Abstract
This paper examines the effects of the Economic and Monetary Union on demand for foreign reserves. The traditional theory on demand for international reserves assigns a pivotal role to imports. However, in a currency union part of imports are settled in the common currency, leaving no incentive for keeping foreign reserves. Moreover, the pooling of the demand for reserves in the currency union and an increasing role of a currency as an international reserve currency may also influence, among other things, the union demand for reserves. Based on estimated demand functions for reserves it is shown that the Economic and Monetary Union has reduced the demand for reserves substantially. It is argued that an enlargement with new member countries of the European Union will result in further savings of reserves. A simple calculation at the end of the paper illustrates the welfare gain associated with the reduced need of reserves in the Economic and Monetary Union.
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Notes
The discussed three effects could be represented more formally. For instance, one could define the total reduction of demand for reserves into the effects as follows: \( {{R_u } \mathord{\left/ {\vphantom {{R_u } {R_{nu} }}} \right. } {R_{nu} }} = {{c_u \tilde{M}_u^{\alpha } } \mathord{\left/ {\vphantom {{c_u \tilde{M}_u^{\alpha } } {\sum {_{i =1}^n c_i M_i^{\alpha } } }}} \right. } {\sum {_{i =1}^n c_i M_i^{\alpha } } }} = IE \cdot PE \cdot RE = \left( {{{\tilde{M}_u } \mathord{\left/ {\vphantom {{\tilde{M}_u } {M_u }}} \right. } {M_u }}} \right)^{\alpha } \cdot \left( {\sum {_{i =1}^n \lambda_i^{\alpha } } } \right)^{- 1} \cdot \left( {{{c_u } \mathord{\left/ {\vphantom {{c_u } {\sum {_{i =1}^n c_i \omega_i } }}} \right. } {\sum {_{i =1}^n c_i \omega_i } }}} \right) \), where λ i = M i /M u and \( \omega_i = {{M_i^{\alpha } } \mathord{\left/ {\vphantom {{M_i^{\alpha } } {\sum {_{i =1}^n M_i^{\alpha } } }}} \right. } {\sum {_{i =1}^n M_i^{\alpha } } }} \). The problem is that such decomposition of the effects is not unique; it depends on the chosen particular basis. Therefore, we concentrate only on estimating the total reduction of demand for reserves in the union, i.e R u / R nu .
See e.g. Chinn and Frankel (2008) who expect the euro to become the leading international currency within about 15 years.
Corresponding empirical data series used to estimate the model are defined in Appendix B.
A broader measure of the role of a currency as an international currency is quite problematic due to multidimensionality of it, and because of lack of data (see e.g. Chinn and Frankel 2007). In this paper we are more specific and concentrate on the role of a currency as an international reserve currency.
More formally, f i (t) = f(t)⋅ 1 {i∈I}, where I denotes an index set of EMU12 countries and t = 0 for 1989, t = 1 for 1990, t = 2 for 1991, and so on. We also explored a hypothesis that the pound sterling, due to its long history as a reserve currency, has a specific (time-invariant) parameter γ UK > γ. However, the difference of these parameters turned out to be highly insignificant.
Several specifications have been estimated. The estimations of various specifications using the S-shaped trend produced the results with trends nearly reaching the asymptote, i.e. 1, around years 1995–1999. The reported estimates of trend yield a trend which reaches the asymptote in 1998 (evaluating at two digit level). It is used in the sequel, since it gave more robust results in other estimations as compared to the alternatives.
10000 repetitions were performed assuming the simultaneous multivariate normal distribution of the error term with the covariance matrix scaled to fit the estimated one that is based on the model. It should also be pointed out that confidence bounds based on the nonparametric bootstrap were narrower.
This only holds for the old member countries of the EMU. For some of the potential member countries of the EMU from Central and Eastern Europe the rate of return of capital is probably also high - as in emerging economies in general.
