International Use of the Euro - Broadly Stable;

UNCLAS SECTION 01 OF 04 FRANKFURT 001092

SIPDIS

SENSATIVE

STATE FOR EUR PDAS RIES, EB, EUR/AGS, AND EUR/ERA
STATE PASS FEDERAL RESERVE BOARD
STATE PASS NSC
TREASURY FOR DAS LEE
TREASURY ALSO FOR ICN COX, HULL
PARIS ALSO FOR OECD
TREASURY FOR OCC RUTLEDGE, MCMAHON

E.O. 12958: N/A
TAGS: ECON EFIN EUN
SUBJECT: International Use of the Euro - Broadly Stable;
Some Increase In Euro Trade Invoicing


T-IA-F-05-0006

This cable is sensitive but unclassified. Not/not for
Internet distribution.


1. (SBU) Summary: The European Central Bank's (ECB)
annual publication on the international role of the Euro
concludes that the euro's role in international capital and
foreign exchange markets and use as an international reserve
currency "has remained largely stable," while "there have
been signs of increasing use" of the euro for settling or
invoicing trade. This rather unexceptional conclusion, akin
to a "dog bites man," story sharply contrasts to the
attention-grabbing headlines "Central Banks Shunning
Dollar," proclaiming that a survey of central banks revealed
many had increased their euro exposure. The survey,
however, was only "impressionistic," in the ECB's assessment
and did not provide any hard data documenting any increases.


2. (SBU) Notable features of the ECB's report are that:
(a) the Euro's share of official exchange reserves increased
slightly, from 19.3% in 2002 to 19.7% in 2003, nearly two-
thirds of the increase in euro holdings was due to an
increase in the euro's price in relation to special drawing
rights (SDRs); (b) the share of exports and imports invoiced
or settled in euros has increased in trade with countries
outside the euro area; and (c) the euro denominated
international debt securities market remains robust, with
the stock of euro international debt instruments holding a
steady 31% market share. The ECB's report identifies merger
and acquisition activities and firms' strategic objective to
broaden their investor base as main reasons for firms,
including many from the US, using the euro international
bond market. End Summary.

International Role of the Euro
--------------


3. (SBU) Each year the ECB publishes a report tracking the
international use of the euro. This year's report,
published in January 2005, covers the period mid-2003 to mid-

2004. The ECB's policy is not to encourage the use of the
euro outside the euro area, but considers developments in
the use of the euro as "the outcome of decisions taken by
market participants." The ECB's success in maintaining the
value of the euro contributes to market participants'
perception of the euro, particularly as a store of value.


4. (SBU) Since its introduction the euro quickly assumed
the role of its legacy currencies in finance and trade.
With the advent of one currency in the euro area, at a
stroke its capital markets were broadened and deepened, at
least in theory. Some accession candidate countries, now
the new member states, pegged their currencies to the euro,
increased their trade with euro area businesses, and, when
the euro cash conversion occurred, saw savers convert their
holdings of Deutsche Marks to euro bank accounts. Earlier
ECB reports document this one time shift.


5. (SBU) This year's report suggests that after the first
rush of conversions, activity has become less dramatic.
Broadly speaking, the report shows a "significant degree of
stability" in the use of the euro by non-euro area
residents. There is some evidence that the euro is
increasingly being used in settling or invoicing trades with
non-euro area countries in neighboring regions, although
some of the shift could be an improvement in data collection
by national authorities.

International Reserve Currency
--------------


6. (SBU) Global reserve assets totaled USD 3, 014 billion
as of the end of 2003, an increase of 26% from the previous
year. The share of euro-denominated assets of total foreign
exchange reserves edged up from 19.3% to 19.7% over this
same time period, driven by an increase in euro-denominated
holdings in developing/emerging market countries (17.9% to
18.9% share). The share of euro-denominated foreign
exchange reserves of industrial countries' total reserve
assets declined from 21.3% to 20.9%. The share of USD
denominated foreign exchange reserves rose slightly, from
63.5% to 63.8%.


