As economist Robert Triffin explained more than 50 years ago, the development of an international reserve currency requires that the issuing country or area records a current account deficit. This partly explains why the yen and the Deutschmark did not develop an equivalent role to the dollar, in spite of the relative strength of the Japanese and German economies. The eurozone economy is now in the same position.
The eurozone countries have adjusted, during the financial crisis, from running a broad external balance, which prevailed until 2010, to a rising surplus (2.7 per cent of gross domestic product in 2013, up to 3 per cent in 2015). Only Estonia, Greece, France, Cyprus and Finland are still expected to have a slight deficit this year. Spain, Italy, Malta, Austria, Slovenia, Portugal and Slovakia have moved from deficit to a surplus.
The fact that the eurozone records a surplus in the trade of goods and services with the rest of the world may be considered appropriate for an ageing society. The accumulation of net assets with the rest of the world is a way to smooth consumption over time.
However, this situation is inconsistent with the desire of the rest of the world to invest part of its savings in the eurozone, given the reserve status of the euro and international investors’ diversification of their portfolios away from the dollar. This strong demand is not being met by a sufficient supply of assets by the eurozone, which is a net exporter of capital.
In the current global financial environment, the status of reserve currency cannot be imposed by the monetary authorities. It is largely determined by the decisions of international investors. The international role of the euro gradually increased after the start of monetary union but stalled in the midst of the euro crisis. More recently, however, as international investors have regained confidence in the ability of the eurozone authorities to muddle through and ultimately avoid a collapse of the single currency, the demand for euro assets has recovered, putting upward pressure on the exchange rate.
The rising eurozone external surplus is magnifying this effect, by reducing the net supply of euro-denominated assets. The combination of rising capital inflows from the rest of the world and higher eurozone current account surplus is creating a new tension in global financial markets, which may distort the valuation of the European single currency. This represents a threat for the economic recovery in the euro area.
There are no easy solutions. A reduction of the financial market fragmentation within the eurozone would certainly help, but only at the margin because the countries that in the past experienced external deficits cannot afford to increase their external debt again. The surplus countries would have some margins to reduce their net savings, but their current policy preferences do not signal any change in that direction. The eurozone could discourage the inflow of capital, but it is difficult to see how this could be achieved without imposing capital controls, as some emerging markets have done.
Short-term capital inflows in the euro area could be discouraged by imposing a negative interest rate on deposits at the central bank. This measure would also encourage eurozone financial institutions with excess liquidity to look for international investment opportunities.
Another possibility could be for the European Central Bank to stop its policy of reabsorbing back the liquidity issued against the purchase of Italian, Spanish, Irish and Portuguese bonds under the Securities Market Program which was conducted in 2010-11. These operations are currently conducted through weekly tender operations. Their termination would release about €180bn of liquidity in the money market. It would create a further incentive for eurozone institutions to lend to each other and to invest in external assets, thus alleviating the pressure on the euro.
If the sterilisation operations were still considered necessary, for window-dressing purposes, they could nevertheless be implemented in a more flexible way – allowing, for instance, counterparties to use foreign currency. This would contribute to absorbing the increasing foreign demand for euro-denominated assets. The maturity of these operations could also be extended, to meet international investors’ preference.
If these instruments prove not to be sufficient to curb international investors’ excess demand for eurozone assets, more drastic measures might be needed, following what other central banks have done. The recent sharp reduction in the size of the ECB’s balance sheet, while that of all other central banks is increasing, is not consistent with the fragile state of the eurozone economy nor with an inflation rate that is increasingly deviating from price stability.
Overall, the eurozone is in a unique situation. It is the issuer of the second-most important currency, whose demand by the rest of the world is on the rise. At the same time its trade surplus with the rest of the world increases. This requires innovative solutions.
The writer is a former member of the executive board of the European Central Bank, and currently visiting scholar at Harvard’s Weatherhead Center for International Affairs and at the Istituto Affari Internazionali in Rome