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International : The Rise of the Deutsche Why the German is being used increasingly worldwide George S. Tavlas

low does a national currency acquire the nating financial transactions. International record of sustained current account deficits status of an international or key currency? currencies are also used by official agents in in excess of normal private capital inflows This question is being asked anew the defining exchange rate parities. As a store of (i.e., those capital inflows that exist in the takes on increasing impor- value, international currencies are held by absence of undue restrictions on trade or tance on the global scene. The postwar world private agents as financial assets (e.g., in the special incentives to incoming or outgoing was dominated by two currencies, the US form of bonds held by nonresidents). Simi- capital) can lead to continuous exchange rate dollar and the . But, as larly, official agents (such as central banks) depreciation, eroding confidence in the cur- explained by Robert Aliber, they "became hold international currencies and financial rency. international currencies neither by Act of assets denominated in such currencies as On the need for well-developed and free Congress (Parliament) nor by Act of God, but reserve assets. financial markets, in general, just as relatively rather because they met various needs of Two sets of factors are essential if a low levels of and inflation variability foreign official institutions and foreign private currency is to be used internationally. First, contribute to the demand for international parties more effectively than other financial there needs to be confidence in the value of currencies, well-developed financial markets assets could" (The Future of the Dollar as an the currency and in the political stability of the facilitate the supply (as well as the demand) International Currency, New York, 1966). issuing country. Second, a country should of such currencies. Thus, the large and free One of the factors underlying the adoption possess financial markets that are substan- financial markets of New York and London of a managed floating exchange rate system tially free of controls, broad (i.e., contain a contribute to the use of the dollar and the in 1973 was the desire to move away from large assortment of financial instruments), pound sterling, respectively, as international the dollar standard that characterized the and deep (i.e., there exist well-developed currencies. Bretton Woods fixed rate system. Although secondary markets). It should also possess The absence of financial market controls the international monetary order continues financial institutions that are sophisticated and contributes to lower costs of transacting in a to be dominated by the dollar, in recent years competitive in offshore financial centers. currency than would otherwise be the case. we have seen the gradual move toward a Regarding the first factor, high and variable Correspondingly, a country that possesses multicurrency system. Other curren- inflation rates—relative to those of other financial markets that are broad and deep is cies—including the deutsche mark and the countries—generate nominal exchange rate in a position to serve as an international yen—are being increasingly used internation- depreciation and uncertainty. This increases banking center. Specifically, such a country ally. This article explains the characteristics the costs of obtaining information and per- can be expected to provide a high degree of of an international currency and the factors forming efficient calculations about the prices efficiency in international liquidity transforma- that affect them, before discussing the extent of tradable goods and capital assets, thereby tion by accepting short-term, liquid, liabilities of the internationalization of the deutsche undermining the use of a currency as an denominated in its own currency, while mark in recent years. international , , making long-term, less liquid, loans abroad. and medium of exchange. Further, inflation While the foregoing conditions are impor- An international currency increases the costs of holding a currency by tant determinants of international currency An international currency fulfills three eroding its purchasing power, thereby debas- use, they do not fully explain why a currency basic functions in the global monetary sys- ing the currency as an international store of emerges as a dominant international cur- tem: it serves as a medium of exchange, unit value and medium of exchange. While holding rency. In this regard, studies of invoicing of account, and store of value. As a medium a relatively high inflation currency in an of exchange, an international currency is used interest yielding form can offset some of the by private agents in foreign trade and inflation cost, such holdings still entail in- international capital transactions. Official creased costs of calculations and are associ- A longer study "On the International Use of agents use international currencies to inter- ated with higher risk. Currencies: The Case of the Deutsche Mark," IMF vene in foreign exchange markets and for The achievement of relatively low levels Working Paper (WP19013), is available from the balance of payments financing. As a unit of of inflation and of inflation variability depends author. A revised version of the Working Paper will account, an international currency is used for importantly on stable and consistent govern- be published in the Princeton University series invoicing merchandise trade and for denomi- ment policies. In this connection, a track Essays in International Finance.

