Box I.1. The euro: an initial assessment of its impact on developing countries of the ESCAP region

On 1 January 1999, the euro came into being, replacing the national currencies of 11 of the 15 EU members.^a Rates of conversion of national currencies into euros were announced and foreign exchange markets determined the value of the euro vis-à-vis the dollar and other internationally traded currencies. This event is the culmination of the process of economic integration in EU whose penultimate phase was set in motion by the Maastricht Treaty of 1991 which, in turn, led to the completion of the single market within EU for goods, services, capital and labour.

The date also signified the creation of the European Central Bank, which will formulate and implement monetary policy in the euro zone on behalf of the participating countries. From 1 January 1999 until 1 January 2002, the national currencies of the 11 countries will no longer be legally independent, although they will retain their physical existence for cash transactions. From 1 January 2002, the euro will no longer be merely an accounting currency but will become the sole legal tender in all the participating countries. During this interim period, there will be no further trading of member States' currencies in the foreign exchange markets. All existing financial assets, such as shares and bonds, will be redenominated in euro and all new government domestic debt will be issued only in euro.

Given the size of the euro-zone economy and the extent of trading links with non-EU countries,^b this is a development of major significance, with wide-ranging implications for the latter group of countries. While it is too early to quantify the likely external impact of the euro, certain broad judgements are possible concerning the implications for developing countries of the ESCAP region. These can be divided into the areas of trade and financial transactions.

In trade, the immediate effect will be that businesses and individuals within the euro zone will save on transaction costs by dealing in one rather than 11 currencies.^c According to the European Commission, the benefits flowing from lower transaction costs could be worth around 0.5 per cent of EU GDP or approximately $40 billion.^d In so far as the increase in real income is directed towards the import of goods and services from the ESCAP region, there would be a beneficial impact. There is, however, clearly a possibility that, as a result of lower transaction costs, euro-origin goods could become more competitive relative to non-euro goods, and this might be to the detriment of the ESCAP region.

Another factor that could impinge in a negative way on prospects for non-euro goods and services is that pricing of goods within the euro zone will eventually move towards greater transparency, with more uniform pricing within the euro zone for broadly similar goods. Thus, the absence of exchange rate uncertainty and lower transaction costs should lead to more efficient markets within the euro zone. Goods and services of non-euro origin could be at a disadvantage as a result.

The sheer mechanics of dealing in the euro may also pose a problem for traders in the ESCAP region. While the problems of becoming familiar with dealing in a new currency should, in principle, apply equally to everyone, those within the euro zone will, in all likelihood, traverse the learning curve quicker than those outside. It is obvious that financial institutions outside the euro zone will take more time than those within the zone to become fully conversant with trade financing, bill discounting and payment collection systems for the euro. In addition, it is probable that non-euro exporters to the euro zone who have been invoicing in third currencies, usually dollars, will have to shift to invoicing in euros. This will almost certainly involve some additional transaction costs to begin with.

It is appropriate, however, not to overemphasize the negative effects. A considerable proportion of non-euro exports to the euro countries, especially from developing countries of the ESCAP region, are of goods that euro countries do not produce in quantity because of significant competitive disadvantage: tropical agricultural products or labour-intensive manufactured goods such as garments and footwear, for example. It does not seem likely that lower transaction costs in these product categories for within-euro trade would, in themselves, be a major consideration. Problems could arise in those products where the possibility of substitution from within the euro zone exists, or with respect to exports from non-euro-zone developing countries that decide to link their currencies to the euro. Against that, there is also the possibility over the longer term that the euro leads to more trade overall, benefiting non-euro-zone producers.

In the area of financial transactions, significant changes are likely to take place gradually. There is general agreement that the euro is eventually expected to give a boost to the development of a wider and deeper capital market denominated in euro. One of the uncertainties in this is the dollar-euro exchange rate over the next one or two years. However, the ingredients for a euro-based capital market are already there, with active equity and bond markets in all 11 countries. As financial markets in the 11 countries integrate, the euro zone will be able to provide a much larger pool of liquidity for both equity and bond issues and more competitive pricing of such issues. Until recently, investors ran several different currency risks and needed to weigh the outlook for interest rates across a range of countries. With the euro, a single currency and a single interest rate regime should be particularly helpful for new companies within the euro zone to raise capital, with potential benefits for non-euro-zone borrowers as well.

As overall capital-raising costs in the euro zone decline, such benefits will not remain confined to euro-zone entities but should become available to non-EU entities as well. This is, incidentally, how the eurodollar market developed. In this context, it is worth remembering that Asian companies have already begun to raise significant volumes of capital through the eurobond markets, while European banks have, in turn, been active with loans and project finance in Asia. The arrival of the euro and improved access to an active, liquid market in which the entire range of securities across the maturity spectrum can be bought and sold should improve the ability of Asian companies to raise finance, in all likelihood at significantly lower cost than in dollars.^e

There are, of course, other areas where the euro will have an impact on both euro and non-euro economies. One of these is the opportunity that it will provide for the redeployment of foreign exchange reserves for countries. Within the euro zone, central banks will gradually shift to a lower overall size as "external" trade becomes intra-euro trade. At the same time, non-euro-zone countries might decide to have more euro and fewer of other currencies, for example the dollar, in their reserves. If these shifts were to take place over a brief period of time, they could, in theory, generate destabilizing exchange rate fluctuations. However, central banks would probably avoid any sudden movements into, or out of, particular currencies. These changes are therefore likely to be spread over a considerable period. In any event, official holdings of dollars (or of other currencies) are small compared with private holdings of assets and liabilities denominated in dollars (or in other currencies). As far as exchange rate stability is concerned, what matters is how private investors rebalance the currency composition of their holdings. This will depend almost entirely upon how the euro-dollar exchange rate evolves over the medium term. Certain developing countries of the ESCAP region have large foreign exchange reserves. They will have to take into account the emerging developments in euro-dollar exchange rates in their decisions regarding the currency composition of these reserves.

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^a Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain. Denmark, Sweden and the United Kingdom opted not to participate in this, the third stage of EMU, while Greece did not qualify.

^b The EU 11 have a GDP of $6.3 trillion. Taking EU as a whole, roughly 44 per cent of exports and 46 per cent of imports go to, or come from, non-EU countries.

^c Transaction costs are an amalgam of bank charges for letter of credit confirmation, commissions incurred in trade-related foreign exchange transactions and costs of hedging against possible losses that might result during such exchanges.

^d The Economist, 24 October 1998.

^e At present, euro interest rates on three-month money market instruments are 1.6 percentage points lower than on dollars; banks' prime rates are 3.4 percentage points lower while corporate bonds are nearly 3 percentage points lower than in dollars. Historically, too, euro-zone interest rates have tended to be lower than dollar interest rates.