How Euro came into Existence

European Countries after the collapse of the Bretton Woods system, sought to restore exchange rate stability. This would improve and promote the Intra-European investments and trade as well as the economic integration. Hence European Community launched the European Monetary System (EMS) in 1979. The objective of EMS was:1) To establish a Zone of Monetary Stability in Europe 2) To coordinate Exchange rate policies with the Non- EMS currencies 3) To pave way for a European Monetary Union. The operational instruments were the European Currency Unit (ECU) - a basket currency constructed as the weighted average of the currencies of EMS member countries, the precursor to the Euro, and the Exchange rate mechanism, a procedure by which the member countries collectively managed the currency exchange rate. A currency could only fluctuate by a maximum of plus or minus 2.25%, a quasi- fixe exchange rate regime for European currencies.

The Challenge: Different Economic Conditions and objectives meant that aligning the
monetary policies between countries under such a system posed a challenge for implementing the EMS and setting up a base for the EURO. Countries had to raise or lower the interest rates to implement the EMS successfully and from fear of higher unemployment. Italy and UK pulled out of the EMS in 1992. Italy subsequently rejoined in 1996 but UK did not.

The Learning: The 1990s EMS crisis posits that a country cannot simultaneously have a
fixed or stable exchange rate, policy autonomy and open capital markets. It can have only two at maximum. This crisis is called the Incompatible Trinity.

The coordination problems were overcome and the EMS fulfilled its mission by launching EURO on January 1, 1999. Since then the EUROPEAN CENTRAL BANK (ECB) has been sole entity responsible for conducting the monetary policy for the whole Euro area. The independence of ECB is legally guaranteed and it is not subject to any pressure from particular interest group.

Mandate of ECB:
Focused on maintaining the Euro-area price stability- defined as annual inflation of less than but close to 2 percent. ECB maintained the inflation level from 1999-2007 at an average of 2.1%, lower than that of 2.7% average of U.S. The credibility of ECB is very high and it helps Euro become competitive as a global key currency.

Benefits of Euro
Stabilizing prices in Euro area Reduction in transaction cost Eliminated exchange rate risks Bolstered cross border trade and investment in the Euro area Facilitated Corporate restructuring via mergers and acquisitions, enabling optimal business locations decisions and strengthening the competitiveness of the European companies Created conditions conducive to the development of Continental European capital markets. As a result, the depth and liquidity of these markets is comparable with that of the U.S. markets Adoption of Euro has lowered the cost of capital and significantly raised value of firms in the Euro area. Companies can now raise capital at favourable rates.

Euro VS Dollar: The Emerging Competition

The US Dollar emerged as the dominant global currency after the World War 1, replacing British pound as the currency of choice in the international transactions. US came out of the War as the largest economy of the World with Gold convertibility of the US dollar intact. This dominant status of the Dollar was solidified in the Bretton Wood agreement of 1944. According to the agreement, the US Dollar was pegged to Gold and all the other currencies were pegged to US Dollar. It remain pegged to Gold till 1971. The peg could not be held and the Bretton Woods system came to an end. The US Dollar still maintained its dominance in the International Monetary system on account of: 1) Sheer size of the US economy 2) US political and military power 3) The credibility of the US Federal Reserve Today, the Euro area is remarkably similar to that of the U.S. and the following table, shows the same in terms of population size, GDP and World Trade Share.

In 2007, the Euro proved more popular than the dollar as a denomination currency for international bonds. But because of the greater development of and dependence on equity financing in U.S. the Euro trailed the U.S. But US dollar, by far remains the primary reserve currency. In 2007, the euro area had a population of 317 million, larger than the US population of 306 million. At the same time, Euro area GDP totaled $12.2 trillion while that of the US amounted to $13.8 trillion. The euro area accounted for 14.5% of world trade, above the US share of 11.4%. And the euro proved more popular than the dollar as a denomination currency for international bonds. Still, the euro area trailed the US in terms of stock market capitalization, reflecting the greater development of, and dependence on, equity financing in the US.

