Authored by Montana Craven, ESG Intern
The euro is yet to convince the world that it could be a viable alternative to the US dollar as a reserve currency, falling over the hurdles of fiscal unity, growth outperformance and political stability. However, sustainable finance currently offers an alternative avenue for the fission of euro-denominated financial assets. The European Commission is boosting the currency’s position on the global economic stage by becoming a hub for sustainable finance; from Q2 onwards the European Union’s plans to issue green bonds up to the value of €225 billion. This has been further supported by the European Central Bank (ECB) which has started accepting sustainability-linked bonds as collateral and plans to begin investing in a green bond fund. The European Investment Bank (EIB) is now one of the largest issuers in this space, denominating in euros, and recent data shows that the euro is also the currency of choice for multilateral development banks tapping global capital markets. Sustainable trade and pioneering regulatory leadership are also supporting the proliferation of the euro, with the benefit of reducing reliance on the US dollar and incrementally insulating the bloc from financial and climate risks.
Sustainable finance in Europe
The European Commission (EC) defines Sustainable Finance as the process of integrating of “non-financial” data, including environmental, social and governance (ESG) data, into investment decision-making processes, leading to longer-term investments into sustainable economic activities and projects. The EC has outlined how the region can fortify its economic and financial resilience by bolstering the single currency’s architecture and grow its green finance via the European Green Deal and the Sustainable Investment Plan. The European Green Deal is the European Union’s response to climate and environmental-related challenges; it aims to transform the EU into a resource-efficient and competitive economy with net-zero emissions of greenhouse gases by 2050. Achieving net-zero emissions will require investing in green technologies to protect the natural environment, fuelling sustainable growth and productivity.
To help achieve the Green Deal, the EU has launched the Sustainable Investment Plan which aims to push more capital towards sustainable activities by injecting discipline into the ESG market. This plan will also see the EU mobilise at least €1 trillion of sustainable investments over the next decade through its budget. In addition, a third of the €750 million from the COVID relief plan will be allocated to green bonds. Issuance of this magnitude will boost the green bond market by 89%. One of the main issues in directing capital towards sustainable finance has been limited market size; green bonds only makeup 3.7% of global bond issuance with the EU looking to plug the demand excess inefficiency as operations expand. The issuance of high-quality euro-denominated bonds will add significant depth and liquidity to the EU’s capital markets, supporting the euro’s stature as the default currency in sustainable finance by meeting the growing demand for sustainable debt.
The European Commission is also using social bonds to further its sustainable finance agenda through the Support to mitigate Unemployment Risks in an Emergency (SURE) investment plan which seeks to mitigate unemployment risk caused by the pandemic. Under this plan the EC has issued a €17 billion inaugural social bond, which aims to protect jobs and keep people in employment. The offering marks the Commission’s largest ever bond issuance and highlights a pivotal shift in the European bond market towards greater integration of social factors within the remit of sustainable finance into its programmes.
Structurally, the COVID-relief plan in particular signals a greater shift towards fiscal solidarity in the bloc unifying the Eurozone countries via joint borrowing, which could support the euro as a potentially viable world reserve currency alternative. In the past, a lack of fiscal coordination has cast doubt among investors regarding the euro’s potential for becoming the world‘s reserve currency; the COVID relief plan in a step towards fiscal consolidation that may support stability and attractiveness of the euro and euro-denominated assets.
Recent data shows that among Supranationals, the euro is the currency of choice for sustainable bond issuance: this year 28% of sustainable debt issued by supranational entities has been denominated in euros, compared to 14% in the US dollar and 17% in pound sterling (see figure 1.). However, the euro’s dominance is partly due to the cost advantage that euro-denominated bonds offer to issuers due to having a lower yield than their US equivalent, reducing the burden of interest rate payments. Though supranational only make up a small segment of the fixed income market, the results thus far are promising for the euro as a sustainable reserve.
Source: African Development Bank, Asian Development Bank, Asian Infrastructure Investment Bank, Banco Latino americano de Comercio Exterior SA, Banque Ouest Africaine de Developpement, Council Of Europe Development Bank, European Bank for Reconstruction & Development, European Financial Stability Facility, European Investment Bank, Inter-American Development Bank, International Bank for Reconstruction & Development, International Finance Corp, International Investment Bank & Nordic Investment Bank.