The reduced costs relate to EMU12 and translate into the bottom line of surplus for the ECB. Hence the effects for the individual member countries of EMU12 depend on the procedures for redistribution of the surplus from the ECB to the individual central banks of the euro system. For details on the redistribution procedure, see Scheller (2004) and Hansen and King (2007).
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We are thankful to the referee for the comments and suggestions that allowed improving the initial version of the paper substantially.
Appendices
Appendix A: Dynamics of imports of goods, interest rates, and variability of reserves in 1994–2007 in the euro area and some non-EMU countries
If establishment of the euro area profoundly changed the behavior of explanatory variables, then one could not rely on the current values of determinants to forecast the demand for reserves. This endogeneity issue is difficult to test. However, to get a rough impression we could compare the development of relevant variables in the EMU and in the countries outside of it. For this purpose we, first of all, use the non-EMU EU15 countries, namely, Denmark, Sweden, and the UK as a ‘control group’. One could argue that these countries are highly influenced by the EMU and cannot be used in comparisons, because the changes in the EMU could have affected the non-EMU countries and defined the economic situation therein, namely, the development of imports and interest rates. It is less likely that establishment of the EMU had such an effect on the US economy. Therefore, we provide the US data-based indicators besides the ones of Denmark, Sweden, and the UK. Figures 3 and 4 plot, respectively, the imports of goods, and the levels of interest rates for the EMU12 (EMU12 countries before 1999), the US, and the total of imports of Denmark, Sweden, and the UK.
Imports of goods (in millions of euro, millions of ECU before 1999) in EMU12 countries (extra EMU12 trade, left axis), non-EMU EU15 countries (Denmark, Sweden, and the UK, right axis), and the US (left axis), 1994–2007. Source: Eurostat.
Money market interest rates in EMU12 countries, Denmark, Sweden, the UK, and the US, 1994–2007. Sources: IMF IFS.
Although the dynamics of imports have changed profoundly in the EMU in 2000 compared to the previous periods, the same development is observed in the non-EMU countries and the US. Consequently, it is difficult to accept that introduction of the EMU changed anything dramatically, unless one believes that establishment of the EMU caused a boom in the world economy, see also Berger and Nitsch (2007) for similar conclusions. Neither imports of goods nor dynamics of interest rates seem to differ significantly in the EMU countries from what has been observed in the non-EMU economies after establishment of the EMU. In general, all the trends seem to be very similar. Thus even if these factors of demand for reserves were affected by the establishment of the EMU, the non-EMU state variables seem unlikely to differ drastically from what is actually observed.
Appendix B: Data and data sources
In general, the dataset of more recent aggregates provided by Eurostat was sufficient to draw figures and prepare tables. For the econometric estimation of log-linear regression model analogue of Eq. (4) we used the data from 1989 to 2007 (excluding the euro-area series), and a more complete dataset of the needed indicators was available from the International Financial Statistics (IFS) database, provided online by the International Monetary Fund (IMF). The data used to estimate the econometric model are as follows:
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end-of-year reserves excluding gold converted to euro using the end-of-year exchange rates;
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yearly value of imports of goods (cif) converted to euro using the mid-year exchange rates;
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standard deviation of quarterly reserves within the two last years (current quarter excluded) calculated based on the IMF IFS data;
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money market interest rates from the IMF IFS; for some countries they were absent and, therefore, substituted or extrapolated using the Treasury Bill Rates or Government Bond Yields, if the former were also not available;
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shares of currencies in the international foreign exchange reserves were obtained from Eichengreen and Mathieson (2000) Table 1 and the COFER database. The data were rescaled based on the average of the overlapping period (1995-1998) to obtain a continuous series.
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Hansen, J.D., King, R.M. & Kvedaras, V. The International Reserves Issue in the EMU. Open Econ Rev 22, 143–161 (2011). https://doi.org/10.1007/s11079-009-9116-x
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DOI: https://doi.org/10.1007/s11079-009-9116-x