Very few currencies –so far only three– have been able to become leading or
dominant international currencies in the world’s history. Those
that have done so tend to become monopolistic due to the centripetal
forces derived from the existence of economies of scale, economies of scope and network externalities in their use.
However, these centripetal forces tend to be counterbalanced by the opposing
centrifugal forces derived from the need by investors to diversify
their asset portfolios by currency due to the existence of a negative
correlation between the two leading currencies. This is the reason
why the incumbent currency is always followed by a competing second candidate currency.
The euro’s share in the different international markets is, on average, still
much smaller than the US dollar’s, with minor exceptions. The
rate of growth of its share, in the 10 years since its creation, was
high at first and lower later, coinciding with an accumulation of global imbalances. In any case, its present rate, if maintained,
could be enough to overtake the US dollar before the end of this century.
The euro’s share in the world’s financial markets would receive a major
boost if the UK were to adopt it, given London’s position as
one of the world’s two leading financial markets, both in euros
and in US dollars. Furthermore, the UK has the EU’s second-largest GDP after Germany. In any case, the Euro Area (EA) is
slowly expanding with the possibility of new EU members and other
potential candidates joining in the future. At present, this is not the case with the US dollar.
In the medium term, higher inflation risks in the US than in the EA could
accelerate the diversification by central banks and sovereign wealth funds away from the US dollar and into the euro.
Nevertheless, there are two major handicaps that will make very difficult for the
euro to overtake the US dollar as a dominant currency. The first is that the EA still has a very fragmented banking and cFirst,apital market,
which makes it more difficult to fully exploit economies of scale and
of scope and network externalities. The second is that since the EU and the EA are only unions of independent nations and not a federal
state, it will be extremely difficult to overtake the US dollar and
maintain a dominant international role while the governance of the EU and EA remains unchanged.
Meanwhile, other currencies, such as the renminbi, are slowly increasing their share,
while large emerging countries are increasingly requesting the creation of a global currency. However, this does not mean that the
euro will be displaced as the main candidate to replace the US dollar in the long term or as the leading pan-European currency.
Lessons to be Learnt from the History of Dominant Currencies
Historical evidence has shown that only three currencies have been able to
become dominant throughout the world’s history. The Dutch
guilder was the dominant currency during the 17th and 18th centuries, even when Spain and France were the dominant political and military powers, while it was only after the First Industrial
Revolution that the pound sterling was able to displace the guilder.
Sterling was able to retain its hegemonic position during the ‘gold
standard’ until World War Two, although the US had overtaken
the UK in terms of total GDP by the end of the 19th century, had achieved a higher volume of trade after World War One
and the dollar was the only currency convertible into gold at a fixed
price in the 1920s. The US dollar took the lead just after World War
Two and has held it until today. There are a few important lessons to be learnt from this historical experience.
The first lesson is that the displacement of the dominant currency by its challenger
takes a long time to materialise. Usually, the incumbent currency
tends to coexist with the challenging currency for many decades –or
more than a century– before it is displaced. The guilder and
sterling did so for more than a century before the latter overtook
the former and sterling and the US dollar coexisted as the two major
currencies for more than five decades before the dollar took the
lead. The Deutschemark and the yen have been coexisting with the
dollar as secondary currencies for some decades until the creation of
the euro 10 years ago made it the new challenger to the dollar.
The second lesson is that only the countries that are more open and more active in the
international trade of goods, services and capital and which have
developed leading trade and financial centres are able to take their
currency to a dominant position, sometimes independently of which
country was the political and military power at the time. For instance, Spain was the world’s leading military power for more
than a century, invading parts of France, Italy and the Low Countries
and conquering large parts of America. But, during the same time, the
Netherlands were the largest trade and financial power, Amsterdam was
the world’s financial centre and the guilder was the dominant
currency. The US was the dominant military power many years before
its currency became hegemonic, because the UK was still a strong
economic and financial power and London was the world’s trade and financial centre.