World Share in Currency Reserves in 2007

4.70% 2.90%
26.50% 63.90% U.S. Dollar Euro British Pound Japnese Yen

Why US Dollar is ahead of Euro in the International market

First, the use of US Dollar is entrenched in the globe. Many of the countries have assets and commodities are denominated in this currency. Second, Euro area does not command the unity and stability of the government of US. The fact that the Euro area is not the United states of Europe reflects that the economic and political environment in member countries is smooth but not as smooth as visioned. Third, there is need to improve the labour mobility within the Euro area. This comes in reference with the article Get Europe Back to Work |Economic Times| New Delhi| Monday|30 January 2012| Page 18.

Fourth, the Euro Crisis, problems in Greek economy recently shows that the Area somehow is not seen as a Unit. Changing monetary policies and handling shocks becomes a difficult task.

How Euro gives a fight to US dollar

ECB has a great credibility in the global market. The actions taken by the ECB have made a big difference in taking the downside risk scenario off the table, in the Global Financial Crisis, especially in terms of the banking system(1). Refer to World Economic Forum Davos 2012 7%
growth nothing to apologise for, says Vikram Pandit, CEO, Citigroup as on 31 Jan, 2012 in Economic Times.

The sheer size of the euro area (in terms of population, economic output, and world trade share), highly developed and open capital markets and credible monetary policy provide the euro with a solid foundation upon which to build its offensive against the US dollar.

The ongoing financial crisis will motivate countries to adopt Euro as their currency. Such countries will benefit from the stability of the Euro. Poland also announced that it will adopt Euro in 2012 (2). Recently, the Polish government announced its plan to adopt the euro in 2012. .

The US continues to suffer from its massive fiscal and trade twin deficits, so that many of the worlds central banks are considering diversifying away from US dollars into other currencies, particularly the euro.

Verbatim after Global Financial Crisis

The Euro is unlikely to replace Dollar for some time due to the following reasons: 1. The euro has not achieved a more dominant transactions domain versus the US dollar. 2. The euro is not backed by a unified European political entity and therefore does not provide the political stability of the US. 3. Labour mobility is still limited within the euro area. All these reasons only add to the high entry barrier to the euro posed by inertia in the choice of global key currency. 4. The US Dollar and the US Treasury Bills are considered the safer havens in times of uncertainty. For example, during the global financial crisis, the Euro fell precipitously

against the US dollar even though the Crisis originated in the US. This perception advantage is not shared by the Euro Government Bonds. These factors or reasons heavily favor the US Dollar. The following picture shows the Euro in current times.

US, Europe and OPEC (Organization of Petroleum Exporting Countries)

Fact and Figure: OPEC is the provider of about 40 percent of the worlds oil. According to a
monthly report by OPEC, Oil use will increase by 1.1 million barrels a day, or 1.2 percent, to 88.9 million a day in the year 2012. With this, OPECs production will rise to its highest level since October 2008. It will need to produce 30.1 million barrels a day to balance global crude supply and demand in 2012, as estimated in the report. Thats up 60,000 barrels a day forecast by OPEC. The group set a formal output target for its 12 members of 30 million barrels a day on 14 December, 2011. Daily supply from the organization increased to 30.82 million barrels a day in December 2011 from 30.65 million in November 2011. OPEC maintained its prediction for production outside the organization in 2012 at 53.1 million barrels a day. This represents an annual increase of about 700,000 barrels a day, driven by Brazil, the U.S., Canada, Colombia and countries in the former Soviet Union.

OPECs Members

Algeria

Angola

Ecuador

Iran

Iraq

Kuwait

Libya

Nigeria

Qatar

Saudi Arabia

The United Arab Emirates

Venezuela

It is interesting to know that problems in Europe or US have a significant impact on the oil market. Europe accounts for about 15 million bpd of the 88.90 million bpd. If Europes turmoil

(Debt crisis) were to worsen, the effect on the oil market could be seen not only through a further decline in oil demand in Europe, but also with spillover effects on oil demand in the emerging economies, OPEC said. (Refer to OPEC Keeps Oil Demand Forecast Steady, Warns on European
Economic Crisis, Bloomberg, By Grant Smith - Jan 16, 2012).

