As Latin American central bank officials shuttled from corridor to corridor at October’s IMF meetings conferring on ways to tackle the global financial crisis, asset managers from some of Europe’s largest banks were also doing their fair share of hall surfing. They, however, wanted to discuss and sell another major financial event: the establishment of Europe’s common currency, the euro, on January 1, 1999.

Why preach about the euro at a time when Latin governments were more preoccupied with defending their own currencies? For one, many European bankers view monetary union as a way of gaining a competitive advantage over their US counterparts when it comes to winning mandates to manage central bank reserves.

That’s because an increasing amount of Latin America’s reserves is expected to be invested in Europe’s new euro-denominated debt market, one that will likely equal the US Treasury market in both size and liquidity. And just as the US Treasury market is the natural domain of US banks, so will the new euro-denominated debt market be the home turf of European financial institutions-or so the logic goes.

But perhaps more important for Latin America’s purveyors of monetary policy is the fact that the arrival of the euro-which some observers think may some day rival the US dollar as a reserve currency-could significantly impact the balance of reserve deposits and may ultimately change the region’s tradition of tying its exchange rates exclusively to the greenback (see box, page 24). And while it may take years before the euro can give the US dollar a run for its money, that possibility has been enough to stir considerable interest among Latin America’s central banks.

“The sector that is taking the biggest interest (in the euro) in Latin America has been the central banks,” said Victor Maruri, head of Latin American investment banking at Paribas. “Over time, these central banks will have a large percentage of their reserves in euros, and that is a shift in asset portfolio management.”

Up until the end of last year, about 80% of most Latin American reserve bases were in US dollars, with the remainder in yen and a variety of European currencies-mostly deutschemarks, says Klaus Friedrich, chief economist at Dresdner Bank. He expects that ratio to change gradually over time, with up to 40% of reserve bases being taken up by euros.

The Trade Factor
While that rebalancing automatically occurs with the conversion into euros of Europe’s core currencies such as the deutschemark, the size of Latin America’s euro reserves will also depend on trade levels with Europe, something which economists expect to grow.

Although at year-end 1997, only 17% of Latin America’s exports headed to Europe-less than two-thirds the amount sent to the US-a successful euro should divert some of the flows away from the US and toward the other side of the Atlantic, according to a recent Paribas report.

Moreover, such figures belie the strong trade links already established between individual Latin American countries and Europe. According to the International Monetary Fund, for instance, about 33.2% of Brazil’s exports last year went to Europe, compared to only 23.1% directed at the US. And even Mexico-which is closely tied to the US through the North American Free Trade Agreement and sells about 87% of its exports there-has recently launched talks to develop a trade agreement with Europe.

“The (European) union represents, by itself, one of the world’s greatest trade powers because of the size of the market,” said Antonio Casas Gonzalez, president of Venezuela’s central bank, in a recent publication by the regional intergovernmental organization, Latin American Economic Systems (SELA). “This will affect the euro itself, increasing its attractiveness as an important reserve asset vis-à-vis the trade risks posed by weaker currencies.”

Still, says Friedrich, up until now, trade deals between Europe and Latin America have traditionally been transacted in dollars simply because the greenback is extremely liquid and more manageable than 11 different European currencies. Moreover, many Latin American exports are raw materials that are priced principally in dollars.

That dollar bias could change, however, if Europe’s single currency gains enough credibility to counterbalance US supremacy, giving Latin Americans trading with Europe a better reason to turn to the euro.

“This means one thing for private traders,” explained Friedrich, “but it also means another thing for the reserve bank because it will now be called upon to do some clearing in euros, and certainly to have at hand reserves if somebody comes and says, ‘I need euros for my Brazilian money.’ ”

Not all Latin American central bankers foresee major leaps in their euro deposits, though.

David Merchán, subdirector of markets at Colombia’s central bank, said late last year that his country’s reserve base is likely to remain the same, for now at least, with 80% in US dollars, 15% deutschemarks and 5% in yen.

“The composition of international reserve currencies is based on balance of payment flows,” said Merchán. “In the sense that we don’t expect those flows to change with the introduction of the euro, the exchange composition should remain the same with the 15% assigned to deutschemarks being converted to euros.”

