Internationalization of the euro as a window of opportunity for Ukraine

Since its inception, the EU’s currency has included the option of “international money”, which is well-known in terms of economic theory. The experts of the European Central Bank (ECB) even made their own assessment of the euro’s international role, according to which its “internationalization” had peaked in 2005. However, the founding fathers of the euro probably avoided this deliberately: such a status results in a number of burdensome commitments, including to serve as an informal supranational central bank. The “success story” of the “godmother of the euro” – the Deutsche Mark – demonstrates an ability to effectively find its own niche in the world of finance, while avoiding the described responsibility before the global community. The EU’s sovereign debt crisis of 2010-2012 has not strengthened the positions of proponents of the “internationalization of the euro”. It revealed the fundamental contradictions enshrined in the European Monetary Union’s foundation: the conflict between the common monetary and separate fiscal policies of the countries-members.

Nevertheless, around 2017-2018 the leaders of the European Union were compelled to weigh the idea of “international euro” more critically. The United States began abusing the dollar’s status as an international reserve currency, having relied excessively on the buck while executing its sanctions policy measures. According to experts of the famous magazine, The Economist, “America has weaponized the dollar. In the rich and emerging world, the search is on for an alternative.” From this perspective, we may notice the actions proposed by the European Commission on 5 December 2018 aimed “to strengthen the role of the euro in a changing world.” Without a doubt, this action plan should be considered jointly with the steps towards the recovery of the EU’s economy in the wake of COVID-19 crisis. The mentioned actions are also to include the design of road-maps to increase productivity, to complete the banking union, and to smooth macroeconomic imbalances existing among the various countries being the participants of European integration project. However, the policy of euro internationalization will, for sure, remain in the top of Common Europe’s agenda in the coming years.

Ukraine may potentially pick significant bonuses from such a policy conducted by the top-officials of the European economy. It is obvious that the US dollar is the dominant currency in the local economy. Arising under such circumstances, dollarization is the source of the threats to financial stability, both in public finance and in corporate business/individual households’ areas. However, it should be emphasized that there is the growing understanding of the prospects for strengthening the euro’s role in Ukraine’s economy and financial system by local political elite. Thus, feeling the aftertaste of the uncontrolled devaluation of the hryvnia (the national currency), in December 2008, Ukraine’s then-Deputy Prime Minister for European Integration, Hryhoriy Nemyria , clearly stated that “it is worth strategically choosing the euro.” He also emphasized the negative consequences of pegging Ukraine’s economy only to the US currency. In May 2017, the Supervision Board of the National Bank of Ukraine (NBU), Ukraine’s local central bank, proclaimed that “it can be observed the beginning of the fundamental economic pre-conditions to use the euro as the main foreign currency” in the realm of trade settlements with other countries.

It should be noted that there is a realistic economic basis for such statements. In particular, in 2019 the EU remained Ukraine’s largest trading partner: exports amounted to $20.75 billion USD (33 percent of total exports), and imports to $25 billion (37 percent of total imports). It is clear that a significant part of settlements for such multibillion-dollar trade flows is made in euros. Additionally, to function as a means of payment, the European currency, like any money, has other core functions. It can serve as a unit of account used to record the value of goods and services, to measure the amount of debt issued (including sovereign debt) or the value created by financial assets. For example, as of 30 June 2020, according to the Ministry of Finance of Ukraine, the euro made up 13 percent of Ukraine’s public and guaranteed debt. According to the estimates of the National Institute for Strategic Studies, as of 1 April 2019, the euro was also among the currencies widely used during crediting: it comprised for 9 percent of the total loan portfolio of Ukraine’s banks. On the other hand, the European currency serves as a means to accumulate wealth (store of value), in particular as a reserve currency of central banks. Thus, as of 1 January 2020, the share of the euro in the structure of gold and foreign exchange reserves of the NBU was 10.6 percent. Thus, we can conclude that despite its less important role in comparison with the US dollar, the euro is quite actively used in the economy and financial system of Ukraine, while having enormous potential to expand its role.

