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The Impact of the Euro and the EMU on Intra-Euro Area Trade, FDI, and the Euro Area Balance of Payments

Bachelor Thesis 2010 67 Pages

Economics - Monetary theory and policy

Excerpt

TABLE OF CONTENTS

List of Figures

List of Tables

List of Abbreviations

Abstract

Auszug

1 Introduction
1.1 Research Aim and Research Question
1.2 Limitations
1.3 Methodology
1.4 Chapter Outline

2 Theoretical Foundation
2.1 The Euro and the European Monetary Union
2.1.1 History of European Currencies
2.1.2 Development of the European Monetary Union
2.2 Intra European Trade
2.3 Foreign Direct Investment
2.3.1 Reasons for Foreign Direct Investment
2.3.2 Factors Affecting Foreign Direct Investment
2.3.3 Effects of Foreign Direct Investment on a Host Country
2.3.4 Costs and Benefits of Foreign Direct Investment to a Host Country.
2.4 Balance of Payments
2.4.1 Current Account
2.4.2 Financial Account
2.4.3 Overall Balance
2.4.4 Indications of the Balance of Payments

3 Impact of the European Monetary Union
3.1 Impact on Intra Euro Area Trade
3.2 Impact on Foreign Direct Investment
3.3 Impact on the Component Parts of the Balance of Payments

4 Analysis

5 Conclusion

Bibliography

Appendix

LIST OF FIGURES

Figure 1: Euro Member States at the Introduction of the Euro in 1999

Figure 2: Euro Member Countries in 2009

Figure 3: Euro Area 11 Trade Development

Figure 4: Euro Area 11 FDI Development

Figure 5: Euro Area 11 Balance of Payments Development

Figure 6: Comparison Balance of Payments and FDI

LIST OF TABLES

Table 1: Intra-Euro Area Trade 2008, Trade Increase and GDP since 1999

Table 2: Intra-Euro Area Trade 2007

Table 3: Intra-Euro Area Trade 2006

Table 4: Intra-Euro Area Trade 2005

Table 5: Intra-Euro Area Trade 2004

Table 6: Intra-Euro Area Trade 2003

Table 7: Intra-Euro Area Trade 2002

Table 8: Intra-Euro Area Trade 2001

Table 9: Intra-Euro Area Trade 2000

Table 10: Intra-Euro Area Trade 1999

Table 11: Intra-Euro Area Trade 1998

Table 12: Intra-Euro Area Trade 1997

Table 13: Intra-Euro Area Trade 1996

Table 14: Intra-Euro Area Trade 1995

Table 15: Euro area FDI Inflows and Comparison to total OECD Inflows

Table 16: Euro Area Balance of Payments

LIST OF ABBREVIATIONS

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ABSTRACT

Although the Euro has already been introduced as an official currency more than 10 years ago, the opinions of its effects so far and its future implications on the participating countries still vary dramatically. In this study, the author analyzes the effects of the Euro and the European Monetary Union on intra-Euro area trade, foreign direct investment inflows into the Euro area, and the balance of payments of the 11 original Euro member countries. This paper starts with an investigation of the historical development of the Euro and the European Monetary Union and an explanation of the terms intra European trade, foreign direct investment, and the balance of payments. By comparing results from prior literature and using data from international institutions, the results show that intra Euro area trade and foreign direct investment inflows into the Euro area have increased and that the Euro area balance of payments is developing towards less surpluses and perhaps even deficits on the current account. On the basis of these findings, the author reasons that the Euro area has become a more attractive place in which to invest which eventually may lead to constant future current account deficits of the Euro area.

AUSZUG

Obwohl der Euro bereits vor 10 Jahren als eine offizielle Währung eingeführt wurde, unterscheiden sich die Meinungen über seine bisherigen und zukünftigen Einflüsse und seine Auswirkungen auf die Mitgliedsländer beträchtlich. In dieser Arbeit analysiert der Autor den Einfluss des Euros und der Europäischen Währungsunion auf den Handel innerhalb des Europäischen Währungsraums, die Auslandsdirektinvestitionen in den Euroraum und die Euroraum Zahlungsbilanz der ursprünglichen elf Mitgliedsländer. Die These beginnt mit einer Untersuchung der historischen Entwicklung des Euros und der Europäischen Währungsunion und einer Erklärung der Begriffe Handel innerhalb des Euroraums, Auslandsdirektinvestition und Zahlungsbilanz. Anhand von Vergleichen früherer Studien und unter Verwendung von Daten internationaler Organisationen, zeigen die Resultate, dass sich der Handel innerhalb des Euroraums intensiviert hat und die Auslandsdirektinvestitionen in den Euroraum angestiegen sind wodurch sich die Zahlungsbilanz des Euroraums in Richtung geringerer Überschüsse und möglicherweise sogar Defizite in der Leistungsbilanz entwickelt. Basierend auf dieser Ermittlung schlussfolgert der Autor, dass der Euroraum ein attraktiverer Investitionsstandort geworden ist, was möglicherweise in der Zukunft zu konstanten Defiziten in der Leistungsbilanz des Euroraums führen könnte.