Observers also point out that the dollar will continue to dominate reserve deposits in Latin America, especially in countries like Argentina-whose convertibility system requires that each peso is backed with a US dollar-and in Brazil, whose central bank also needs hefty dollar reserves to defend its real against speculators.

Guarding Against Volatility
Still, not counting the trade factor, some economists argue that accumulating more euros reserves would serve another useful purpose.

If the new European central bank has the fortitude to achieve reserve currency status for the euro and consequently helps create a global economy that revolves around two major currencies, heavier euro deposits may be a way to guard against exchange rate volatility. In this bi-polar system, central banks will take a hit if their dollar-heavy reserves fall in value against the euro-a risk that economists say could be softened with a more even balance between the two currencies.

That may be sound advice, particularly considering that the euro’s arrival is no guarantee for greater stability in the world’s foreign exchange markets. “I can’t sit here and predict a nice, stable, easygoing relationship between the dollar and the euro-which is all the more reason to be in both currencies,” said Friedrich. “I believe the central banks are beginning to see that now.”

In the end, say bankers, the rise of a strong euro on the world’s economic stage will require more active management of currencies among central banks. Part of that is likely to involve pouring more money into Europe’s new euro-denominated debt market, and perhaps some movement away from Latin American central banks’ traditional investment havens such as US Treasuries.

The attractions of Europe’s new bond market are numerous. As Merchán points out, while investors can no longer tap the diversity of a multi-currency bond market, the benefit of 11 governments issuing euro-denominated paper is that there is now another market comparable to the US in size and liquidity.

It also means that Europe will have a common yield curve and that investment strategies will no longer focus on exchange rate risk and short-term interest rate movements, says Carlos Penny, director for Latin American asset management at Paribas. Instead, he notes, spreads between the various government bonds will be largely based on a country’s credit rating and the soundness of its economic fundamentals. “The value added that we asset managers will bring is credit analysis,” he said.

Enter European banks like Paribas, Dresdner and Deutsche Bank, which view this new landscape as an opportunity to woo Latin American central banks with their euro expertise. “It means that firms like ourselves-which up until now because we were European have been at a disadvantage in offering asset management services-will all of a sudden have a product that is becoming increasingly viable,” said Paribas’ Maruri.

Dresdner’s Friedrich also seems to sense that the dawning of the euro is tilting the tables in his favor. “They (central banks) are going to look at a European bank that they feel comfortable in managing assets in euros,” he noted. “So there may be more business here, although it is certainly not the case that American banks have given up on this…But it is not their home currency.”

Currency Changes?
In efforts to stamp out inflation and attract foreign investors, many Latin American countries this decade chose to tie their currencies in some form or another to the US dollar, usually through a crawling peg such as Brazil has done with its real or as in Argentina’s case through a currency board that requires each local peso to be backed by one dollar.

That traditional connection with the greenback, say economists and bankers, is a logical extension of the robust trade flows between North and South America and the fact that the US dollar has been the world’s currency of choice since World War Two.

But if Europe’s new central bank manages to achieve reserve currency status for its new euro-and trade between Latin America and Europe grows-looking exclusively to the dollar to determine the value of a currency may be less practical, say some observers.

“It is obvious you would peg to the dollar under current dollar mono-culture circumstance,” said Klaus Friedrich, chief economist at Dresdner Bank. “But I think when the world changes into a bi-polar system, it will not make much sense.”

Depending on how strong the euro becomes, some Latin American countries may start considering pegging to both the dollar and the euro, says Charles Mallis, managing director for global financial services and European Union project coordinator at BankBoston.

That approach could be similar to the Chilean foreign exchange system, which differs from the dollar-linked currencies of its Latin American brethren in that it uses a basket of currencies to calculate the band in which its peso trades.

Still, Robert Lynch, currency strategist at Paribas, doesn’t expect Latin policy makers to shift their monetary alliances any time soon, particularly considering that the US is still the region’s dominant trading partner and that much of Latin America’s exports are dollar-priced raw materials. Much, he says, depends on whether the euro achieves reserve currency status and whether trade flows with Europe start to equal those between the US and Latin America.