OPEC also said that oil use in European members of the Organization for Economic Cooperation and Development (OECD) would fall by 160,000 barrels per day (bpd) in 2012 and would drop further if the euro zone crisis deteriorates. The U.S. Energy Information Administration also makes forecasts on demand and production of the OPEC.

Top oil exporter is Saudi Arabia. (Refer to the Globe and Mail, OPEC sees downside risk to oil demand from
EU Crisis, by Alex Lawler, Jan. 16, 2012)

US Policy and OPEC

U.S. Administrations work with OPEC to stabilize the global Oil market and maintain Worlds energy supply. This protects the global economy from large oil price shocks. US depend on OPECs oil as it did back in 1973 during the Oil Crisis. Its American Energy self sufficiency targets have failed, leading to its dependency on Oil imports. US, out of its total oil imports, imported 46.1 percent in 2008 and 41 percent in 2009 from OPEC, with Persian Gulf barrels accounting for 18 percent in 2008 and 14.4 percent in 2009
(Refer to Amy Myers and Jareer Elass, The History of U.S. Relations with OPEC: Lessons to Policymakers).

US has sent its sitting Presidents to heads of state of OPECs members to diplomatically contain high crude prices. US did this with strength in its persuasive powers or through political, economical threats. President Barack Obama and Former President Nixons vision to get US, energy independence is said to be unrealistic by some members of OPEC. Thereby, stating that there is no possible substitute for Oil. Such stances often bring friction in the relations. OPECs best defense against alternative energy would be to slash price of oil to levels which would render alternative source commercially unviable. OPECs leaders are not concerned with

the idea of alternative energy for now as they believe that it is impossible to substitute oil at a substantial commercial level in the next two-three decades.

Trade Concern for OPEC: The only concern for OPEC would be that a U.S. or a global
climate regime not tax or penalizes petroleum in a substantial fashion that significantly disadvantages oil-based fuel. A U.S. border carbon Tax that hits all US imports, including oil imports from Saudi Arabia, might be viewed as a more serious trade problem than U.S. policies to promote alternative energy. Today, Obamas administration is more concerned with a struggling US economy. So, a progress in alternative energy and climate policy plans will not act as a worry for OPEC.

Conclusion of U.S. and OPEC: Oil Producers seek high prices for oil and consuming nations
demand for low prices. US has shifted weathered energy market crisis with its relations with key members of OPEC. But, maintaining this win-win scenario is becoming difficult overtime, given the concerns that US economy confronts. The result has been a repetition in boom-bust cycle which has damaged economic growth not just in US, but also over the long run, in the Middle East as well. Important global Oil producers like the UAE, Kuwait and Saudi Arabia, which maintain spare oil, can serve an important role in limiting the power of speculators in the global oil market in times of Crisis or significant supply-demand imbalances.

OPEC, Iraq, the euro, and global economics

On November 6th of 2000 Iraq became the first country to receive all of its oil export payments in euros instead of American dollars. This switch was estimated to cost Iraq $270 million dollars, but Iraq had since actually come out on top due to the rise in the value of the euro, which was actually probably influenced by Iraqs decision to use the euro as its foreign exchange currency. At the time of the switch Iraq was selling over $60 million in crude oil a day so its easy to see that the change to the use of the euro could have a positive effect on the value of the euro. Iraq had also been threatening to stop all of its oil exports, which represented about 5% of the world market. This certainly put Iraq in a position to create a certain amount of economic havoc.

