal discipline, e.g., low
budget deficit and debt levels,
should also benefit economic
performance over the long run.
However, a successful EMU will
require a sustained commitment to
making what are likely to be
difficult policy choices. Because
national governments will no
longer be able to use monetary or
exchange rate policies to adjust
to economic downturns, and the
use of fiscal policy will be
constrained, they will have to
turn to structural reforms to
allow labor and capital to more
easily move among firms,
industries, and member countries.
According to some analysts, this
is how EMU may ultimately provide
a strong boost to growth.
However, some analysts continue
to express concerns about member
countries' and the ECB's ability
to make policy choices that are
crucial to the euro's long-term
success. These include concerns
about the countries' ability to
keep deficits low; the ECB's
ability to maintain price
stability; and the countries'
ability to, in fact, achieve
needed structural reforms.
Q. What are the recent levels and
composition of foreign direct
investment (FDI) between the
United States and euro area
countries?
A. U.S. direct investment in the
euro area accounted for about 25
percent of total U.S. FDI at the
end of 1998. This share has been
fairly stable over the past 3
years. The euro area's direct
investment in the United States
was about 38 percent of all FDI
into the United States at the end
of 1998, up from 35 percent in
1997. Europe as a whole accounted
for about 67 percent of the total
stock of FDI in the United
States at the end of 1998.
In recent years, the United
States has invested more in the
Netherlands, Germany, and France
than in other euro area
countries, and these three
countries also invested more in
the United States. (See fig.
5.4.)
Figure 5.4: U.S. Direct
Investment Position in Euro Area
Countries 1998 - Historical Cost
Basis Data
Source: U.S. Department of
Commerce.
U.S. companies invested in
sectors in euro area countries
similar to those that U.S.
companies invested in elsewhere:
two major groupings
(manufacturing sectors and
finance/ insurance/ and real
estate sectors) each accounted
for more than one-third of total
direct investment. However, in
1998, the manufacturing sector's
share is higher in the euro area
than in U.S. FDI elsewhere (39
percent in the euro area compared
to 31 percent in all countries).
(See fig. 5.5.)
Figure 5.5: Sectoral Composition
of U.S. Direct Investment
Position in Euro Area 1998 -
Historical Cost Basis Data
Source: U.S. Department of
Commerce.
Q. How could the euro affect
foreign direct investment between
the United States and Europe?
A. Euro area countries are
more significant partners with
the United States in terms of
direct foreign investment than in
terms of trade. As European
economic integration continues,
analysts expect countries to
remove restrictions on FDI and
harmonize regulations over time.
This would help all
multinationals, including U.S.
companies, to consolidate their
capacity across Europe and become
more cost-efficient. These
efficiencies can in part be
achieved through mergers.
However, at this time it would be
quite difficult to predict the
magnitude of these impacts and
identify the sectors most likely
affected. In general, if the
euro area economies manage to
become more market-oriented with
less burdensome government
regulation and intervention over
time, FDI from many countries
could increase, including
investment from U.S. companies.
Without increased efficiencies,
FDI in Europe could well
decrease.
Chapter 6
What Are the
Implications of EMU
for International
Economic Policymaking?
Page 64 GAO/GGD/NSIAD-00-105
Q. How could EMU directly affect
international economic
policymaking?
A. The introduction of the euro
and the related establishment of
the ECB slightly complicate, but
do not significantly change,
international economic
policymaking, according to
experts. International economic
policy making was, prior to the
creation of the ECB, and still is
largely the purview of nation
states and international
organizations composed of
representatives from nation
states. The ECB is a new,
transnational player in these
discussions, requiring some new
arrangements.
The management of international
macroeconomic policy is currently
addressed at meetings of the G-7
countries. The seven countries
in the G-7 regularly consult on
general economic and financial
matters.1
With the existence of the euro,
when the finance ministers from
the G-7 meet, the agenda is to be
split into two parts. The first
part deals with global
macroeconomic and exchange rate
issues. The president of the ECB
and the finance minister from the
European country that currently
holds the EU presidency is to
attend these discussions. Central
bank representatives from France,
Italy, and Germany do not
participate except when one of
those countries holds the EU
presidency. The second part of
the agenda is to deal with such
issues as banking regulation,
debt relief, and assistance
issues. Central bank
representatives from France,
Italy, and Germany are to
participate, but the ECB does
not. In addition, the European
Commission participates in the
second part for discussions on
Russia.
Some experts believe that the
creation of a more economically
unified EU could affect trade
negotiations between the United
States and the EU. However, U.S.
officials told us that they did
not expect EMU to affect trade
negotiations. These officials
told us that the EU took a
strong, unified position on trade
issues prior to the creation of
the euro, and they expect that to
continue.
Q. How could EMU affect
decisionmaking by international
financial institutions?
A. In general, the adoption of
the euro and continued evolution
of EMU has not had significant
effects on the formal
decisionmaking processes of
international financial
institutions.
