The rise of the euro

Will the euro replace the dollar as the leading international currency? With 65% of all identified international reserves still held in U.S. currency and only 26% in euros (end 2006), the challenge may appear remote. Indeed, this was the widely held view when the euro was introduced less than a decade ago.1 But the euro’s share has already risen considerably, from only 15.5 % in 2000. Recent research2 argues that the euro’s ascent to major international currency status may no longer be as implausible as many still believe.

The reserve currency role is only one of the attributes of an international currency, which may function as a vehicle currency in the foreign exchange markets, an invoicing currency, and a currency of denomination of financial assets that are internationally traded. But the reserve currency status attracts particular attention now, because reserve growth in recent years has been dramatic. The global total is up 160% since end 2000. East Asian and fuel-exporting countries have seen massive increases (see Charts 1 and 2).

It matters greatly whose money is accepted as foreign exchange reserves. The reserve currency status of the dollar has conferred an “exorbitant privilege” on the United States3, which has been able to run large and prolonged current account deficits, financing them in its own currency. Over the past few decades, too, the US has functioned as a world banker, borrowing short and lending long. And it has earned a significantly higher rate of return on its assets than it has paid on its liabilities – another aspect of the "exorbitant privilege". Moreover, if foreign central banks were to shift the currency composition of their portfolios away from dollars, this would likely result in significant exchange rate movements – in particular, sizable dollar depreciation.

In a 2005 survey of central banks, most respondents said they did intend further diversification away from the dollar, and several have recently made public announcements along these lines. The euro is the major alternative placement. Its growing appeal comes from several factors: the euro zone is comparable to the U.S. economy in term of GDP and trade openness; the European Central Bank has kept inflation in check; and the EU experiences nothing like America’s current account deficit and external debt, which apply considerable pressures on the dollar. In addition, the spreads on transactions in the euro have fallen sharply, thus making diversification away from the dollar more attractive, and euro-area financial markets have developed very rapidly since the introduction of the single currency. All this is positive – but many euro-area firms and politicians would not find it welcome if a portfolio shift were to bring a substantial appreciation of the euro vis-à-vis the dollar.

My recent research with Elias Papaioannou and Grigorios Siourounis studies the composition of central banks’ foreign exchange reserves to learn how changes in the invoicing of financial and international trade transactions affect the composition of reserves. We find that the choice of currency pegs and the currencies of foreign exchange market intervention strongly influence the composition of reserves. This in turn may yield insights on other aspects of internationalisation, such as the vehicle currency role in foreign exchange markets.

We assess the impact of the euro on international reserve holdings via a dynamic mean-variance currency portfolio optimiser in a before-after event study framework. Making various assumptions about the returns to holding the five main international currencies (dollar, euro, Swiss franc, British pound, and Japanese yen), we obtain the optimal portfolio composition of central banks’ foreign exchange reserves for the 11 years surrounding the introduction of the euro in 1999. We look at a theoretical “representative central bank” at the aggregate level and compare these estimated optimal shares with the actual aggregate shares reported by the International Monetary Fund. The results show an increase in the shares of both the dollar and the euro in recent years at the expense of other currencies, with the euro gradually becoming more important, especially in the developing world.

The mean-variance optimisation framework yields roughly equal allocations of the four main non-dollar currencies. The optimal euro share is lower than what the IMF data show. This suggests an increasing international role for the euro, which leads to higher reserve holdings in the European currency than optimal portfolios would show. So far, however, this increased internationalisation has come primarily at the expense of the yen, Britain’s pound, and the Swiss franc rather than against the dollar.

We augment the currency-optimiser with constraints capturing the desire of central banks to hold sizable portions of their reserves in the currency of their external debt and in the trade invoicing currency. We perform some simulations for four emerging market countries (Brazil, Russia, India, and China) that have recently accumulated large foreign reserve assets and find larger weights for the euro than the aggregate estimate for the “representative central bank.” This indicates that the euro’s challenge to the dollar might occur sooner than imagined, as emerging market reserve holdings continue to rise rapidly.

We also find that the reference currency, or the choice of risk-free asset, is the chief determinant in the optimal composition of reserves in the mean-variance framework. But in practice, where there is a managed exchange rate regime, the reference currency is naturally the currency or currencies to which a country’s own currency is pegged. This suggests a major challenge to the dollar if more countries move away from managing their exchange rates with respect to the dollar and adopt euro-based anchors or baskets in which the euro figures strongly.

A substantial increase in the euro’s share of central bank reserves would require 1) that more countries include the euro in their currency pegs (the composition of debt and trade having smaller effects than the choice of reference currency), and 2) that the scope for active central bank management of their portfolios widen by permitting them to take short positions (which becomes increasingly important with the observed trend to increased co-movement of the major currencies). Recent evidence of moves in the first direction comes from Russia and Eastern Europe, China, and Kuwait, whereas there is some suggestion of movement in the second direction from Japan, Singapore, and perhaps China.

A rising number of central banks now do pursue optimisation strategies similar to the framework we employ, consulting or even hiring money managers to assist them. Besides rebalancing the currency composition of foreign reserves, there is currently increasing pressure on central banks to invest in higher return assets, such as mortgage and asset-backed securities, highly rated corporate bonds and even equity. Several countries have created ‘stabilisation funds’ and ‘sovereign wealth funds’, such as the UAE’s Abu Dhabi fund and Russia’s stabilisation fund, as well as Norway’s GPF and Singapore’s Temasek and GIC. China is also establishing a sovereign wealth fund. These funds are typically managed as diversified portfolios, taking on riskier assets than US Treasury securities. China’s recently announced intention to put $3 billion into Blackstone is a prominent example. The funds may still invest substantial proportions of their holdings in dollars, as in this case, but it is likely that they will seek higher-return opportunities in other currencies. This too is likely to bring some reallocation towards euro-denominated assets.

The advocates of a ‘strong euro’ that will rival the dollar may be pleased. But some of them (President Sarkozy?) may also find the consequences unattractive, at least as regards the competitiveness of euro-area firms. And we should all recall that the last time there was a struggle for international currency hegemony was in the 1930s. The ‘hegemonic stability’ hypothesis arose from that experience – this period without a dominant international currency was a disaster for international economic relations. Let us hope that policy-makers can manage the transition better this time around.

1 Even then, some analyses suggested that the inertia which has typically characterised dominant international currency status need not block the euro’s rise in importance – see R. Portes and H. Rey, ‘The Emergence of the Euro as an International Currency’, Economic Policy, April 1998.
2 E. Papaioannou, R. Portes and G. Siourounis, ‘Optimal Currency Shares in International Reserves: The Impact of the Euro and the Prospects for the Dollar’, Journal of the Japanese and International Economies, December 2006; M. Chinn and J. Frankel, ‘Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?’, in R. Clarida, ed., G7 Current Account Imbalances: Sustainability and Adjustment, The University of Chicago Press, 2007.
3 P.-O. Gourinchas and H. Rey, ‘From World Banker to World Venture Capitalist: U.S. External Adjustment and the Exorbitant Privilege’, in R. Clarida, ed., G7 Current Account Imbalances: Sustainability and Adjustment, University of Chicago Press, 2007.