7. (SBU) One interesting feature was the role that price
changes played during the recent reporting period. The
International Monetary Fund (IMF) tallies foreign exchange
reserves in special drawing rights (SDRs),whose value is
derived from a basket of currencies. Therefore, when a
currency appreciates against the SDR, the SDR price of
assets denominated in that currency also rise. In 2003 the
amount of euros in official holdings of foreign exchange
increased by 55 billion SDRs, but 34 billion of the increase
was due to a price change. This reflects the euro
appreciation and, according to ECB experts, the large stock
of euro-denominated foreign assets being held as reserves.


8. (SBU) The ECB report notes that the amount of USDs in
official holdings of foreign exchange increased by 161
billion SDRs. The increase in quantity (263 billion SDRs)
more than compensated for the decrease in price (-102 SDRs).
This large increase in USD denominated holdings reflects, in
part, macro economic strategy by some Asian countries,
according to ECB staff, to maintain a stable exchange rate.
An October 2004 publication of the New York Federal Reserve
Bank surmises, "The largest USD reserve purchases likely
came from Japan, China and Taiwan, with India and Korea also
making sizable purchases."


9. (SBU) This relatively mundane picture is contrary to
the attention-grabbing headlines on January 23 proclaiming
that central banks are "shunning the US dollar." Those
headlines were prompted (or promoted?) by a survey conducted
by Central Banking Publications. The survey proclaimed that
39 of 65 central banks were raising their euro holdings and
29 were reducing their dollar holdings.


10. (SBU) ECB staff, surprised by the report (and summoned
to brief ECB President Trichet),examined it carefully. The
survey results were "impressionistic," in their view, based
on one question: " Have you increased or decreased exposure
to a certain currency?" The survey did not contain any more
recent information or hard data and reflected views of a
wide range of banks, from very small to some very large,
although the largest Asian central banks did not respond to
the questionnaire, in the ECB staff's assessment. The ECB
relies on IMF data to calculate reserves and does not
collect its own information from central banks.

Trade :Invoicing and Settling
--------------


11. (SBU) The ECB report notes that the share of the use of
euro to settle or invoice trades for exports and imports
outside the euro area has increased, more so for goods than
for services. Most dramatic among the increases has been
for Germany, which had 63% of its exports invoiced/settled
in euros in 2003 compared to 49% in 2002, and 55% of its
imports invoiced/settled in euros in 2003 up from 48% the
previous year.


12. (SBU) Germany, France, Italy and Spain all had more
than 50% of their exports settled/invoiced in euro while
only Germany and Spain had more than 50% of their imports
settled in euro. ECB staff observes that this result
reflects "Grassman's Law" whereby "exporters are typically
in a better position to enforce their currency preferences"
than importers. Of the new member states, the Czech
Republic, Estonia, Latvia, Poland and Slovenia all had more
than half their exports invoiced/settled in euros (no data
for Malta and Slovakia). Candidate countries Bulgaria and
Romania have better than 60% of their exports
invoiced/settled in euros.

13. (SBU) Reasons for the increase are partially due to new
data. The ECB relies on national authorities for this data,
some of which has become available only recently. ECB staff
also suspects valuation has contributed to the increase as
well as long-term contracts that had been in legacy
currencies and are now being renewed in euros. The ECB
report notes that the use of the euro in trade is
geographically concentrated in countries neighboring the
euro area, but also detects "some evidence" of an increase
use in other countries. There is, however, a natural
ceiling to the use of euros in trade, particularly import
transactions, as certain commodities that are traded on
exchanges or referenced priced in USD, such as oil.


14. (SBU) A recent staff paper of the New York Federal
Reserve Bank broadly confirms the ECB's findings. It states
that the USD is "strongly used on all trade transactions
with the United States and on other transactions that are
primarily in goods that are traded on organized exchanges or
that are referenced priced." The staff paper reports that
USD invoicing accounts for more than 50% of exports and
imports in the Asian countries of Japan, Korea, Malaysia and
Thailand as well as Australia. Greece was the lone euro
area country in this category, most likely due to the
predominance of maritime shipping in its trade. However,
the NY Fed paper notes that the share of exports and imports
of goods that are traded on organized exchanges or reference
priced has declined as trade in manufactures has increased.
Thus, the paper concludes that these declines suggest that
there has been a steady decline in USD invoicing via this
channel.