Finance & Development / September 1990 35

©International Monetary Fund. Not for Redistribution practices between exporters and importers industrial countries, the medium-term orien- instruments—including floating rate notes, have shown that the international dominance tation of 's monetary policy has been zero coupon bonds, and bonds linked to of a nation's currency appears to be directly quite successful in maintaining a stable currency and interest rate swaps—were related to the country's share of world internal value of the deutsche mark. In fact, strictly prohibited. Finally, in the 1970s, exports, the proportion of specialized manu- over 1970-89 Germany experienced the there were also restrictions against the factured products in its exports, and the lowest average annual inflation rate (3.9 holding of German securities by foreign extent of its trade with developing countries. percent) among these countries. The Bun- official institutions, thereby limiting the use These observed behavioral patterns reflect desbank's success in controlling inflation of the deutsche mark as a . the tendency for trade between developed established credibility for Germany's mone- These and other restrictions, including a countries to typically be denominated in the tary policy and led eventually to the deutsche withholding tax on interest income, which currency of the exporter. Importers often mark being used, in effect, as the nominal was announced in late 1987, weakened the refrain from currency hedging because for- anchor for the other currencies participating competitive position of German banks vis-a- ward markets are typically thinner than spot in the Exchange Rate Mechanism (ERM) of vis foreign banks, while the surge and markets and therefore entail larger bid-ask the . In turn, this increased variability in inflation during the spreads. Importers often guard against cur- situation has allowed Germany to retain a fair 1970s rendered fixed rate bonds less attrac- rency fluctuations by passing through the degree of domestic monetary independence tive than other, more flexible instruments. consequences of exchange rate changes to and decreased the volatility of its nominal These developments led to innovations aimed their customers in the domestic market in the exchange rate against the currencies of its at eroding the regulations, an effort facilitated form of higher prices. This course of action EMS partners. by technological improvements (e. g., in data is most practical in small, open economies in processing) that lowered transaction costs. which a large domestic import-competing German financial markets For example, in 1983 a foreign deutsche mark industry does not exist and helps explain why But the Bundesbank did not favor a broad bond issue had been used to arrange a trade between developed and developing international role for its currency until the currency swap, allowing foreign access to the countries is usually denominated in the mid-1980s, when it acknowledged the diffi- deutsche mark bond market. Subsequently, currency of the developed countries. Export- culty of inhibiting market forces underlying to maintain the competitive position of the ers are also more likely to have an incentive the demand for deutsche mark-denominated deutsche mark relative to other currencies, to invoice in their own currency to guard assets. During the period encompassing the the Bundesbank has lifted most financial against unforeseeable exchange rates. They late 1960s through the early 1980s, the market restrictions in recent years, with the cannot easily cut factor payments that had Bundesbank attempted to moderate the withholding tax abolished as of July 1989. been previously set via contracts, particularly international use of the deutsche mark. Nevertheless, partly because of Germany's in the case of manufactured exports involving Underlying this approach—which emerged relatively late move to ease restrictions, the long production lags. Exporters can use the under the Bretton Woods fixed exchange rate breadth and depth of German financial mar- forward market to cover their risk but this regime—was the view that substantial swings kets have lagged behind some other large increases their costs. It is more expedient to in capital flows could impede domestic stabili- financial centers, most notably London and pass the risk off to the importer. zation objectives. While the move to a floating New York. Further, a turnover tax on all The combination of all these fac- exchange rate system increased the Bun- secondary market dealings in bonds and tors—relatively low inflation, broad and deep desbank's control over domestic monetary equities has prevented the establishment of financial markets, and pertinent trade pat- conditions, the gain in control may have been a market in short-term commercial instru- terns—fosters the use of a currency for less for Germany than for other large ments and encouraged the switching of international transactions. Against this back- developed countries in view of the relative secondary trading in deutsche mark-denomi- ground, we can examine the use of the openness of the German economy. In particu- nated instruments to foreign financial centers. deutsche mark as an international currency lar, the Bundesbank's view was that the Also, the equity market is not as developed since the 1970s. relative openness of the German economy in as the New York and London equity markets, terms of foreign trade made that economy and futures trading has only recently been Inflation and monetary policy particularly susceptible to the conse- allowed. While measures have recently been Keeping the value of money stable has quences—including on inflation—of exchange taken to enhance Germany's competitiveness been the aim of the rate changes. in these areas, the relatively late shift to ever since its establishment. Since 1975 that Consequently, to tighten its grip on domes- more open financial markets has restricted aim has been pursued by formulating and tic monetary conditions, the Bundesbank Germany's relative efficiency in competing for announcing monetary growth targets. A extended relatively firm control over capital international funds. similar anti-inflationary orientation for mone- inflows. In this context, a "gentleman's tary policy was also adopted in the 1970s by agreement" entered into by the Bundesbank Trade patterns a number of other large industrial countries, and the German banks in 1968 stipulated that Developments in Germany's trade pat- including France, Italy, Japan, Switzerland, only German banks could lead syndicates for terns in recent years have generally been the United Kingdom, and the United States. deutsche mark-denominated bonds. The ra- conducive to the international use of the Underlying this medium-term approach was tionale underlying the agreement was that deutsche mark on several accounts. First, in the view that in the short run, monetary German banks would be more apt to follow 1986, Germany became the world's largest growth is an important determinant of nomi- the advice of the Bundesbank than would exporter, surpassing the United States, thus nal income growth and the balance of pay- foreign banks and therefore could be more enhancing the potential role of the deutsche ments, and that over the medium term, its effectively controlled. A second important mark in global invoicing. Germany remained primary impact is on inflation and the nominal restriction concerned the kind of bonds that the world's largest exporter until 1989, when exchange rate. could be issued. Only the standard fixed rate the United States regained the position of the In comparison with these other major bond was permitted. Innovative financial world's largest exporter. Second, over 1980-

