How will the euro affect Indonesia?

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.