Debt Securities
--------------


15. (SBU) The ECB uses a narrow definition of international
securities, referring to issuance in a currency other that
the currency of the country in which the borrower resides.
Using this measure, the stock of outstanding international
debt securities is USD 5,042 billion, 31% of which are
denominated in euros, 42% in USDs. These shares have been
steady for the last few years, after the euro legacy
currency share climbed quickly after its introduction in
1999, gaining nearly 10% in market share by 2001 while the
USD share eased 2%. Using a "global measure" of debt
securities that includes securities denominated in the home
currency and targets the international and domestic market
shows that the USD account for 43% of USD 53,000 billion in
outstanding debt securities while the euro accounts for
25.6%.


16. (SBU) The ECB explains in another report on the euro
bond market reasons for the rapid gains of the issuance of
euro denominated international debt securities. It explains
this development as a product of efficiency gains brought
about by the growing size of the euro area financial
markets, supported by the creation of payment and security
settlement systems and a unified money market, as well as
increased competition from non-euro area underwriters that
drove down underwriting fees. In a special section of this
year's report, the ECB analyzes in detail the issuance
activity by private entities and concludes that is it often
associated with merger and acquisition activity or with the
strategic objective of broadening the investor base.


17. (SBU) The largest issuers in this market are European
entities, especially UK firms, accounting for 44% of the
total in outstanding international debt instruments. US
residents account for about 20% of the issuance activity.
Large issuers from the United States include Federal Home
Loan Mortgage (Freddie Mac),Merrill Lynch, Goldman Sachs,
General Motors Acceptance Corporation and GE Capital. On
average, around 80% of these debt issues are initially
purchased by European investors.

Foreign Exchange
--------------


18. (SBU) According to the 2004 Triennial Survey conducted
by the Bank of International Settlements, the euro was
involved in 37% of all foreign exchange transactions in
2004, a decrease of less that one percentage point compared
to its share in 2001. Average daily turnover in the forex
market is estimated to be USD 1,880 billion. 76% of all
global activity involving the euro was in trading vis--vis
the USD.

Use As Parallel Currency
--------------



19. (SBU) Residents in some countries outside the euro area
hold assets in euro denominated assets, mostly as cash or
euro denominated bank accounts. In countries neighboring
the euro area, foreign cash held in legacy currencies,
predominately Deutsche Marks, had been converted into euro
cash notes or deposits. By the end of 2002, two years after
the conversion to euro cash notes, the flow of euro
banknotes shipped to destinations outside the euro area has
stabilized. Net shipments of euro banknotes to destinations
outside the euro area amounted to euro 9.4 billion down from
euro 14.2 billion in the previous year. The cumulative
stock of euro banknotes outside the euro area was euro 45.8
billion by the end of June 2004 compared to euro 36.4
billion a year earlier.


20. (SBU) The ECB's data showed that Russian businesses and
households demand euro cash for conducting trade and
tourism. However, when some Russian banks faced liquidity
problems in mid-2004, depositors preferred to exchange their
ruble deposits into USD cash.


21. (SBU) The nations of the former Yugoslavia have a
significant share of bank deposits denominated in euro. In
Croatia, Macedonia, Montenegro and Serbia better than half
of the total bank deposits are denominated in euros.
Interestingly, the new member states have a much smaller
share of euro-denominated deposits with the highest in
Latvia, at 19.8%. This suggests that new member states have
more credible monetary policy that protects the value of
their local currency. ECB experts point out that conducting
monetary policy is rendered more difficult when a large
share of deposits are denominated in foreign currency.


22. (U) This message coordinated with Embassies Berlin, and
USEU Brussels.


23. (U) POC: James Wallar, Treasury Representative, e-mail
wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)-
7535-2238

Bodde