It is not just sustainable bonds that are positioning Europe as the new home for sustainable markets. Firstly, the EU has been home to the EU Emissions Trading System (ETS) – reducing greenhouse gas emissions in the bloc by placing a limit on overall emissions by issuing emissions permits and allowing the trade of these permits – which has established the EU as the world’s first major carbon market, and thence beginning the pricing of carbon in euros. The EU has also established the euro at the heart of sustainable trade by expanding its renewable energy production and establishing cross-border hydrogen trade with neighbouring countries, whilst concurrently developing a harmonized standard for the hydrogen market. Not only does this somewhat shield the bloc from heavy dependence on stranded assets and establish the area as a leader in green trade, it will likely also increase demand for euro-denominated exports as demand for renewables increases. In the first half of 2020, Europe generated more electricity from renewable sources than fossil fuels, positioning the bloc, and thereby the euro, well for the transition.
Challenges ahead for the euro
The euro is currently the second most commonly held reserve currency in the world though constitutes a mere 21% of international foreign currency reserves whilst the dollar makes up 61%. Thus, the euro still has a way to go before it could achieve world reserve currency status. Some key structural issues have prevented the currency from being an enticing alternative to the dollar.
One key factor in becoming a reserve currency is stability and the euro is hindered by the structural factors underpinning a shared single-currency across different nations. The euro area struggles with macroeconomic divergence between member states and this divergence in economic conditions threatens the stability of the bloc; evident from the 2010-2012 European debt crisis where Greece’s mounting debt caused significant volatility in the euro, and arguably was itself a function of the single currency system. To date, there are persisting severe disparities in economic strength and financial conditions in the bloc. The restrictive preferences of fiscally conservative states such as Germany and the Netherlands have caused conflict among other bloc members who wish to adhere to looser fiscal targets to support their economies. The ECB is unable to set policy to accommodate for these wide-ranging economic settings and a one–size fits all approach can be particularly disastrous to member states during a crisis when they face idiosyncratic risks and are unable to respond with monetary policy or currency depreciation. Thus, no matter how well positioned within sustainable markets, the Trilemma continues to present additional economic barriers to the euro relative to the US dollar.
This resultant economic hardship and concomitant impingement on national liberties have also led to political volatility. Events by the German Constitutional Court last summer illustrated the lack of co-operation and unwillingness of member states to share costs when the German Constitutional Court threatened to block the Bundesbank from participating in the ECB COVID relief plan, arguing that the ECB was illegally intervening in the monetary financing of governments. Additional stability issues in the Eurozone stem from Italy’s mounting debt and its volatile populist movement which puts the bloc at risk of a systematic domino effect. Response to the Syrian refugee crisis also saw heavy burden concentrated on affected countries, sparking heated disagreement. If the euro is to become a viable alternative to the dollar, there needs to be an improvement in the governance framework, more equal member state representation, and greater synchronization in macroeconomic factors and economic needs across the bloc. Perhaps we have seen the beginning of this process in the COVID-19 recovery fund, but there is still a long way to go.
Additionally, Europe is at risk of being overtaken by the US in sustainable markets. JP. Morgan analysts predict that in 2021, the US will issue more green, social and sustainable debt than Europe as climate change has become a top priority for the Biden-led administration and is beginning to be integrated into the Federal Reserve’s core mission. Thus, though the euro is currently leading in sustainable markets, it may soon be overtaken by the dollar as US investors become more attuned to sustainable markets and US institutions respond with increased supply of sustainable financial products. The bloc must maintain momentum in order to stay ahead.
The milestone COVID recovery fund is a step in the right direction as it seeks to unify Europe’s capital markets, systematically integrate sustainable finance into fiscal apparatus, and signals a policy shift towards greater fiscal integration. Moreover, the bloc is certainly positioning itself to be resilient to market disruption for the incoming risk of climate crisis. Sustainable finance is a fast growing sector that will continue to gain momentum, and the proliferation of the euro is being propelled along with it. Europe is set to benefit from this continued growth and will benefit from first-mover advantage as it becomes the benchmark for sustainable finance; however if Europe takes its foot of the gas it could soon be overtaken by other countries such as the US. In addition, the Eurozone still faces many critics and greater work needs to be done to encourage confidence that the euro can remain resilient in times of economic and political crisis, not just the climate crisis.
The race is far from won, but the euro has been set up well for achieving a place on the podium as a key currency denominator in the markets of the future.
 For 1995–99, 2006–19: “Currency Composition of Official Foreign Exchange Reserves (COFER)”. Washington, DC: International Monetary Fund. 11 April 2020.
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