1 INTRODUCTION

With the aim to further foster integration among European countries, eleven countries have decided to use the same currency and follow the same monetary policy. In 1999 the European Monetary Union (EMU) was established and the Euro was introduced as the single currency in the before mentioned eleven nations. After three years of virtual utilization, the Euro was introduced in 2002 as a real, tangible currency when 300 million people have started to actually use the same currency. The Euro has turned its members into one of the biggest single currency using economic zone in the world that accounts for approximately 20 percent of world output and 30percent of world trade. The Euro has become the world’s largest economic policy experiment that has attracted the interest of several economists to study the Euro’s impact on its participating countries (Baldwin, 2006, p. 6).

Today, numerous works exist that deal with the impact of the Euro on, for example, intra Euro area trade or foreign direct investment (FDI). The results of the studies vary to some degree, but mainly conclude that the introduction of the single currency has had positive effects on intra-Euro area trade and FDI. However, no studies have been published so far that deal with the impact of the Euro and the EMU on the Euro area balance of payments. This thesis closes this gap and adds to the understanding of the impact of the Euro and the EMU on the Euro area balance of payments.

1.1 Research Aim and Research Question

The purpose of this paper is to investigate the impact of the Euro and the EMU on intra-Euro area trade, FDI, and the balance of payments of the original eleven Euro member countries. The purpose of this work is not to establish any models or theories, and is also not meant to prove or to question any already existing theories or models. Furthermore, this study does not compare industry specific data and only bases the research that has been conducted and the consequential results on data that has been comprised from general data on trade, FDI, and the balance of payments. In addition, there is an enormous amount of theoretical literature regarding the discussed topics in this paper available. Therefore, this paper only concentrates on parts of the theoretical literature available that are essential in order to discuss the issue of this work.

The described research aim of this paper leads to the following research questions:

1. Did the introduction of the Euro and the establishment of a European Monetary Union make the Euro countries a more attractive market place for investments?
2. What are likely developments of a European Monetary Union in terms of intra-Euro area trade and the Euro area balance of payments?

In the course of answering the two research questions, the author only states possible implications and does not give any future predictions or question implications or future outlooks of other authors. Therefore, this study shall not serve as a proof of some theories and shall rather be used as a basis for future studies.

1.2 Limitations

In this paper only already processed data have been used and no market research has been conducted. Furthermore, this work only considers a small part of influences that might have affected intra-Euro area trade, FDI and the Euro area balance of payments.

1.3 Methodology

In order to develop a better understanding and an economic insight into the topic, an expert interview has been conducted right at the start of the investigations. To better address and support the research aim, the author has also focused on reviewing relevant literature. The literature review implies using text books, articles, and course documents that have been dealt with throughout the author’s studies at the IMC Krems.

Published research papers from acknowledged economists, speeches from members of the European Central Bank (ECB), and articles from journals have been used to help investigating the impact of the EMU on intra-Euro area trade and FDI. While gathering relevant information and studies, it has turned out that the topic of the impact of the EMU on the Euro area balance of payments has not yet been covered by other authors. Furthermore, data from international institutions have been used for the analysis of the impact of the EMU on intra-Euro area trade, FDI, and the balance of payments. Based on the analyzed data, several figures and tables have been developed and serve as basis for the assessment. Additionally, the findings have been used to analyze and answer the two above mentioned research questions.

1.4 Chapter Outline

After presenting an overview of the discussed issue in this paper, defining the research aim and research question, and defining the methodology in the first chapter, the second chapter provides a theoretical foundation that covers the history of currencies in Europe and the development of the EMU. Chapter three analyzes the impact of the EMU on intra-Euro are trade, FDI, and the Euro area balance of payments. In the fourth chapter the two research questions that have been defined in chapter 1.1 are analyzed. At last, the fifth chapter summarizes the findings of this paper and points out the need for further research.

2 THEORETICAL FOUNDATION

This chapter aims to provide the reader a theoretical foundation on the history of the Euro, the development of the European Monetary Union (EMU), intra European trade, foreign direct investments, and the balance of payments.