EU countries remain individual
members of the IMF. Because the
IMF grants membership only to
countries, the euro area cannot
be represented as a single entity
on the Executive Board. However,
the IMF has granted the ECB
observer status at selected
Executive Board meetings. In
addition, the IMF holds
discussions with the ECB and the
European Commission as part of
its regular economic reporting on
its members. The details of this
process, known as Article IV
consultations, continue to evolve
as the IMF tries to ensure that
the positions of the ECB, the EU,
and national governments are
included in assessments of
countries in the euro area. The
IMF also has changed the
composition of its currency, the
special drawing rights (SDR),
replacing the French franc and
the German mark with the euro.2
The World Bank and the
Organization for Economic
Cooperation and Development
(OECD) grant membership only to
countries, not organizations.
Thus, no changes are necessary
for the decisionmaking processes
of these organizations. The EU
already has a seat on the
European Bank for Reconstruction
and Development's (EBRD) Board
of Directors. The existence of
EMU will not change this.
The Bank for International
Settlements (BIS), which is owned
and controlled by central banks,
provides a number of specialized
services to them and, through
them, to the international
financial system more generally.
The central banks of 14 EU
members hold shares in the BIS.
The ECB was invited to become a
BIS member in November 1999.
According to BIS, formal
membership of the ECB will be
made final when certain
formalities have been completed.
Q. What are the broader
implications of EMU for global
economic policymaking?
A. If EMU works as European
leaders hope, it could lead to an
economically stronger and more
politically unified Europe. These
changes could translate into
greater power and influence on
the global economic scene.
However, experts believe it is
too early to discern the extent
to which this is taking place.
In the near term, most experts
believe that representatives from
national governments will
continue to play the predominant
roles in international economic
policymaking.
_______________________________
1The G-7 comprises Canada,
France, Germany, Italy, Japan,
the United Kingdom, and the
United States.
2The SDR is an international
reserve asset created by the IMF
from a basket of international
currencies.
Appendix I
Objectives, Scope, and
Methodology
Page 67 GAO/GGD/NSIAD-00-105
At the request of the
Chairman of the Subcommittee on
Domestic and International
Monetary Policy of the House
Banking Committee, we undertook a
review of the implications of
Europe's new single currency for
the United States. Specifically,
our objectives were to answer the
following questions: (1) What is
the euro and why is Europe moving
to it now? (2) What are the
potential effects of the euro on
the dollar? (3) What are the
potential monetary policy and
exchange rate effects of the
euro? (4) What are the
implications of the euro for
financial markets and
institutions and their
regulation? (5) What are the
euro's implications for U.S.
trade and investment with Europe?
And (6) What are the implications
of the euro for international
economic policymaking?
To meet our objectives, we
interviewed officials from the
Board of Governors of the Federal
Reserve; the Federal Reserve Bank
of New York; the Departments of
State, Commerce, and the
Treasury; the European Commission
Delegation to the United States;
the IMF; and commercial and
investment banks. We also
interviewed financial analysts
and experts.
In addition, we reviewed
U.S. government, EU, ECB,
international organization, trade
association, academic, industry,
and private firm documents,
including regulations, annual and
other published reports, papers
and articles, industry journals,
and information available at
various sites on the World Wide
Web.
We conducted our work in
Washington, D.C.; and New York,
NY, between November 1999 and
January 2000 in accordance with
generally accepted government
auditing standards.
We requested comments on the
technical accuracy of this report
from officials at the Departments
of State, Commerce, and the
Treasury; the Board of Governors
of the Federal Reserve; the
European Commission Delegation to
the United States; and the IMF.
Their comments have been
incorporated where appropriate.
Appendix II
Glossary
Page 69 GAO/GGD/NSIAD-00-105
Bond
Interest-bearing or discounted
certificate of indebtedness,
paying a fixed rate of interest
over the life of the obligation.
The issuer is obligated by a
written agreement to pay the
holder a specific sum of money,
usually semiannually but
sometimes at maturity, and the
face value of the certificate at
maturity. Also called fixed-
income security.
Council of the European Union
The Council is composed of
ministers of EU governments and
represents member states within
the EU meeting to discuss
specific interests. For example,
the Ecofin Council consists of
the economic and finance
ministers. The Council has
decision-making powers in the EU
legislative process and
coordinates the general economic
policy of member states. The
Council of the European Union
should not be confused with the
European Council.
Economic and Monetary Union
EMU is a three-stage process that
was launched in 1990. The first
stage lifted restrictions on
movements of capital across
internal EU borders (July 1990).
The second stage set up the
European Monetary Institute (EMI)
to pave the way for the European
Central Bank (ECB) (January
1994). The third stage (January
1999) was the introduction of the
euro and beginning of the ECB.
Euro
The official name for the single
currency of 11 of the European
Union's 15 countries. The euro
was approved at the EU Madrid
Summit in December 1995 and went
into effect on January 1, 1999.
Euro Area
The area in which the euro
operates as the official single
currency. Also called the
eurozone and euroland.
