Paying for a brand new currency

That is just one example of the monumental changes that the birth of the euro, three weeks away, will wreak. What happens is this: on December 31 the exchange rates of the Euro-11s various currencies will lock in at a fixed conversion rate between them and the euro. On January 1, a day later, the euro becomes the single currency of these countries for sovereign transactions and legal tender among the Euro-11 countries in the financial markets and non-cash transactions. All government debt and wholesale payments will be in euros, and the entire euro zone will come under a single monetary policy supervised by the European CentralBank (ECB). These countries’ national currencies will still be used for their retail transactions, till they are phased out in 2002.

How the future looks

The euro will create a common currency area accounting for 18.6 per cent of world trade, 2 per cent more than America’s, and 19.6 per cent of world GDP, just 0.2 per cent less than America’s. This is a region with a combined current account surplus in 1997 equal to $100 billion.Those figures are by themselves sufficient to explain why no part of the world will remain unaffected.

From India’s point of view, it is a world of opportunity out there — potentially. Critics say India might already have thrown away a political opportunity: it behoved Indian leaders long ago to say that they welcomed the euro and that a certain part of its foreign reserves would be held in the euro. China already has indicated that it will do so.

Omkar Goswami, economist and adviser to the CII, who has studied the matter closely, predicts that within six months of itslaunch, the euro will be an important international reserve currency and says the RBI should gear itself to reduce its dollar reserves and substitute them with the euro. Eventually, he guesses, about a third of the foreign reserves could be held in euros.Even before that, the coming of the euro will “present a structural break in the invoicing patterns of international trade relations,” as a European Commission study on the euro’s impact on non-EU countries puts it.

Trade between developed and developing countries is generally invoiced in either the developed country’s currency or a third currency, usually the dollar. The reason is perhaps the limited convertibility of several developing-world currencies. This means that euro zone companies whose home currency is insignificant in the world market will rapidly want a shift to euro invocing.

It is essential for Indian companies to be prepared to do their invoicing in euros virtually from the beginning of the euro’s life regardless of the three-yeartransition period.

Interbank payment vouchers and letters of credit in the euro zone will also be in euros. Indian custom houses, the RBI and commercial banks need to adjust to this. Otherwise, as Goswami worries, “hundreds of customs clerks will go berserk trying to ascertain what the euro is” and what its exchange rate is. Indian banks that don’t adjust their accounting systems and computer systems could lose their correspondent status with institutions of the euro zone.

Investment and pension funds, banks and insurance companies will spread risks by converting some dollar holdings into euro ones. Indian companies could benefit from this cheap market not only by switching dollar debt to euro debt but also tapping the euroissue market.

All this is aside from the prediction of a FIEO study that Indian firms could benefit as subcontractors and software suppliers in an exploding telecom and software market as a result of mergers and other stimuli.For banks, the transition period to the single currencyupto 2002 would facilitate “planned migration” to single euro nostro accounts, RBI officials say. Foreign Currency Non-Resident accounts, deposits in which the RBI hopes will increase, now include the deutsche mark and the RBI has said it can include the euro.

As Goswami puts it, it is silly to ask in what way India can benefit from the euro’s arrival. It is more pertinent to ask how it will not affect India or the world. Businesses cannot afford to wait to learn about something of such import.

And the euro zone?

Consider in some more detail what goes on in Europe. In the Euro-11, efficiency gains will accrue from the elimination of exchange rate uncertainty within the area and the removal of transaction costs between currencies. This will result in higher output and real incomes.

Large gains will also follow from more disciplined monetary and fiscal policies. While the ECB will supervise the region’s unified monetary policy, the Euro-11 are bound by a so-called Stability Pact not to lettheir budget deficits exceed 3 per cent of GDP on pain of punishment in the form of fines. All this adds up to lower inflation and risk premia determining interest rates. That means lower interest rates and high investment rates.

The trade effect

Studies estimate that a reduction of 0.5 per cent in risk premia in the Euro-11 economies could mean added GDP growth in the region of 5-10 per cent in the long run. Naturally this will have spillover effects for non-EU economies. Higher growth will mean higher imports by the world’s largest trading region. For India, more than a quarter of whose exports already go to the EU, the opportunity is immense if properly exploited.

Crucial will be how much of third countries’ external trade these countries account for. On that score, India will be sharply influenced. It sends a quarter of its exports to the EU-15 and gets a quarter of its imports from them. However, another criterion is how strongly the trade performance of such third countries affects theirgrowth. Since India’s foreign trade as a proportion of its GDP is still relatively small, this connection is less strong. Still, assuming that trade will account for an increasing proportion of India’s GDP, that should change in a positive direction too.

The euro will be the second most traded currency on foreign exchange markets, but studies say it may not overtake the dollar because two or more vehicle currencies can raise transaction costs.For investors this represents a great opportunity to diversify their holdings across the euro zone. The shift away from dollar into EU currency assets is already underway, with the dollar’s share falling from around 50 to some 40 per cent. The role of the euro as an exchange rate peg will grow over time, especially with trade flows intensifying and invoicing moving to the euro. Non-EU trading partners can minimise the exchange rate risk of their foreign trade by pegging to the euro. Reserve Bank officials stressed the role of the euro as an exchange rate anchor at theIndia Economic Summit last week.