36 Finance & Development I September 1990

©International Monetary Fund. Not for Redistribution 88 the share of specialized manufactured goods (primarily machinery and transport Table 1 Currency distribution of foreign exchange goods) in relation to total German exports intervention in the EMS and by the rose from 45 to 48 percent. US Federal Reserve and Treasury1 On the other hand, Germany's trade with (in percent) developing countries has decreased in recent years. Exports to developing countries as a EMS share of total German exports declined from 1979-822 1983-85 1986-873 about 26 percent in 1980 to 19 percent in US dollars 71,5 53.7 26.3 1988, and imports from developing countries EMS currencies 27.2 43.5 71.7 as a percentage of total German imports Of which: declined from 29 percent to 21 percent. Deutsche mark (23.7) (39.4) (59.0) These declines, however, have been more Others4 1.3 2.8 2.0 than offset by a rising proportion of German United States trade with other European countries. For example, German imports from EC countries Deutsche mark 89.7 67.9 57.5 rose from 62 percent in 1980 to 70 percent 12.3 22.1 42.5 in 1988. Given that EC countries have in Sources: "Interventions, Sterilization and Monetary Policy in the European Monetary System Countries" by C. Mastropasgua et a/, 1988; Deutsche Bundesbank; and Federal recent years invoiced a growing proportion Reserve Bank of New York. 'Total intervention includes both purchases and sales. of their exports in deutsche marks, the 2From March 1979. 3Upto June 1987. decline in Germany's trade with developing 4From 1985 onward, the figures include intervention in private European Currency countries need not imply an overall decline in Units. the share of world trade denominated in deutsche marks. Moreover, corresponding declines in trade shares with developing countries were experienced by most other European Monetary System has risen from billion. Likewise, deutsche mark-denomi- large developed countries—including Japan about 24 percent in the early 1980s to almost nated claims outside Germany in the form of and the United States—during the 1980s. 60 percent in recent years, with most of the eurodeutsche mark deposits and external The preceding discussion suggests that, in increase coming at the expense of the dollar. deutsche mark bonds, more than doubled, general, the determinants of international Again, the data reflect the increased use of reaching DM 730 billion at the end of the currency use presage an expanding interna- the deutsche mark by European countries. period. In terms of the performance of the tional role for the deutsche mark. Recent data The use of the deutsche mark as an deutsche mark relative to other currencies, trends confirm this expectation. There has international store of value has also increased. the deutsche mark's share of issues been an increase in the use of the deutsche Deutsche mark-denominated claims in Ger- rose from about 6.5 percent in the early 1980s mark as an international unit of account, with many held by nonresidents more than doubled to about 9 percent in the late 1980s; during a growing share in the deutsche mark- between 1980 and 1986, reflecting measures this period, the share of the Japanese yen denomination of world exports. Taking into taken to deregulate the financial system in rose from about 5.5 percent to 10.5 percent, account the invoicing practices of the six those years. However, the announcement in while the share of the US dollar declined from largest industrial countries and of the Organi- 1987 of the withholding tax decreased the 63 percent to 47 percent. Likewise, the share zation for Petroleum Exporting Countries, demand for deutsche mark-denominated in- of deutsche mark eurocurrency deposits rose as well as these countries' share of world struments. Consequently, deutsche mark- from 11 percent to 13 percent. The yen's trade, the following trends emerge: in 1980, denominated claims held in Germany by share rose from 2 percent to 5 percent while at least 34.5 percent of world exports were nonresidents showed little overall increase in the US dollar's share declined from 74 denominated in dollars while 10.2 percent 1987 and 1988. The subsequent abolition of percent to 62 percent. were denominated in deutsche marks; by the withholding tax in 1989 led to a sharp It is noteworthy, however, that most of the 1987, the respective numbers were: 24.8 increase in foreign deutsche mark claims held increase in the deutsche mark claims in percent in dollars and 12.4 percent in in Germany in that year. Taking the entire Germany held by nonresidents was in long- deutsche marks. period 1980 through the first half of 1989, term claims. The share of long-term claims Other uses such claims almost tripled, rising to DM 585 rose from roughly 60 percent at the beginning of the 1980s to over 70 percent in the late As mentioned earlier, one measure of a 1980s. This reflects Germany's comparative currency's role as an international medium of George S. Tavlas disadvantage with regard to short-term finan- exchange is its use in exchange market a (7S citizen, is in the cial instruments; as noted, the turnover tax intervention by central banks. In this connec- Financial Relations Divi- on all secondary market dealings in bonds and tion, the deutsche mark is one of two sion of the Fund's Treas- equities has prevented the establishment of currencies used for intervention by the US urer's Department. He holds a market in short-term commercial instru- Federal Reserve and the US Treasury, the a PhD from New York ments. In turn, this has restricted the other currency being the Japanese yen. In University and has worked efficiency of the German financial market in fact, the deutsche mark has accounted for at the US Department of State and the OECD. exercising one of the central functions of a more than half of US intervention throughout key-currency country—notably in providing the 1980s, although its share vis-a-vis the yen a high degree of efficiency in international has declined (see Table 1). Further, the share liquidity transformation by being able to of deutsche mark intervention within the accept short-term liquid liabilities denomi-