To be sure, it must be noted that Ukraine isn’t able to influence positively to fully complete the EU’s banking union. However, the leaders of the European economic bloc have on their agenda a number of measures aimed at deepening the euro’s internationalization, the implementation of which may significantly benefit Ukraine. Given the above, at the level of bilateral economic relations between Ukraine and the EU, the following measures can be identified to contribute as much as possible to the internationalization of the euro:

• taking for granted the active trade relationships existing between the EU and Ukraine, it would be necessary to design a system of economic motivation to cover by settlement in euros the highest possible share of such trade flows. A similar action would be required for investments having the EU’s origination. The propelling of lending programs for small and medium enterprises (SME), of the funding of infrastructure projects, and of energy efficiency measures would also be particularly beneficial in this regard. The role of the European development finance institutions (EBRD and EIB) is especially important in this case: these financial institutions have high-quality expertise and deep knowledge of Ukraine’s economy specifics;
• the issuance of sovereign debt denominated in euros may be expanded by Ukraine. A variety of quantitative easing programs has resulted in controversial situation: the European markets are affected by multibillion-euro financial injections denominated in the single European currency. Ukraine’s business and the state have a unique opportunity to raise these funds at almost zero percent interest rates. This would enable local borrowers to refinance partially external debt payments denominated in US dollars: the peak of such repayments falls in the coming years, creating a potential threat to the financial stability of the country. According to the calendar of payments on external debt in foreign currency as of 1 April 2020, compiled by experts of the NBU, Ukraine’s enterprises, the central bank and banks have to pay about $26.2 billion in the third and fourth quarters of 2020 and in 2021;
• the creation of European-wide safe assets is a priority to promote the euro’s internationalization. By this term are meant financial assets (mostly sovereign bonds) that carry a minimal risk of financial losses, holdings in which may guarantee the safety of investments. Unfortunately, during the sovereign debt crisis 2010-2012 the problem of the “doom loop” became obvious. This situation by its economic nature is the opposite of the described “safe asset” concept: European banks accumulated on their balance sheets a huge amount of sovereign bonds. Given the risk that these sovereigns might face possible default, the bonds generate potential losses for financial institutions instead of being a reliable insurance. It can be predicted that the demand for such safe assets will be extremely high in Ukraine and such investments may become a civilised alternative to funnelling funds to offshore jurisdictions;
• foreign-exchange swap lines of central banks may effectively hedge Ukraine’s financial system against losses caused by currency exchange rate fluctuations. Such special kind of derivatives would ensure the supply of the European currency desperately needed by the local financial market. The fundamental principle of this financial instrument function is to provide a certain amount of currency in exchange for another currency for a certain period of time: there is a reverse exchange of currencies at the new rate after this period. Given that central banks, printing own national currencies and managing gold and foreign exchange reserves, are the counter partners of such transaction, it is possible to supply a required amount of the currency to the market of a particular country. Nowadays the US Federal Reserve, albeit reluctantly, serves as the world’s central bank through conducting such dollar currency swaps operations (including those with four less economically developed countries: Brazil, Mexico, Singapore, and South Korea). According to The Economist, by the end of April 2020 ten central banks had drawn over $440 billion between them. From Ukraine’s perspective, such type of potential financial support from the ECB will be a significant argument in favour of the promotion of the euro’s internationalization.

In summary, we can assume that against the background of the COVID-19 crisis there will be a downward trend in globalisation and some regionalisation of the world economy. In such circumstances, the internationalization of the euro can become a powerful tool to strengthen the EU’s role as a heavyweight in the world of global finance. Ukraine, while being the European Union’s closest neighbour, can benefit greatly from this vector of the European policy. The core priorities for Ukraine’s top-officials are to understand the mutual benefits of such cooperation for both parties, the ability to design and implement the road-map of measures required. In this context, the newly-appointed management of the NBU has all the opportunities to demonstrate a successful sample of cooperation based on “win-win” principles.

Vadym Syrota is an independent banking expert, a regular contributor to the specialized blog of the Kennan Institute (Woodrow Wilson Center) and the permanent author of Ukraine’s business publications on finance&banking issues. Previously he worked at the National Bank of Ukraine (local central bank) on banking supervision and financial stability issues. He holds a Ph.D. degree in economics with a focus on crisis management in Ukraine’s banking institutions.