2.1 The Euro and the European Monetary Union

2.1.1 History of European Currencies

Prior to the 1870s, the international monetary system can be characterized as “bimetallism”, a system in which both gold and silver were used as international means of payments and gold and silver coins circulated side by side. The exchange rate between gold and silver depended on discoveries of gold or silver mines. However, this does not imply that each individual country was on a bimetallic standard. In fact, many countries were on either a gold standard or a silver standard by 1870. During that time, for example, the British pound was fully based on a gold standard, whereas the French franc was based on a bimetallic standard. On the other hand, the German mark was based on a silver standard. Basically it can be concluded that two currencies, gold and silver, and therefore two currency unions existed, which did not match national borders. (Baldwin/Wyplosz, 2004, p. 276; Eun/Resnick, 2007, p. 26).

2.1.1.1 Gold Standard

After 1870 all major economies including France and Germany started to adopt the gold standard. During the era of the gold standard, from 1880 - 1914, gold was the international means of payment, and each currency was assessed according to its gold value. This means that one could exchange German marks for British pounds in exact proportion to their gold value. The international reserves of a country were completely made up by gold as well as all national bank notes and coins were backed by the gold reserves of a country.

However, the major problem of the gold standard system was that the money supply could only grow at the rate of new gold mining. The economic growth rate in the 19th century became much larger than the physical growth in gold reserves which led to negative inflation in all major economies. Moreover, a country could not have a flexible monetary policy as all national economic policies were totally subordinated to a fixed exchange rate objective (Eun/Resnick, 2007, p. 27; Solnik/McLeavey, 2009, pp. 76, 77).

2.1.1.2 Interwar Period

The system of the classical gold standard ended at the beginning of World War I in 1914. After the war many countries suffered hyperinflation and countries depreciated their currencies as a means of gaining advantages in the world export market. Countries tried to introduce the gold standard again, but at the latest the Great Depression in 1929 ended this attempt. The first country that abandoned the gold standard was Great Britain in 1931 and paper standard came into being. During this period no coherent international monetary system prevailed, which led to grave unfavorable effects on international trade and investments (Eun/Resnick, 2007, pp. 28-29).

2.1.1.3 The Bretton Woods System

The United States of America (USA) and Great Britain were the initiators of the Bretton Woods conference and were determined to draw on the inter-war lessons. In other words this means that there would be no return to the gold standard, there would be a collective construction with active management of the international monetary system, and exchange rates would be neither set free nor rigidly fixed (Baldwin/Wyplosz, 2004, pp. 283, 284).

In 1944 representatives of 44 nations gathered in Bretton Woods, New Hampshire, USA, to design a new post-war international monetary system. The outcome of this conference was the foundation of two international organizations. Firstly, the International Monetary Fund (IMF) was created which embodied an explicit set of rules about the conduct of international monetary policies and was furthermore responsible for enforcing these rules. Secondly, the International Bank for Reconstruction and Development (IBRD), also known as the World Bank, was founded with the aim to finance individual development projects. In addition, the General Agreement on Tariffs and Trade (GATT) was created which later on transformed into the International Trade Organization (ITO) (Eun/Resnick, 2007, p. 29).

Under the Bretton Woods system each country established a par value, which represents the official exchange rate between two countries’ currencies in relation to the U.S. dollar. The U.S. dollar in turn was pegged to gold at $35 per ounce. Each country was responsible for maintaining its exchange rate within ± 1 percent of the adopted par value. The U.S. dollar was the only currency that was fully convertible to gold and other countries held gold and U.S. dollars for use as an international means of payment (Eun/Resnick, 2007, p. 30; Financial Dictionary, 2009, n.p.a).

Owing to that economic policies and inflation rates became so diverse it was difficult to maintain these pegged exchange rates, thus the international system did not work for long. Gold stopped playing a role and the U.S. dollar became de facto the international currency. Several attempts to save the system failed and in 1973 a system of floating exchange rates became the rule, with each currency’s value determined in the marketplace (Solnik/McLeavey, 2009, p. 80).

2.1.1.4 European Snake, European Monetary System and the Euro

In a desperate attempt to save the Bretton Woods agreement the Smithsonian Agreement was signed in 1971 that allowed exchange rates to move ± 2.25 percent. However, the member countries of the European Economic Community (EEC) decided on a more narrowed band of ± 1.125 percent of their currencies. This scaled down exchange rate system was called the “European Snake” and was developed to promote intra-EEC trade and to deepen economic integration through stabilized exchange rates. The main problem of this system, again, was the inability of some members to keep inflation in check and therefore had to leave the Snake arrangement (Baldwin/Wyplosz, 2004, pp. 285, 286; Eun/Resnick, 2007, p. 35).