In the year 2002, the world had the following outlook towards the four
One of the arguments for keeping oil pricing and payments in dollars had been that the US remained a large importer of oil, despite being a substantial crude producer itself. However, looking at the statistics of crude oil exports, one notes that the euro-zone was an even larger importer of oil and petroleum products than the US. But, there were also very strong trade links between OPEC Member Countries (MCs) and the euro-zone, with more than 45 per cent of total merchandise imports of OPEC MCs coming from the countries of the euro-zone, while OPEC MCs are main suppliers of oil and crude oil products to Europe.

A Reason of inflation: The trading of oil in dollars has served the interests of the US, giving
it an immediate advantage over other countries because it carries no currency exchange risk. For most other oil consumers around the world, the pricing and payment of crude in dollars increases the risk for these countries because of currency fluctuations. When the dollar

rises against other currencies, the price of oil is more expensive for the rest of the world, thus potentially increasing inflation in these countries. The ECB raises its interest rates primarily due to headline inflation. Oil, or energy more broadly understood, is a key driver of euro-zone inflation. Higher oil prices raise the prospects of ECB tightening.

Objective of EU (A common Union) in the context: To minimize oil price risk and
currency risk. A shift in payment of oil from the dollar to the euro, will effectively removes the currency risk. This will also help to increase the demand of Euro and thus raising its value.

The Gold, Oil and US relationship (Unraveling the Mechanism)

In a general context, an increasing oil price results in increasing inflation which negatively impacts the global economy, particularly oil-dependent economies such as the US. Apart from increased transportation, heating and utility costs, higher oil prices are eventually reflected in virtually every finished product, as well as food and commodities in general. USs oil reserves are not much when compared to worlds oil output. And because of USs dependency on both oil and foreign suppliers, any increases in price or supply disruptions will negatively impact the US economy to a greater degree than any other nation. Frequent terrorist attacks on Iraqi oil production causes disruption and the risk of political problems in Saudi Arabia grows. The timing for these risks is uncertain and hard to quantify.

Oil and gas experts say that demand of oil is growing tremendously. Once a supply shortfall materializes, the US will be in competition with China, India, Japan and other importing countries for available oil. Oil, gold and commodities have all been priced in US dollars since 1975 when, OPEC officially agreed to sell its oil exclusively for US dollars. From 1944-1971, US dollars were convertible into gold by central banks in order to adjust for any trade imbalances between countries. Up to that point, the price of gold was fixed at US$35 per ounce, and the price of oil was relatively stable at about US$3.00 per barrel. Once the US ceased gold convertibility in 1971, OPEC producers were forced to convert their excess US dollars by purchasing gold in the marketplace. This resulted in price increase of both Gold and Oil. Today, the price of Gold and Oil can be expected to increase as the US dollar declines. If the oil producers opt for Euro, the value of US dollar will plummet. This is why US focus a lot on its diplomatic and critical stance towards its relations with OPEC. If value of US dollar decreases over longer periods, Middle East may decide to keep its holdings of the currency in different precious metals and other currencies.

Conclusion: The price of oil is poised to rise steadily as the supply/demand imbalance
increases and the dollar declines, even if there are no supply disruptions, terrorist threats or geopolitical concerns to consider. Should oil producers demand euros, dinars or precious metals in payment for their product, the decline in the US dollar will accelerate while the price of precious metals explodes. If oil producers and other foreign US dollar holders begin to sell the trillions they hold and diversify into alternatives, then the price of both oil and precious metals will rise to levels that today are hard to imagine.

Trivia (Get Europe Back to Work |Economic Times| New Delhi| Monday|30 January 2012|
Page 18) EU has 27 members. Europeans speak a total of 23 languages within the EU. Labour market reforms are now the top priority in the Eurozone. European Nations have to allow more labour mobility to become more productive. Turkeys (Not a member of EU) manufacturing success owes much to workers returning from Germany. Europe is ageing while the average age in Egypt is 24, in Tunisia it is 29.7. Euro exerts a stronger influence over South African Rand as compared to US dollar. (Taken from reference paper, Page 8) By the late 90s, more than four-fifths of all foreign exchange transactions, and half of all world exports, were denominated in dollars. (OPEC, Iraq, the euro, and global economics)