Deutsche Bank Research

Frankfurt, January 14, 2002

Prof. Norbert Walter
Chief Economist
Deutsche Bank Group

Changeover accomplished: the euro becomes a real currency

1. The final steps to the euro

The introduction of euro notes and coins marks the final step of the multi-year EMU
timetable. Since January 1, the euro is legal tender in 12 EMU countries for more
than 300 million Europeans from Lapland to the Mediterranean. The euro cash rollout
has worked smoothly and in any case much better than expected by many
doomsayers. Besides, the two final steps in the banking and corporate sector
deserve special mention. In a tremendous effort, banks re-denominated the accounts
of their corporate and private clients in euros by the end of 2001. That completed the
switchover to the euro in the financial sector. Moreover, the corporates also changed
over to the euro more or less smoothly by that date. Since the beginning of the year
the euro is the sole currency unit for prices, salaries, contracts etc. On February 28,
over three years of transition will end.

2. Introduction of euro cash - a historic event

In technical terms the cash changeover has been a tremendous logistic challenge.
The distribution of euro cash has been successfully managed so far although some
problems have emerged (such as coin shortages in some countries and the
appearance of false coins in Italy). No doubt, the thorough preparation and the close
co-operation of all concerned – central bankers, bankers, retailers, cash-in-transit
and security firms etc. – have been the key to the successful management of the
cash changeover.

The introduction of euro cash is, however, more than a purely technical step. It is a
historic event and a milestone in European integration. The national currency symbol
has been replaced by a European one. The introduction of cash is psychologically
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important because it has transformed the euro from a "virtual" to a "real" currency.
People now hold the euro in their hands, use it in everyday life and enjoy the related
advantages throughout the euro area. That has already boosted acceptance and
credibility. [I am still convinced that the transition period of three years since the start
of EMU in 1999 was too long and an earlier introduction of euro cash would have
been very helpful to support confidence in the new currency. It is a pity that the virtual
euro led to many misunderstandings about EMU and stood in the way of a better
acceptance in the markets and the general public, in particular in Germany. But that
is past history.]

People in Euroland welcomed the euro notes and coins with more enthusiasm than
expected. Many queued up at banks and cash dispensers in the first few days of the
new year. This was surprising insofar as it is not mandatory to use euro cash right
away as national cash can still be used until the end of February. But people were
curious to get to know the new euro banknotes as early as possible (while many
people were already familiar with the euro coins thanks to the "starter kits").
Acceptance is also underpinned by the fact that, on average, about three-quarters of
all cash transactions in the euro area were already carried out in euros by the end of
the first week of the new year (according to the European Commission). The euro
proportion exceeded 60% in all EMU countries. Therefore I am confident that the
euro will actually be regarded as "our currency" soon.

There are several reasons for the quick changeover to the euro. It is much more
convenient for consumers to handle only one kind of cash. Moreover, almost all
prices are shown in euros, while price tags with national denominations are
disappearing. Surprisingly, even people in Germany have been quick to part with
their beloved D-mark notes and coins, which officially lost the status of legal tender at
the end of 2001. The guiding principle of the Germans, obviously, has been
pragmatism and not euro-scepticism.

[Excursus: Italy has become a cause for concern in the context of the introduction of
the euro cash. But it is not the rollout of euro notes and coins that has been
associated with more trouble than elsewhere. The source of concern is the debate
within the Italian government over the country’s future relationship with the European
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Union. This could be misread as a change in the government’s attitude towards the
EU and a reduction of the political commitment to European integration. Any return of
EU founding member Italy to national egoism would cause many political and
economic risks and set a bad example. After the completion of EMU the European
Union requires Italy’s traditionally strong support for European integration more than
ever given the big challenges ahead with regard to enlargement and institutional
reforms. We also need Italy in order to increase Europe’s voice and clout in the
world. Therefore the current "Italian issue" should be resolved as soon as possible.]

3. The macroeconomic impact of euro cash is small

The "world of prices" is particularly affected by the introduction of euro cash. The
general changeover to euro prices since the beginning of 2002 requires people in
all EMU countries to develop a new feeling for prices, based on the conversion rates
between their national currency and the euro. I think that this will happen relatively
quickly in everyday life. The situation is similar to the changeover of financial markets
to the euro in 1999, when market participants came to regard use of the euro as
"business as usual" within a few weeks. I admit, however, that the conversion is
easier in some countries (such as Germany where the conversion rate is EUR 1 =
approx. DEM 2, or Italy at EUR 1 = approx. ITL 2000) than in other countries (e.g.
Spain where EUR 1 = ESP 116.386).

The impact of the introduction of euro cash on the inflation rate has been a fiercely
debated issue. People in Euroland are worried that the currency changeover might
be misused by companies to increase prices. Opinion polls show that this concern is
shared by about two-thirds of the citizens throughout Euroland. So far we have seen
euro-related price increases as well as euro-related reductions (e.g. in special offer
actions and in the field of "signal" prices: DEM 19.95 before and EUR 9.95 after the
changeover; "exact" conversion would have led to a price of EUR 10.20). At present
there is hardly any hard information available about the overall impact on the price
level. The Euroland inflation rate for January 2002 will not be available until early
February. However, there are good arguments that inflationary effects will be limited.
The weak state of the economy in most EMU member states and fierce competition
in the retail sector will leave little scope for raising prices for this part of the economy.
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The greater price transparency and competition will also have a dampening effect.
Besides, consumer-protection organisations and the media will keep a watchful eye
on the changeover process. However, quite a significant part of the CPI reflects non-
market or administered prices. So in areas where competition does not exist, prices
may go up.

