By Andrew Sheng, guest economist of Caijing and former Chairman of Hong Kong Securities and Futures Commission

(Caijing Magazine) The European Union is the largest economy in the world, accounting for 30 percent of the world's GDP. In practice, though, the euro is the official currency for only 16 of the EU's 27 countries. Britain, for example, is an EU member but is not part of the euro currency zone.

The euro is so well established that some tend to forget it was created just a decade ago, with the first currency notes issued in 2002. The EU's predecessor, the European Economic Community, was formed in 1957. So it took more than 40 years for Europe to establish a single currency after experimenting with several forms of currency arrangements before launching the euro.

In the 1980s, the European Monetary System failed. Europe's central banks spent countless sums of money fighting volatility and speculation within EMS. This explains why, even today, some European central banks don't fully trust hedge funds and offshore financial centers.

EMS failed because of obvious difficulties in coordinating the monetary and fiscal policies in Europe that were designed to maintain currency stability or parity between different currencies. A primary condition for a single currency union is a system for compensating countries that may suffer from its adoption, since regional monetary policy may not fit a particular country's situation. For example, the deutschmark was very strong because of Germany's growing economic power and the German Bundesbank's strict policy of fighting inflation, given the country's bad experiences with hyperinflation in the 1930s and immediately after World War II. Britain did not join the euro precisely because its citizens felt they should not lose their ability to determine their own monetary policy.

One key condition for the euro's successful launch was the Maastricht Treaty, which imposed restraints on all member countries that prevented each from running up too much fiscal debt. Maastricht criteria limited deficits to no more than 3 percent of GDP. So far, EU members seem to have adhered to these limits, although there were times when some large members seemed to skate close to the ice. Today, monetary policy in Europe is conducted by the European Central Bank.

The euro has been successful in the sense that it has appreciated against the U.S. dollar from a low of 0.82 to a high point at 1.60, and as of mid-September had reached 1.42. Meanwhile, the volume of currency turnover against the euro, according to data from Bank for International Settlements, hardly changed from 38 percent of total global foreign exchange turnover in 2001 to 37 percent in 2007. International Monetary Fund data said U.S. dollars accounted for 64.1 percent of the US$ 6.4 trillion in official foreign exchange reserves worldwide and US$ 4.1 trillion in identified reserves at the end of the first quarter 2009. The euro accounted for 26.3 percent, the pound 4.4 percent, and the yen 2.5 percent. This shows the euro is the second-largest reserve currency and the yen a distant fourth.

What lessons of the euro can be applied in Asia? First, the euro was a major tool of political integration, not economic integration. The EU came together to avoid beggar-thy-neighbor policies within Europe that eventually led to war. It was possible to create the EU because the largest country Germany and second-largest France -- former enemies -- agreed to a political union for long-term peace and prosperity. No such understanding exists in East Asia.

Second, the euro was born of a union of many currencies before becoming a leading reserve currency on its own, replacing the deutschmark, franc, lira, peseta and others. However, in the case of yen or sterling, one country is trying to make its money a reserve currency. The euro actually has an internally fixed exchange rate among EU members as well as an externally flexible exchange rate against the U.S. dollar and others.

A third lesson is that Europe has an advantage in size – a large, stable internal market. However, Europe overall runs a small current account deficit with the rest of the world, with a net international balance sheet deficit of 10 percent GDP.

The sequence of European integration was political integration first, then real sector integration, and finally financial integration through a common currency. Note that financial integration is still not complete in Europe because national rivalries protect nationalized banking systems. Asia has neither political nor financial integration; the only convergence is at the level of trade integration.

In sum, despite Anglo-Saxon skeptics and critics, the EU is a successful integration story and the euro a real competitor to the U.S. dollar as a reserve currency. The euro's one weakness is related to the EU's military might, since the EU is not quite a military union. Astute market observers note that if there are political tensions among Europe's neighbors, such as a military conflict in the Balkans, the euro will weaken relative to the U.S. dollar. When people talk about flight to the dollar, they usually mean flight to somewhere shielded from military conflict.

Hence, when we discuss the role of reserve currencies, we cannot discuss monetary or financial issues alone. Rather, we must look at the whole picture.

Full article in Chinese: http://magazine.caijing.com.cn/2009-09-13/110248334.html