Is the euro challenging the dollar's role as a global currency?

When the Euro was launched in 1999, there was much speculation among academics and policy makers about whether the euro could challenge, or even overtake, the dollar as an international currency. An influential paper at the time by Richard Portes and Helene Rey argued that the introduction of the euro would "have substantial implications for the international monetary system; for the currency composition of portfolios; for exchange rates, and hence monetary policies; and for economic efficiency and welfare. The key determinant of the extent and speed of internationalisation of the euro [would] be transaction costs in foreign exchange and securities markets.’

Towards the end 2006, the euro has indeed become a big international currency, but has so far failed to challenge the dollar’s predominance in the main categories that could define it as the world’s premier currency.

What do we mean by an international role of a currency? Paul Krugman defined the role of an international currency for the public and the private sector according to the following functional characteristics:

The Functions of the international currency

Source: Paul Krugman

Here is a list of the some of the categories for which data are presented below

-         the use as reserve currency

-         the use as invoicing currency

-         the use in daily foreign exchange transactions

-         the use in various types of investment securities

In all those areas, the euro has not yet challenged the dollar as the world’s premier reserve currency. The euro's share as a global reserve currency has increased gradual in the first few years. In 2002, its share was around 19%.
In the years 2003 and 2004, the euro’s share of global currency reserves rose to around 25%. But the euro's role in foreign exchange has been lower than expected. In 2004, Helene Rey reported:

Foreign exchange trading in euros as a percent of global trade has not increased compared to the share of EMS currencies. In 1998, the dollar was present 87.3% of the time at one end of a transaction on the foreign exchange market while the EMS currencies were present 52.5% of the time (note that the percentages sum up to 200% since transactions involved pair of currencies). In 2001, the share of the dollar was 90.4% and the share of the euro was a mere 37.6%. All the intra-european trades have been netted out with the arrival of the euro so in fact that there is no dramatic fall in the share of the euro compared to EMS currency, but there is no increase either.

That portion has since gone up to 43% in 2005 (note: since the exchange rate are bilateral transactions, the percentages add up to 200 per cent).

Here is an overview of the euro’s shares in the various categories from the report on the international role of the Euro by the ECB (December 2005). The next report is due December 2006.

Table: International Role of the Euro

Share of the euro in:

¹ At constant 1994Q1 exchange rates

² Given the convention to account for both sides of each trade in foreign exchange markets, percentages add up to 200%, meaning that the euro’s actual share in total turnover is half the percentage reported in this key data sheet.  

Source: European Central Bank

 
The euro's percentage share in most of those categories has been relatively stable in the 2004-2005 period. The euro has become increasingly popular as an issuing currency for international debt securities, as an anchor and intervention currency, and as a deposit currency. Its role in international trade and in foreign exchange markets has not changed fundamentally during the period 2004 and 2005.

Philip D Wooldridge of the Bank for International Settlements reports that the share of the euro in reserves of developing countries was 30% in 2006. He also says that over while the share of euro reserve rose slightly after monetary union, “by early 2006 it was not much higher than it had been in the mid-1990s” – taking the total of legacy currency as the comparative benchmark. The currencies that have been losing significance as global reserve currencies are the yen and the Swiss Franc. Wooldridge draws the following conclusions:

The bulk of foreign currency reserves are still invested in bank deposits and government securities, and the US dollar has maintained its place as the dominant reserve currency. This is not too surprising. The primary reason to hold reserves is to be prepared for continegencies and, given the tendency for liquidity to concentrate, the range of investments available to satisfy this need is limited.

The main shift that have been observed in recent years is less from one currency to another – and certainly not from dollar to euros – but from “safe” instruments such as government bond yields and deposit accounts to higher-risk instruments, something known reserve diversification.

Papaioannou, Portes and Siourounis have taken a detailed looked at the optimal currency shares in international reserves, and found that optimum portfolios would show a much lower weight for the euro than is observed. This suggesst that the euro may be punching above its weight. The conclude that Growth in the issuance of euro-denominated securities, a rise in euro area trade with key emerging markets, and the increased use of the euro a currency peg, would all work towards raising the optimal euro shares - the last factor being quantitatively the most important.

Brad Setser of Roubini Global Economics recently asked the interesting question whether the decline in the dollar in late November 2006 might have led to a shift. He proposed two possible logical responses by a central bank to a falling dollar:

-         maintain the ratio of dollar to euro reserves, by selling euros.

-         Selling dollars to hedge against further declines in the portfolio.

 
He argue that since Asian central banks are still increasing the foreign reserves, they may not be selling euros, merely buying cheap dollars, as a result of which the dollar/euro stabilizes (in value). So far, there is no evidence that Asian central banks are getting out dollars to seek refuge in euros.

But none of the above considerations tells us anything about the future. The Euro has indeed still the potential to challenge dollar but this would greatly depend on a number of factors, not least the performance of the US economy, and the foreign exchange rate of dollar. We would expect the dollar depreciate further, as part of a wider process of an adjustment of global  imbalances.

Obviously, Asian central banks themselves play a significant role in determining how this process unfolds, given their huge dollar holdings. We would not be surprised if the dollar devalued by a further 10 to 20% on a trade weighted basis. I am not so sure that Asian central banks will forever try to maintain their dollar exposures at any costs. While the reported figures of the euro's international role by the ECB and others appear relatively robust and stable, one could expect fairly rapid changes if their overall economic environment changes. What happens then is anybody’s guess.