JStaff writer

Eleven of the 15 European Union countries unified their currencies into a new single currency, the euro, today.

It will be used only on the books until January 2002, when euro cash enters circulation. But the prospects of integration have already been affecting economic activities in and outside Europe. The euro zone is expected to incorporate not only Britain and the remaining EU states but Eastern Europe in the future.

This may radically change the world's financial landscape.

Koetsu Aizawa, professor of economics at Nagasaki University, says Japan faces tough economic challenges from the euro economies.

Aizawa, a member of the Economic Planning Agency's advisory group on the European monetary integration and author of several books on the issue, argues that Japanese industries have to consolidate to compete with their counterparts in Europe and the United States. In an interview, he discussed implications of the single currency. The following are excerpts:

What is the biggest advantage the euro brings to Europe?It will help complete the economic integration of Europe, which has formed a customs union and then a single market (the free movement of goods, people, services and capital within the region).

The euro makes a common currency area that can match the U.S. Without the currency integration, each European country could not survive the international business competition and keep its living standards from falling. European firms could not beat their Japanese counterparts.

The monetary integration greatly reduces costs for businesses in the area, because they need to bear fewer transaction costs and no foreign exchange risks. They can relocate their factories to, say, Spain or Greece, where they can operate relatively cheaply.

Meanwhile, financial institutions will see lower profits, by 10 percent to 20 percent in some estimates, because they cannot earn foreign exchange commissions. Yet the unified market is a big advantage for them. As the issuance of euro-denominated bonds expands, they can benefit tremendously from the increasing liquidity.

How will the euro compare with the dollar, which has so far accounted for some 60 percent of the world's foreign exchange reserves and 50 percent of international trade?I believe the euro will eventually match the dollar. So far, the dollar has been the only global currency. But the deutsche mark has been widely used in Europe since the 1980s, and the euro will now take over its role as the region's single currency.

By simple arithmetic, the economic size of the euro-11 rivals the U.S. (Of the world's gross domestic product, the euro-11 account for 19 percent, the U.S. 20 percent and Japan 8 percent).

If the European Central Bank maintains sound monetary policy and member countries keep their budget deficit below 3 percent of GDP as stipulated by the euro pact, the euro may become a stable currency. If it does, it could account for 30 percent of the world's foreign currency reserves, whereas the dollar's share could go down to about 50 percent. In financial transactions, the euro could become just as dominant as the dollar. It is much more liquid than the mark if the new currency accurately reflects the EU's economic size.

How does that affect the position of the yen?Asian countries will probably use the euro extensively for political and economic reasons, though they will still continue to use the dollar as well. As a result, the yen will probably be used less and less in Asia. So there is a possibility that Tokyo, which is considered one of the three financial centers in the world (with New York and London), will become a mere local market -- if no preventive action is taken.

If the yen is used less, that would decrease the benefits for Japan's gains in financial markets and expose Japanese firms to more foreign exchange risks if they cannot transact in yen.

So the euro is bad for the Japanese economy, if anything?It is a negative factor, especially as the competitiveness of European firms rise. They compete hard to sell products in 11 countries just like one country. Already there has been a lot of realignment going on in the manufacturing and financial sectors, as we saw in the merger between Daimler-Benz (of Germany) and Chrysler (of the U.S.). This occurred because of the monetary integration.

Japan's manufacturing sector still has the strength to compete internationally, and it can also take advantage of the integrated European market to sell goods. But there is little hope for the financial sector. It is too late. Major Japanese banks are even withdrawing from their overseas operations when (European) banks are advancing abroad, such as into the U.S.

What should Japanese firms do?Manufacturers need to realign themselves but maintain the good aspects of Japanese business practices, such as lifetime employment. They should consolidate by forming holding companies. Hitachi, Ltd., for instance, should turn its divisions into independent firms under a holding firm.

As for banks, let them fail. There are 18 major banks, which is too many. (Nippon Credit Bank, one of the 18, was deemed insolvent and placed under state control in December). There should be only five at most, and preferably three. Reduce the number by letting them merge, inject 30 trillion yen to 40 trillion yen in public funds into them and sell off their bad loans.

Then there are two options. One is to form financial holding companies. One possibility is an investment banking group combining Industrial Bank of Japan, Nomura Securities Co. and Sumitomo Bank.

The other option is to permit universal banks, which can handle all sorts of financial business, including securities business. They should buy big foreign banks, because a Japanese bank alone cannot compete abroad.

What role should the government play?As a matter of course, the government must lift regulations in the financial markets so Asian countries can use the yen conveniently for foreign currency reserves, settlements and financial transactions.

Another thing is -- I know this is an unusual idea -- Japan should form an Asian Union with China and Singapore or a broader Asian region. To make all of Asia prosper economically, selected Japanese industries should be transferred to other parts of the region. That is the way Japan can form a yen bloc and survive international competition.

Before that, Japan should remember how the Germans took responsibility for what they did during the war. China and South Korea will never accept Japan unless it demonstrates true soul-searching.

What would be the scenario for a euro failure?If the economy worsens significantly, Italy and Spain, for example, might increase the issuance of government bonds to shore up their economies. That could prompt the new European Central Bank (which is responsible for monetary policy in the euro zone) to cut interest rates, leading to a devaluation of the euro and subsequent inflation in the area. If the inflation gets out of hand, Germans might say no to the euro and demand a return of the mark. They could then leave the Maastricht Treaty (which in 1991 set the path for a comprehensive European integration), although there is no such provision in the treaty.

But I don't think this scenario is likely and I hope not.

What is the main focus of the euro's debut in 1999?It is whether the European Central Bank can carry out adequate monetary policy, independent of political pressure.