Finance & Development I September 1990 37

©International Monetary Fund. Not for Redistribution Conclusion Table 2 Official holding of foreign exchange, 1975-881 The deutsche mark has emerged as an (in percet) essential component of the international monetary system, to a significant extent 1975 1980 1985 1988 because of the deutsche mark's increasing importance as a key currency within Europe. US dollar 79.4 68.6 64.2 63.3 Pound sterling 3.9 2.9 3.1 3.1 In this regard, recent actions taken to open Deutsche mark 6.3 14.9 14.9 16.2 trade and financial connections between East- French 1.2 1.7 1.3 1.7 ern and should contribute Swiss franc 1.6 3.2 2.3 1.5 to wider use of the deutsche mark as a Netherlands guilder 0.6 1.3 1.0 1.1 transaction and reference currency within Japanese yen 0.5 4.3 7.8 7.2 Europe. Indicative of the growing use of the Unspecified currencies 6.5 3.1 5.4 6.0 deutsche mark within Europe was the deci- Source: IMF Annual Report, 1989. sion, effective in January 1990, to peg the 1 End-of-year data. Official holdings include monetary authorities' claims on nonresidents in the form of bank deposits, treasury bills, short-term and long-term government securities, European Currency to the deutsche mark. An- Units, and other claims usable in the event of balance of payments need, including nonmarketable claims arising from intercentral bank and intergovernmental arrangements, without regard as to other important move is the currency union whether the claim is denominated in the currency of the debtors or the creditors. between the two German republics, provided that it does not undermine the internal value of the deutsche mark. The essential require- nated in its own currency, while making with the period 1985-88, the data show that ments for the continued use of the deutsche long-term, less liquid loans abroad. the largest gains in shares were registered mark as a key international currency are the Currency shares of official holdings of by the Japanese yen (2.9 percentage points) maintenance of the Bundesbank's firm anti- foreign exchange from 1980 through 1988 are and the deutsche mark (2.3 percentage inflationary bent, the further deepening and another measure of a currency's use as an points). On the other hand, the shares of the widening of German financial markets, and international store of value (see Table 2). dollar and Swiss franc fell by 5.4 percent and the continuation of Germany's role as a major Comparing the average holdings in 1980-83 1.0 percent, respectively. world exporter. •

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38 Finance & Development I September 1990

©International Monetary Fund. Not for Redistribution