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Does a digital euro challenge the dollar’s global dominance?

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A European Central Bank research paper on the feasibility of the digital euro has garnered a lot of attention over the past couple of weeks.

It would, as the FT’s Martin Sandbu writes here, appear as though the writing is on the wall and the eurozone will launch its own central bank-backed digital currency in the not too distant future:

After six months of consultation and initial technical experimentation, the ECB’s governing council will decide on an investigation phase that could take about a year and a half, then take another decision on whether to actually develop a digital euro, which could take another couple of years depending on the chosen design. So let me stick my neck out and predict an official digital euro will come to an e-wallet near you by the end of 2025. You heard it here first.

The thing we found most interesting about the paper was that, if a digital euro indeed does happen, the ECB seems to have something in mind that would open up the possibility of participants outside the single currency area having access to digital wallets (hat-tip to Ousmène Mandeng of the London School of Economics for pointing this out to us).

Here’s how it is set out in the paper, for reference:

Understanding why this is so important does, to those of you not obsessed with payments, take some explaining.

We on FT Alphaville have long been of the opinion that Libra — Facebook’s plan for a digital currency — is a lousy idea. It has, however, had the less-than-lousy consequence of forcing the world’s monetary guardians to wake up and address some pretty major flaws in the way in which their currency works right now.

Libra’s design was more like something you’d find on the back of a fag packet than a blueprint for the future of payments. Yet it still managed to induce collective panic among economic officials because it highlighted that they have done far too little to correct the fact that, despite decades of digitalisation, it remains expensive, slow and somewhat unsafe to make payments across national borders.

To see why, it’s worth looking at how central bank money works at the moment. Most central banks distribute their currency to banks through what are known as open market operations. In order for banks to participate in those operations, however, they must have a business in the country where the central bank is based. Once they have an account at the central bank, they must also park assets denominated in the currency they wish to receive the funds in. That means that at the moment official reserves — which, along with cash, is one of the safest forms of money — remain pretty much exclusively within the jurisdiction in which the central bank is based. Here’s how Mandeng puts it:

The ECB report testifies to a longstanding limitation. Central bank money is very local. Only resident banks typically have access to central bank accounts. Banknotes are distributed normally to the local general public.

This in turn has a knock-on impact on how payments are made:

It implies that electronic payments can only be cleared in central bank money among resident institutions. While international transactions can be conducted in claims denominated in dollars or euros, those normally always constitute claims on commercial banks.

So while large interbank settlements flow through ultra-safe central-bank run payments systems such as the Bank of England’s CHAPS, cross-border payments come with risk attached. To appreciate these risks it’s worth referring to this, from the Swiss National Bank, on how settlement works in the FX market:

If there is no direct account relationship between two operators on the foreign exchange market, foreign exchange transactions are traditionally settled via correspondent banks. In this case, when one party meets its obligation irrevocably, it does so without knowing whether its counterparty will settle its liability. This means that there is a risk of the counterparty delivering late (liquidity risk) or, in the worst case, not at all (credit risk). These risks are compounded if the foreign exchange market participants are in different time zones. If one party does not fulfil its obligations, depending on the size of the transaction liquidity and/or solvency problems may arise for the counterparty and thereby trigger a chain reaction (systemic risk).

The price of those risks is passed to the customer whether explicitly through fees, or implicitly through a delay. This explains why Facebook’s idea of creating instant, cheap, cross-border transfers led to such a wave of panic, with central bankers fretting that Libra would challenge their monopoly in currency production.

We are in the very early stages of the development of a central bank digital currency for the euro area. It’s not worth getting too excited just yet.

It’s also worth remembering that the euro still lags behind the dollar in terms of its global use by some margin. The single currency makes up just over 20 per cent of official reserves, compared with a little over 60 per cent for the dollar.

Central bankers in Frankfurt ought to ask themselves whether this is desirable for the eurozone too. Allowing foreigners to freely use the Eurosystem’s monetary base is all very well. But a likely consequence is that there will be far more euro-denominated assets out there, all governed by regulatory and legal frameworks over which the Eurosystem holds no sway. We have already seen how much woe Greece’s overextension caused the currency union, and it had a system governed by EU law.

Of course, the politics of the Greek situation would not exist for a country on the other side of the world from Brussels. Still, it is likely that the Eurosystem would bear some responsibility to act should borrowers in far-flung lands run into trouble. The Federal Reserve has dealt with this by extending dollar swap lines around the world, enabling foreign borrowers to access greenbacks at their local central bank. The Fed did this both in the aftermath of the 2008 financial crisis and more recently during the early days of the pandemic. Those swap lines have caused political controversy at times and led to challenges on the central bank’s independence. It is worth remembering too that a mass default in foreign dollar-denominated assets — the amount of which has skyrocketed since 2008 — is still yet to happen, owing to the federal funds rate remaining so low. The ECB has offered swap lines too, but to a far more limited extent than its US counterpart.