European Central Bank
The ECB is the common,
independent central bank for the
euro area. The primary objective
of the ECB is the maintenance of
price stability. The Governing
Council of the ECB comprises
representatives from the 11
countries in the euro area and
formulates the common monetary
policy for these countries. The
ECB's Executive Board implements
monetary policy for the euro
area. The General Council has
representatives from all 15
countries in the EU and is
responsible for a variety of
tasks including collecting
statistical information and
preparing reports and financial
statements. The ECB was
inaugurated on June 30, 1998, and
became operational on January 1,
1999.
European Commission
The executive body of the
European Union. The Commission
initiates legislation through
proposals and recommendations to
the Council of the European Union
and European Parliament. The
Commission also executes adopted
legislation and is the guarantor
of the EU Treaty.
European Council
The European Council comprises
the heads of state or government
of EU members. The European
Council provides the EU with
general political guidance. It
makes, in practice, major
political decisions at its twice
yearly summits. The European
Council should not be confused
with the Council of the European
Union.
European Currency Unit
The European Currency Unit was a
composite basket of currencies in
which each currency is weighted
according to its share in intra-
European trade, its percentage
share of EU gross national
product, and the relative
importance of each country's
foreign exchange reserves. The
monetary unit was created in 1979
by nine European nations to
promote currency stability in the
European Economic Community. As
of Jan. 1, 1999, the ECU was
converted into the euro on a one-
for-one basis.
European Monetary Institute
The precursor to the ECB. EMI was
formed in January 1994 to advise
on monetary issues in the run up
to the establishment of EMU.
European System of Central Banks
The European System of Central
Banks is composed of the central
banks of the EU countries and the
European Central Bank. The ESCB
defines and implements monetary
policy in the euro area, conducts
foreign exchange operations, and
manages the official reserves of
members states. EU members that
are not in the euro area are
still part of the ESCB, but do
not participate in decisions or
implementation of monetary
policy. ESCB has full
constitutional independence in
that it is not permitted to seek
or take instructions from
European Community institutions
or bodies or others.
European Union
The EU is a treaty-based,
supranational organization that
defines and manages economic and
political cooperation among 15
member countries. The EU attempts
to create an ever-closer union by
exercising sovereignty
voluntarily ceded by its members
in economic and political
affairs. The European Union
replaces the European Community,
which succeeds the European
Economic Community founded by the
Treaty of Rome in 1957.
Exchange Rate Mechanism
ERM fixed participating member
currencies within a band that
includes either side of a fixed
bilateral central rate against
the currencies of other members.
Exchange Rate Risk
The possibility that the value of
a foreign currency will move in
an adverse manner due to
unforeseen changes in foreign
currency exchange rates.
Foreign Direct Investment
FDI occurs when citizens of one
nation purchase assets in some
other nation that give them some
managerial influence in economic
activities related to those
assets.
Foreign Exchange Market
The international market in which
currencies are traded.
Transactions in foreign exchange
include those in the spot,
forward, swap, options, and
futures markets.
Foreign Exchange Reserves
The stock of official assets
denominated in foreign currencies
held by the monetary authorities
(finance ministry or central
bank) of a country. Reserves
enable the monetary authorities
to intervene in foreign exchange
markets to affect the exchange
value of their domestic currency
in the market. Reserves are
typically part of the balance
sheet of the central bank and are
managed by the central bank.
Reserves are generally invested
in low-risk and liquid
assets-often in foreign
government securities.
Foreign Portfolio Investment
The purchase by one country's
private citizens or their agents
of a marketable noncontrolling
position in foreign equity and
debt securities issues by another
country's private citizens,
corporation, banks, and
governments.
International Bond
Domestic currency issues in a
given country by nonresidents and
foreign currency issues in a
given country by either residents
or nonresidents.
Maastricht Treaty
The Treaty of European Union
agreed at Maastricht, the
Netherlands, in 1991, which set
out the current procedures and
timetable for EMU. The Maastricht
Treaty also addressed political
integration through provisions on
the two areas of security and
foreign affairs, and justice and
home affairs.
Market Capitalization
A financial measure calculated by
multiplying the number of shares
by the market value of shares.
Monetary Policy
Central bank activity designed to
influence the cost and
availability of credit. In the
United States, the legislated
goals of monetary policy are
economic growth, full employment,
price stability, and balanced
trade with other countries. In
the euro area, the primary goal
is price stability.
Note
Written promise to pay a
specified amount to a certain
entity on demand or on a
specified date.
Reserve Currency
Any currency that is commonly
used by central banks as part of
their foreign exchange reserves.
See the definition of foreign
exchange reserves.
Securitization
The broad process whereby capital
financing occurs through
securities issuance rather than
bank financing, including
conversion of bank loans and
other assets into marketable
securities for sale to investors.
Seigniorage
The profit a government earns
from issuing currency notes.
Because currency does not pay
interest, the issuing government
in effect obtains an interest-
free loan.
Trans-European Automated Real-
time Gross Settlement Express
Transfer (TARGET)
The settlement system for the
euro that processes cross-border
transactions denominated in
euros. It links the national
settlement systems of the
participating euro area countries
and facilitates the borrowing and
lending of funds from their
central banks.
Appendix III
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