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The Euro from the Japanese Perspective

Summary of a speech given by Kazumasa Iwata, Deputy Governor of the Bank of Japan, at Frankfurt European Banking Congress on November 19, 2004

December 2, 2004
Bank of Japan

Looking back over the postwar history, we observe that the first proposal on European Monetary Union by the EC Committee appeared in 1962. At that time it aimed at consolidating and completing the Bretton Woods system. After two decades the European Monetary Union was established in 1979 based on the Exchange Rate Mechanism which replaced the "snake in the tunnel" system (a joint floating rate vis-à-vis the dollar) after the breakdown of the dollar standard system in 1971. After forming a single market, the euro was launched in 1999. Now the international monetary system has moved from the dollar-based system to the bipolar dollar-euro system. The role of the euro as a vehicle currency in the international money markets, an invoice currency in trade, reserve money, as well as an intervention currency has been solidly established. Moreover, it has expanded more rapidly and widely than the rigorous definition of an optimal currency area might suggest. It is a great achievement and it has added a new dimension to the architecture of the international monetary system. I feel sympathy with the argument that either a common currency area or a flexible exchange system is the only viable choice for the international monetary system of the 21st century.

With regards to the history of currency unification in Japan, the introduction of a common currency and a central bank had a significant impact on economic development and financial markets. Before the Meiji Restoration in 1868, more than 200 local governments (clans) issued their notes. These local notes circulated alongside gold, silver and copper coins. Most of the local notes were convertible in principle, but in many cases they were issued excessively. In the early Meiji Era both government notes and Japanese National Bank Notes circulated replacing the local notes. The National Banking System in Japan was modeled after that of the United States which started to issue "greenbacks" during the Civil War. The need to finance the Seinan Civil War in 1877 escalated the issue of government and National Bank Notes which were inconvertible into gold and silver, resulting in a rampant inflation. The Bank of Japan was established in 1882 to introduce the convertible common currency and to launch a modern credit system. The common currency was introduced in 1885, replacing government and National Bank Notes. The introduction of a convertible common currency issued by the Bank of Japan contributed to securing price stability. The establishment of a modern credit system includes the stabilization of interest rates both geographically and inter-temporally. The Bank of Japan facilitated financial transactions through the consolidation of payment systems. And the convergence of interest rates emerged after the establishment of the Bank of Japan through the development of a nation-wide financial network.

The Euroland, after the introduction of the euro and the European Central Bank, also achieved price stability and convergence of interest rates and inflation rates, although initially a divergence of inflation rates among member countries lingered1. It was also expected that a massive increase in intra-regional trade and investment would raise efficiency (total factor productivity), giving rise to a dynamic bonus effect on the potential growth rate2. Although we have not yet seen a visible rise in the potential growth rate of the euro area, we may expect the realization of higher growth over coming years.

On the external front, the trade and investment linkage between Europe and Asia has been strengthened significantly. There is an increasing tendency for Asian multinational companies to raise funds in euro-denominated debt, while currency diversification among private asset-holders is proceeding, albeit gradually. Yet some Asian countries presume that the stability of their exchange rates against the dollar is essential for an export-oriented development strategy3. In addition, the development of domestic capital markets is delayed, reflecting a still largely bank-based financial system in many Asian countries. As a result, dollar-denominated assets dominate asset holdings among Asian investors. Thus, the use of the euro as a key currency in Asia has so far been limited. Furthermore, the move and institutional arrangements toward economic integration and a common currency area are far behind the case of the Euroland.

The experience of European monetary integration, however, provides us with several important implications.

First, the evolution of an international currency can be promoted by market selection and political will4. The case of the euro serves as a good model of a combination of the two. On the other hand, in Asia, market selection based on the relative market size of participating countries and economic integration may play a more important role given the lack of strong political will among major countries. Having said this, I would like to emphasize that cooperative actions are beginning in Asia. The Chiang Mai Initiative on swap arrangements among Asian countries promotes international cooperation, while projects by the EMEAP of eleven central banks, such as the Asian Bond Fund I (an investment fund in dollar-denominated bonds issued by Asian countries) and the Asian Bond Fund II, (an investment fund in Asian currency-denominated bonds) serve to develop the Asian capital market.

Second, it is interesting to see that the use of a basket currency such as the ECU preceded the introduction of the common currency, serving as the unit of account in Europe. It will still take a very long time to talk about the ACU for Asia. Nevertheless, it raises the issue as to whether the stability of a currency's value in terms of a basket of major currencies (dollar, euro and yen), instead of the dollar, may enhance the stability of trade account. Moreover there may arise another interesting issue; if the policy concern among Asian countries changes from trade to price stability, what would the implication of the shift be for the international monetary system?

Third, the success of the formation of a single market in Europe enhanced the introduction of a common currency issued by the ECB. In the case of Asia, it is urgent to promote regional economic integration through the formation of free trade areas compatible with the multilateral trade and investment rules.

Finally, I would like to stress that the process of the Asian move toward economic and monetary integration is evolutionary, and based on market selection, given the wide differences in development stages and divergent cultures.

  1. I once pointed out that the remaining price level divergence within the Euro area may be due partly to the difference of fiscal policy management (Statement at the Conference on the ASEM expert meeting in March 2002). Initial divergence of inflation may be due to the difference in the initial level of interest rates and the transmission mechanism of monetary policy arising from different sensitivities to demand shocks and different slopes of the Phillips curve (I. Angeloni and M. Ehrmann (2004), "Euro Area Inflation Differentials", ECB Working Paper Series, No. 388, September 2004).
  2. A dynamic bonus effect on growth can be expressed as the change in total factor productivity multiplied by the saving rate. The IMF presented the simulation result that the growth rate in the Euroland may increase by 1-3% in the coming decade (IMF, "World Economic Outlook", May 1999).
  3. Dooley, Folkerts-Landau and Garber (2004) identified the trade account region (Asia) and capital account region (Europe); the former groups are concerned about stability of exchange rate vis-à-vis the dollar and belong to the revived Bretton Woods system, while the latter care about risk and return of investment position in the U.S. and adopt floating exchange rates. More recently they argue that the U.S. current account deficit provides the periphery with the collateral for a total return swap between government bond and equity in the form of foreign direct investment (M. P. Dooley, D. Folkerts-Landau and P. M. Garber, "The U.S. Current Account Deficit and Economic Development: Collateral for a Total Return Swap", NBER Working Paper, No.10727, 2004).
  4. Matsuyama, Kiyotaki and Matsui (1993) developed the market selection hypothesis and argued that an international currency can emerge from too many currency areas in the evolutionary process and enhance welfare within a framework of random matching game theory (K. Matsuyama, N. Kiyotaki and A. Matsui, "Toward a Theory of International Currency", Review of Economic Studies,60, 1993).