The response to the failed Snake arrangement was the European Monetary System (EMS) with its instrument of the European Exchange Rate Mechanism (ERM). The ERM had the scope to manage the exchange rates among the EEC members but, again, inflation made it difficult to obtain the ERM and hence also the EMS. In order to maintain the monetary system the EMS had to be realigned several times (Baldwin/Wyplosz, 2004, p. 287; Eun/Resnick, 2007, p. 38).

Despite the turbulences in the EMS, its members met in Maastricht in 1991 and decided to further foster European integration. The Maastricht Council envisioned that the European Community will be replaced by an economic and political union, the European Union (EU), and included a schedule to establish a monetary union. On January 4, 1999 the exchange rates of eleven countries were frozen and their old currencies became fractions of the Euro. In January 2002 Euro coins and banknotes were finally issued and the undertaking of a common currency among European countries that seemed almost impossible, was complete (Baldwin/Wyplosz, 2004, pp. 288, 289; Eun/Resnick, 2007, p. 38).

2.1.2 Development of the European Monetary Union

The establishment of the European Economic Community (EEC), by the Treaty of Rome in 1957, was a very important step towards European economic integration. However, as all participating states were also participants in the Bretton Woods system no further monetary system was needed. When the international monetary system of Bretton Woods was imminent to collapse, the Heads of States and Government of the EEC countries decided to progressively transform the Community into an economic and monetary union. The first step towards further integration was the introduction of the “Snake” that tried to regulate the fluctuations of the currencies of the EEC countries. The results were disappointing and by 1977 only 5 out of 9 EEC member countries remained within the mechanism (Bahr, 2007, n.p.a; Europa, n.d.c., n.p.a).

2.1.2.1 European Monetary System

The monetary disorders followed by the end of Bretton Woods made the EEC to act and in 1978 the German Chancellor Helmut Schmidt and the French President Valery Giscard d’Estaing initiated the Brussels Summit of December 1978. This summit aimed to create the European Monetary System (EMS) and with it a zone of monetary stability in Europe. According to Baldwin/Wyplosz (2004, pp. 314, 315) the only meaningful part of the EMS, however, was the Exchange Rate

Mechanism (ERM), an optional scheme all EEC countries joined except the UK. The ERM was built on several core elements. One of these core elements was a parity grid that fixed the exchange rates to each other by using a band of fluctuation of ± 2.25 percent around the central parity (Italy was the only country that was allowed a margin of fluctuation of ± 6 percent). This grid represented the first European exchange rate system that was standing on its own and compared to Bretton Woods no currency played any special role. Another core element was the symbolic creation of the European Currency Unit (ECU). The ECU was a basket of all EMS currencies that weighted each country’s currency depending on the country’s share of community gross domestic product (GDP) and intra­community trade. These weights were initially chosen and revised every 5 years so that 1 ECU was worth 1 US$. The ECU was the official accounting currency that was used as a payment instrument among the central banks. However, it was no official currency and did not have legal tender (Bahr, 2008, n.p.a; Baldwin/Wyplosz, 2004, pp. 314, 315).

Despite the well theoretical set up of the EMS it did not work the way it was designed for. The main problem it had to fight was the divergence of inflation. Countries like Germany had low inflation rates (about 4 to 5 percent) whereas inflation was high (about 9 percent) in other countries like France. Consequently, the EMS adjusted exchange rates as frequently as needed to avoid competitiveness problems and trade imbalances. The German Deutschmark developed more and more to be the leading currency within the EMS and the system became similar to the Bretton Woods system (Baldwin/Wyplosz, 2004, pp. 317-319; Toman, 2007, pp. 13, 14).

The EMS worked rather well until 1992, when the Maastricht Treaty was signed. This Treaty intended to create a monetary union in Europe and markets started to test if the current exchange rates within the EMS had the correct conversion rates for the introduction of the Euro. Heavy speculations on the financial markets that led to devaluations of several currencies were the result (Toman, 2007, pp. 14, 15).

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Details

Pages
67
Year
2010
ISBN (eBook)
9783640649372
ISBN (Book)
9783640652730
File size
1.4 MB
Language
English
Catalog Number
v152575
Institution / College
University of applied sciences
Grade
1
Tags
Euro Euro Area EMU Trade FDI Balance of Payments

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Title: The Impact of the Euro and the EMU on Intra-Euro Area Trade, FDI, and the Euro Area Balance of Payments