1.5.2 Consequences of introducing the Euro into the international system
The jump in the Euro as currency of choice for bond denomination in 1999 in part reflects the advent of the Euro as a common currency across the Euro-zone. But is has also encouraged those countries in the EU who are not in the Euro-zone, or those not in the EU at all, to borrow in Euros as well. The point about the consolidation and integration of the Euro bond market discussed in Subsection 1.5, even though it is by no means complete, is that this adds depth and liquidity to the market because there are more players participating in the market. These features increase the attractiveness of Euro-denominated bonds, and allow borrowers to borrow at lower interest rates and at reduced risk. There is a great advantage for countries in borrowing in their own currency (which is obviously possible in the case of the Euro-zone countries). It means that exchange rate risks are eliminated. Any borrowing in a foreign currency always creates a liability which has to be financed, so if exchange rates change there is uncertainty about the equivalent domestic currency obligation that is incurred by borrowing. This problem is eliminated if the government borrows in its own currency.
The USA has traditionally benefited a great deal from the fact that it can borrow in its own currency, given the traditional dominance of the US dollar as the currency of choice for international transactions. In effect, it has meant that the USA can purchase goods and services on the international market simply by printing pieces of paper (issuing bonds or printing its currency). Given the chronic balance of payments difficulties faced by the USA in the 1990s and 2000s, it has been able to finance these deficits by issuing US government paper (US Treasury Bills), which have mainly been purchased by east-Asian central banks (these bonds then become part of their foreign currency reserves). The increasing trend in the absolute value of US dollar-denominated bonds issued over the 1990s and early 2000s, as shown in Table 4, in large part reflects this process. But this obviously creates exchange rate risks for the east-Asian countries and financial institutions which hold these US Treasury Bills. If the value of the US dollar were to dramatically fall on world currency markets, the liabilities in equivalent domestic currencies for those holding dollar-denominated paper would dramatically increase.
Two consequences have followed. The first is that as US dollar reserves increase there is an incentive to diversify into other currencies so as to spread this risk, and here the Euro offers an obvious alternative. Thus there could be an increase in the demand for Euro-denominated bonds, which in principle as least could allow the Euro-zone countries and others to borrow more easily. Secondly, there is an incentive for the east-Asian countries to themselves establish a coordinated and integrated bond market of their own, probably in the first instance based upon a ‘weighted basket’ of east-Asian currencies. This would allow those countries to borrow in their ‘own’ currency, and hence also reap any advantages of eliminating exchange rate risks. At the moment, most of the east-Asian currencies are linked to the US dollar, so as the dollar has depreciated since 2001 these countries have also benefited from that depreciation; however this has produced tensions in the international payments system and pressures for the east-Asian currencies, particularly the Chinese renminbi, to break away from the US dollar and be allowed to appreciate in value.