But if the eurozone’s monetary guardian decides it is in its interest and a digital euro revolutionises cross-border payments, then we imagine that balance might begin to shift.

Related links
Breaking the Zuck Buck — FT Alphaville


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Markets

Oil hits highest price since April 2019 before moderating

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The price of crude oil briefly hit its highest level for more than two years on Monday, lifting shares in energy companies, as traders banked on strong demand from the rebounding manufacturing and travel industries.

Brent crude crossed $75 a barrel for the first time since April 2019 before falling back slightly, while energy shares were the top performers on an otherwise lacklustre Stoxx Europe 600 index, gaining 0.7 per cent.

The international oil benchmark has risen around 50 per cent this year, underscoring strong demand ahead of next week’s meeting of the Opec+ group of oil-producing nations.

US manufacturing activity expanded at a record rate in May, according to a purchasing managers’ index produced by IHS Markit. Air travel in the EU has reached almost 50 per cent of pre-pandemic levels, ahead of the July 1 introduction of passes that will allow vaccinated or Covid-negative people to move freely.

“This is a higher consuming part of the year,” said Pictet multi-asset investment manager Shaniel Ramjee, referring to the summer travel season. “And the oil market is pricing in strong near-term demand that is better than previous expectations.”

In stock markets, the Stoxx Europe 600 dipped 0.3 per cent while futures markets signalled Wall Street’s S&P 500 share index would add 0.1 per cent at the New York opening bell.

The yield on the 10-year US Treasury was steady at 1.494 per cent. Germany’s equivalent Bund yield gained 0.02 percentage points to minus 0.154 per cent.

Equity and bond markets have consolidated after an erratic few sessions since US central bank officials last week put out forecasts indicating the first post-pandemic interest rate rise might come in 2023, a year earlier than previously thought.

US shares tumbled last week, while government bonds rallied, on fears of tighter monetary policy derailing the global economic recovery.

Wall Street equities then bounced back on Monday, with a follow-on rally in some Asian markets on Tuesday, as sentiment got a boost from more dovish commentary from Fed officials.

Fed chair Jay Powell, in prepared remarks ahead of congressional testimony later on Tuesday said the central bank “will do everything we can to support the economy for as long as it takes to complete the recovery”.

John Williams, president of the Federal Reserve Bank of New York, also said that the US economy was not ready yet for the central bank to start pulling back its hefty monetary support.

Jean Boivin, head of the BlackRock Investment Institute, said that “the Fed’s new outlook will not translate into significantly higher policy rates any time soon”.

“We may see bouts of market volatility . . . but we advocate staying invested and looking through any turbulence,” Boivin added.

The dollar index, which measures the greenback against trading partners’ currencies and has been boosted by expectations of US interest rates moving higher before other major central banks take action, was steady at around a two-month high.

The euro dipped 0.1 per cent against the dollar to purchase $1.1901, around its lowest level since early April. Sterling also lost 0.1 per cent to $1.3909.



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Wall Street rebounds as markets adjust to Fed rate rise outlook

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Wall Street stocks bounced back and government bonds softened on Monday following tumultuous moves last week after the Federal Reserve took a hawkish shift on interest rates and inflation.

The S&P 500 added 1.2 per cent in early New York dealings. The share index’s resurgence came after it posted its worst performance in almost four months last week in the wake of Fed officials signalling the central bank could raise rates to tame inflation sooner than investors had expected.

The yield on the benchmark 10-year US Treasury bond dropped sharply last week as investors viewed the Fed as ready to control surges in inflation that erode the returns from fixed interest securities. On Monday it rose 0.02 percentage points to 1.472 per cent.

Fed policymakers on Wednesday projected that interest rates would rise from record-low levels in 2023, from their earlier median forecast of 2024. James Bullard, president of the St Louis Fed, told television network CNBC on Friday that the first rate increase could come as soon as next year as inflation grew.

However, Gregory Perdon, co-chief investment officer at private bank Arbuthnot Latham, urged caution. “The facts are that the Fed hasn’t done anything yet. Wall Street loves to climb the wall of worry.”

Fed officials’ statements last week prompted fears of rapid policy tightening by the world’s most powerful central bank that could derail the global economic recovery from Covid-19. Investors also backed out of so-called reflation trades, which had involved selling government bonds and buying shares in companies that benefit from economic growth, such as materials producers and banks.

On Monday, however, energy, basic materials and banking stocks were the best performers on the S&P 500. The technology-focused Nasdaq Composite index was also up, gaining 0.7 per cent in early dealings.