With regard to the next monthly figures for the Euroland inflation rate, the immediate
problem will be to decide how to isolate euro-related price effects. The inflation rate
for January will be fuelled by many other factors such as increases in consumption
taxes (e.g. Germany, Ireland) and administered prices while the lower oil price will
have a counterbalancing effect. Deutsche Bank forecasts a Euroland inflation rate of
just over 2% for January 2002, i.e. a few decimals higher than the 2.0% in December
2001. The forecast for average 2002 is 1.6% (2001: 2.6%). The introduction of euro
cash is not expected to be a risk for price stability.

Some doomsayers argued that private consumption in the first quarter of 2002
might suffer because of a lack of availability of euro notes and coins, long queues in
the stores and businesses as well as difficulties in the handling of parallel cash in
January and February ("chaos scenario"). However, given the successful introduction
of euro coins and notes and the rapid changeover to euro cash "shopping in euros"
will soon become business as usual. Private consumption is expected to be
moderate in the first quarter but for other reasons than the euro changeover. By
contrast, private consumption in the fourth quarter of 2001 – in particular the
Christmas business – was stronger than expected because it was boosted by the
spending of legacy-currency cash which had been hoarded in the form of "mattress"
or black money.

The foreign exchange market reacted to the successful introduction of the euro
cash with a higher valuation of the exchange rate on the first trading day (plus 2.6%
vis-à-vis the US dollar). But this firming of the rate was only short-lived and the euro
soon fell back to a level below USD 0.90/EUR. It is not surprising that other
determinants have been more important for the exchange rate. I think that the cash
changeover is only of minor importance. However, I am convinced that the euro has
received a psychological boost internationally from the fact that it is now a real
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currency. Moreover, the euro-sceptical Anglo-Saxon market participants recognise

that the risk of an exit of a country or a breakdown of the whole project has
decreased with the introduction of euro cash.

[There was controversial debate in the academic and banking communities last year
about the probable impact of the large volume of D-mark cash in circulation in
Eastern Europe and Turkey (in the magnitude of DEM 70-100 bn) on the euro
exchange rate vis-à-vis the dollar. Some academics (Prof. Sinn, IFO Institute Munich)
argued that the weakness of the euro could be explained by a large-scale exchange
of D-marks into US dollars in advance of the cash changeover. It was argued that
holders of D-mark cash were not familiar with the euro and wanted to avoid receiving
"soft euros" after the changeover. Obviously there has been no overwhelming
evidence for the assumption of massive buying of US cash. The fact is that
Germany's Bundesbank launched a wide-ranging information campaign in these
countries in 2001 and the process of changing D-marks into euro cash or euro
accounts started in Eastern Europe at the turn of the year. This is also true for
Montenegro and Kosovo which adopted the euro as official means of payment as of
January 1, 2002 (instead of the D-mark). It is taken for granted that the euro will slip
into the role of the D-mark in Eastern Europe and Turkey.]

4. What are the most pressing issues after the completion of EMU?

The changeover to the euro is definitely not the end of monetary integration in
Europe. The European monetary house is built now, with the euro. But the work on
the interior is far from being completed, and the house will have to be extended by
adding a new wing with prospective EU enlargement by up to 12 candidate countries.

Now the focus should be on the following EU "construction sites":

I. Stimulating of growth since the economy is weak and the credibility of the
vision of the Lisbon summit 2000 ("EU to become the world's most dynamic
knowledge-driven economy by 2001") is at stake. It is argued that the euro
brings more price transparency and stimulates growth. But good money is not
sufficient to boost the growth potential. We must seize a new initiative to
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implement structural reforms in particular with respect to labour markets and

social security systems. Growth performance will also be an important
yardstick for the international attractiveness of the euro.

II. The integration of the euro financial market is far from being satisfactory.
Differences in legal, accounting and tax systems are, for instance, a major
obstacle to creating an integrated equity market. The FSAP provides a
constructive agenda towards the creation of an internationally competitive
financial market. However, tendencies towards over-regulation of markets
should be avoided. In any case, a swift implementation of the FSAP
programme needs to be ensured. Speeding up the legislative process as
suggested by the Lamfalussy Report is imperative. It is gratifying to note that
the European Parliament and the Commission have made significant progress
on the way towards a common approach. Integrated and more liquid financial
markets are a crucial factor for the attractiveness of the euro for international
investors.

III. EU institutions including the ECB need to be reshaped in order to

strengthen the ability to act after enlargement. For instance, membership of
the ECB’s Governing Council could grow to 30 members (or 33 if the UK,
Sweden and Denmark are also integrated) compared with 18 members at
present. 33 members are too many as this would paralyse the decision-
making body. It is welcomed that the Nice EU Treaty has already provided the
legal framework for a flexible adjustment of the ECB statute.

IV. EU enlargement is on a good track. EU membership for the candidate

countries of course does not automatically mean immediate EMU participation.
EMU membership is to be won by satisfying the respective convergence
criteria. It looks as if the first candidate countries will be ready to join EMU by
2007.

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