Despite the euro's volatility, it remains likely to surpass existing EU currencies combined as both a reserve currency and a currency of denomination for international financial transactions. A rebalancing of official and private portfolios and shifts in the pattern of international capital flows are likely to noticeably affect foreign exchange markets and the major domestic financial markets worldwide.
Whether this implies a weak or a strong euro will depend on perceptions about Europe's financial policymakers' ability to deliver fiscal consolidation and structural reforms including in capital markets and retail banking systems, and the effectiveness and credibility of European Central Bank monetary policies.
While the financial markets have adapted relatively quickly to the reality of EMU, this complex adjustment process will necessarily take longer in some other areas of economic policy. The new conditions - where monetary policy is set by the European Central Bank - will demand a steep learning curve on the part of policy-makers, businesses, trade unions and the public at large and especially politicians.
The size, nature and development of capital markets are of special relevance. For more than a century the leading international currency (sterling, then the dollar) was underpinned by the broadest and deepest capital market in the world. This lends credence to the importance of capital markets in determining the future roles of currencies.
Indeed, the role of capital markets, rather than public sector preferences, has rapidly become the received wisdom among economists in determining the strength of the euro as a currency.
The available evidence is mixed, although a noticeable trend towards a strong euro can be discerned. On the one hand, European markets remain substantially smaller than in the US.
EU equities amount to roughly 55 per cent of US stock market capitalisation. There are also differences in structure. While in the US securities markets are more important, in Europe banking dominates. It is estimated that in continental Europe only 25 per cent of corporate finance comes from capital markets, while in the US the figure is more than 75 per cent. Another drag is that so far Britain has chosen to remain outside EMU.
Progress is also being made in other relevant fields. Spurred on by the introduction of the euro, the stock exchanges of Frankfurt, London, Paris and other financial centres have agreed to link their trading systems by November 2000 and to harmonise trading rules. Although this falls short of initial and preferable plans for a single electronic platform to trade shares in leading European companies, it is an important step forward. US companies and institutions are eager to profit from the changes in the financial landscape that EMU has brought about.
Nasdaq, the US stock market, has announced plans to start trading shares in high-tech companies from across Europe in October 2000. Other changes include the so-called TARGET system, which provides an efficient, real-time gross settlement system for payments in euros. In time, Europe can build a strong integrated European capital market that can match the US market in depth, width and liquidity.
European firms will be greatly helped by a more integrated, liquid and efficient capital market that can offer tailor-made corporate finance arrangements, and can also do so more cheaply than before.
The European Central Bank, European Commission and national finance ministries co-operating in the EU's Economic and Financial Committee (EFC) have a crucial role to play here. One positive step could be the creation of a single European regulator modelled loosely on America's Securities and Exchange Commission (SEC). This EUROSEC would end the existing complexity that investors and companies face of having to deal with 15 different national regulators.
Depending on the integration of the European capital market, the euro might in the long term come to play a role that would equal that of the dollar, not surpass it. This would represent a significant decline in the use of the dollar.
Economist Dr John Ryan is a principal consultant with PA Consulting in Dublin