The Russell 2000 index of smaller US companies, whose fortunes are viewed as pegged to economic growth, gained 1.7 per cent. Europe’s Stoxx 600 share index rose 0.7 per cent, with materials stocks at the top of its leaderboard.

The yield on the 30-year Treasury briefly fell below 2 per cent on Monday morning for the first time since February 2020 before bouncing back to 2.065 per cent.

Investors last week had taken profits on reflation trades that had become “crowded” and “expensive”, said Salman Baig, portfolio manager at Unigestion.

Baig added that, following the initial shocks after the Fed meeting, markets would probably return to betting on “a cyclical recovery as economies reopen”.

Other analysts said the bond market reaction had been too pessimistic, predicting a broad-based economic slowdown in response to Fed rate increases that had not happened yet.

The fall in long-term yields “is only justified if the Fed is making a policy error, choking the economy”, said Peter Chatwell, head of multi-asset strategy at Mizuho. “We think this is far from the truth — the Fed has simply sought to prevent inflation expectations from de-anchoring.”

Elsewhere in markets, the dollar index, which measures the greenback against other major currencies, dropped 0.3 per cent after gaining almost 2 per cent last week.

Brent crude, the international oil benchmark, rose 0.9 per cent to $74.18 a barrel.

Additional reporting by Tommy Stubbington in London

Unhedged — Markets, finance and strong opinion

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Saudis agree oil deal with Pakistan to counter Iran influence

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Saudi Arabia has agreed to restart oil aid to Pakistan worth at least $1.5bn annually in July, according to officials in Islamabad, as Riyadh works to counter Iran’s influence in the region.

Riyadh demanded that Pakistan repay a $3bn loan last year after Islamabad pressured Saudi Arabia to criticise India’s nullification of Kashmir’s special status.

But the acrimony between the two longtime allies has eased after Imran Khan, the prime minister, met Saudi Crown Prince Mohammed bin Salman in May.

News of the oil deal with Pakistan comes as Saudi Arabia embarks on a diplomatic push with the US and Qatar to build a front against Iran, said analysts. Riyadh lifted a three-year blockade of Qatar in January in what experts said was an attempt to curry favour with the newly elected Joe Biden.

Pakistan had shifted closer to Saudi Arabia’s regional rivals Iran and Turkey, which, along with Malaysia, have sought to establish a Muslim bloc to rival the Saudi-led Organisation of Islamic Cooperation.

Khan has developed a strong rapport with President Recep Tayyip Erdogan, encouraging Pakistanis to watch the Turkish historical television series Dirilis Ertugrul (Ertugrul’s Resurrection) for its depiction of Islamic values.

Ali Shihabi, a Saudi commentator familiar with the leadership’s thinking, said that “bad blood” had accumulated between Riyadh and Islamabad, but recent bilateral meetings had “cleared the air” and reset relations to the extent that oil credit payments would restart soon.

A senior Pakistan government official said: “Our relations with Saudi Arabia have recovered from [a downturn] earlier. Saudi Arabia’s support will come through deferred payments [on oil] and the Saudis are looking to resume their investment plans in Pakistan.”

The Saudi offer is less than half of the previous oil facility of $3.4bn, which was put on hold when ties frayed.

But Fahad Rauf, head of equity research at Ismail Iqbal Securities in Karachi, said: “Any amount of dollars helps because time and again we face a current account crisis. And with these prices north of $70 a barrel anything helps.”

Pakistan’s foreign reserves were more than $16bn in June compared with about $7bn in 2019 before it entered its $6bn IMF programme.

Robin Mills at consultancy Qamar Energy said: “Saudi Arabia and Pakistan are allies, but their relationship has always been rocky. And the Pakistan-Iran relationship is better than you might think.”

Mills said that the timing of the Saudi gesture was “interesting” given that Iran was preparing to step up oil exports with the US considering easing sanctions.

“The Saudis are on a bridge-building mission more generally. They have sought to mend fences with the US and there is also the resumption of relations with Qatar,” he said.

Ahmed Rashid, an author of books on Afghanistan, Pakistan and the Taliban, said that there were a variety of factors that might have spurred Riyadh to restart the oil facility.

It may be “partially linked to the American need for bases” to launch counter-terrorism attacks in Afghanistan from Pakistan, he said, but added that its priority was probably to prevent Islamabad from falling under Tehran’s influence.

Rashid pointed out that Pakistan was caught between China, which has invested billions of dollars in infrastructure projects, and the US.

“Pakistan has to play it carefully, it is dependent on China for the Belt and Road, dependent on the west for loans,” said Rashi. “This is a very complex game.”

Anjli Raval in London and Simeon Kerr in Dubai



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