How will the euro affect Indonesia?

The following is an excerpt of a paper presented at the ABN- AMRO Conference on the European Single Currency on June 17 in Jakarta by J. Soedradjad Djiwandono, a professor of economics at the University of Indonesia and Governor of Bank Indonesia. This is the first of two articles.

JAKARTA: I will try to describe the development of the European single currency, to analyze the importance of the new euro market being created and its impact on Indonesian and other financial markets. Overlying these issues are the uncertainties that surround how and when it may all happen. As a measure of this, we can look back to just the last couple of weeks.

The failed German gold revaluation incident, the outcome of the French election, the Luxembourg summit on June 8 and the Amsterdam summit currently underway have all resulted in almost daily changes to the economic forecasts for the method and timetable for the euro's introduction.

Basically, the argument goes as follows: given the historical large fluctuations between the dollar and European currencies, one important key in considering the European Monetary Union (EMU) is how it effects the exchange rate of the dollar against the new European currency, the euro.

My emphasis is on the short and long-term prospects of the euro, its contribution to the international monetary system as well as its potential as a huge financial market and the opportunities opened for Indonesian business communities.

Since the Treaty of Rome, which laid the foundations for the modern European Union, it was felt that a single currency among the member states would reinforce the objectives of the creation of a modern European Union. The idea of a joint currency appeared for the first time in 1972 and led to the creation of the European Currency Unit before the euro was christened in Madrid in 1996.

Although the principle of the EMU was formally adopted at Maastricht in February 1992, the details of its birth and in particular which countries will join at the outset, have not yet been decided despite the indicative timetable that aims for an irrevocable fixing of exchange rates on Jan. 1, 1999, and completion of the project in January 2002.

There are many possible outcomes to the European Monetary Union process:

* First, a core group of countries, including Germany and France, proceed toward the EMU as planned, with a second group scheduled to participate at a fixed future date;

* Second, the EMU occurs on time and includes all member states that wish to join, excluding the United Kingdom and Sweden, or those that have failed all the Maastricht criteria by a wide margin;

* Third, a very small group proceeds as planned and other countries join after a short delay, during which time their economies converge further with the first wave countries; and

* Fourth, a much longer or even permanent delay in which the consensus for the EMU is revisited.

I believe it is a safe assumption to make that although some countries may not participate in the initial round, the EMU in some form is likely and within a short period of time a majority of those countries wishing to proceed to a full EMU will have done so.

Therefore, we may consider that there is a high probability of the euro becoming a reality in the near future. When it happens, both immediately before and after the actual irrevocable fixing of exchange rates, foreign exchange markets will be asked to pass judgment on the nature of the new currency.

In the shorter term, a number of key factors will influence the value of the euro. These include:

- The behavior of national central banks with regard to their foreign currency reserves. How European central banks, which are currently holding larger amounts of foreign currency reserves, respond to the euro will be watched closely by the markets.

- The perception in the markets of the state of the European economy and politicians desired policy responses. The value of the euro will be influenced by how national governments respond to the economic criteria laid down by the Maastricht Treaty.

- The agreed composition of the currency and the perceived conservatism of the new European Central Bank (ECB). Probably the key to the markets perception of the new currency will be its composition and the latitude that the ECB will have in the conduct of monetary policy.

In the long term, it is too early to tell and too difficult to predict whether the impact of strict monetary policies by the ECB will result in a stronger or weaker euro. However, in the longer term, the euro would appear to have all the characteristics of a strong currency.

The new central bank has its independence enshrined in international treaty. Given this independence, and the bank's objective of ensuring price stability, it is likely that inflation and nominal interest rates in Europe will be low in the long term.

In addition, the reduction of exchange rate uncertainty within the euro zone could also lead to an increase in trade and investment and consequently to additional economic growth.

Long term euro strength will also be bolstered by the huge and liquid financial markets that Europe possesses and will be merged after the EMU. London is already the largest foreign exchange market in the world, with a turnover that is greater than New York and Tokyo combined. European equity and bond markets are large and liquid and are expected to develop further.

The future euro bond market, when fully developed, can be expected to be much bigger, broader and more liquid than the present national markets. It will offer market participants new opportunities in the form of wide-ranging funding and investment possibilities.

It should become the second largest bond market in the world after the United States dollar market, even with only limited EMU. When it happens, we would expect that, over time, many international and multinational institutions that hold dollars as their sole reserve currency will seek to diversify their holdings into the euro. This stream of demand will bolster the currency and support a long term appreciation of the euro.

The development of the euro may also influence European capital markets. The European Monetary Union has been seen as the capital market's equivalent of the European Single Market in goods and services that has been fully applied since 1992.

At present, despite the convergence of key financial indicators among many of the most prominent European countries and the prospect of an imminent EMU, capital markets within Europe remain fragmented along national lines.

The EMU will mean that interest rates across the single currency zone are the same. Investors will no longer face a currency risk when investing within the currency zone. This reduction in risk will reduce the premium investors will demand when investing in other euro countries.

This united capital market will rival that of the United States. The economy of the European Union (EU) is 22 percent larger than that of the United States. Its population is 370 million, 112 million more than in the U.S.

The EU accounts for 21 percent of world trade, excluding trade within the EU, versus 18 percent for the U.S. In addition, the EU has a higher savings rate than the U.S. and runs a smaller current account surplus with the rest of the world, allowing it to export capital.

The potential strength of a united European capital market is further evidenced by the fact that while the U.S. capital market is a US$17.5 trillion market, the current size of the fragmented European capital market is already $16 trillion.

The euro area, therefore, has the makings of one of the world's principal capital zones. The factors that drive the internal capital market will, because of the market size, be transmitted well beyond the area's boundaries.