Nevertheless, at present, these three factors are combined in one country. The
US is the world’s leading economic, financial and military
power all at the same time, so it will be extremely difficult to
displace its currency from its dominant position, given that the EA
is less important financially, economically and militarily than the
US. Financially, the EA’s stock market capitalisation is US$5.8
billion versus US$9.5 billion in the US (plus its main competing
financial centre is London, outside the EA, which has a market
capitalisation of US$1.8); economically, because the EA’s GDP
is still smaller than that of the US (US$12.6 billion versus US$14.3
billion); and, militarily, the US has an annual military budget of
US$630 billion dollars and the EU, at US$314 billion, only half that
(the EA spends only US$230 billion: France US$70 billion, Germany
US$46 billion, Italy US$40 billion and Spain US$19 billion). Moreover, US expenditure on nuclear weapons comes under the
Department of Energy and the wars in Iraq and Afghanistan are funded through supplemental appropriation bills.
The third lesson is that, although in every country the currency is used by its citizens because it has the full guarantee of the State that issues it, in the international markets this guarantee is not a
sufficient condition to make it of preferred use. Private economic
agents are the ones that, in the last instance, decide which currency
to use for their international transactions. These agents have a
number of requirements for deciding which currency to use. The first
is that it should be issued by a strong, open and competitive economy
that itself accounts for a large share of the world’s trade and
financial transactions. The second is that the country that issues
the currency should have a very large and efficient financial system
that is well developed and regulated, very deep and liquid, allowing
economic agents to finance their transactions at very competitive
costs and at high speed. Large volumes and low transaction costs are
the two key drivers for private economic agents to prefer a foreign
currency to their own national one and a different financial market to their own in which to transact.
The fourth lesson is that the same dominance of a currency in the world
markets tends to create the necessary conditions for another
currency –or currencies– to emerge as a competitor. In a
world of multiple currencies and free multilateral trade, the agents
that engage in international transactions between countries have the
problem of coordinating the purchases and sales of the currencies
they need. As the purchase of a currency by an agent is not easily
compensated by the simultaneous sale of another currency by another
agent, the financial intermediaries must make their clients wait or
hold large inventories of different currencies. Nevertheless, when
the volume of transactions in one currency is very large, the waiting
time or inventory volumes are very low, reducing the costs of the
transaction. The greater the use of a currency, the greater its liquidity, the lower its bid and ask spreads and the more attractive
it becomes until it ends up achieving a kind of natural monopoly.
Hence, the currencies that are able to reach a high level of international
use tend to become monopolists due to the centripetal forces derived
from the economies of scale and agglomeration effects caused by
economies of scope and network externalities in currency markets.
International currencies derive their value from their use by
citizens and companies of other countries. Thus, there is a strong
bias in favour of increasing even further the currency that is being
most used that is known as having a ‘positive feedback’
(Arthur, 1990). Therefore, the value of a dominant currency depends
more on its past performance than on its intrinsic value, since its value is based on its relative level of use.
It works in a similar way to international languages, that also show large network externalities. Today, the
dominant language in the world is English, not because it is
intrinsically superior to others but because it is the most used as a
second language and the more it is used, the more it tends to be used
by others. A person who speaks English as a second language tends to
interact with a larger number of other people and to have access to
more information and knowledge than others who do not. In the end, he improves his potential more than with other languages.
However, fortunately for other leading currencies, it becomes increasingly
difficult for the dominant currency to maintain such a monopoly
position since these centripetal forces are increasingly counterbalanced by the opposing centrifugal forces that emerge as a
consequence of the portfolio diversification of financial assets, which tend to reduce the risk of the concentration by investors on a
single currency by diversifying their allocation to other currencies.
These centrifugal forces are very powerful, since currencies offer
much larger diversification opportunities than any other financial
instrument, such as fixed income or equities. The average price of
all currencies, by definition, does not show any trend and
diversifying therefore tends to reduce a portfolio’s covariance and risk.
This diversification outcome is even stronger between the two leading
currencies today, given that when the euro rises the dollar falls and vice-versa. The more global the financial
markets, the more fixed-income securities and equity prices tend to
move in the same direction due to the increasing interconnection and
contagion of the different financial markets, as occurred in the
recent credit crisis. Therefore, currency diversification becomes
increasingly necessary to reduce portfolio risk. This is the main
reason why the euro is becoming a growing challenger to the dollar in
a very short period of time, mainly in terms of asset allocation by
portfolio managers, while the yen remains the third choice, despite the dollar’s dominance.
Finally, for a currency to achieve a leading or dominant position it should
not only be strong but also have a very well proved record of
stability. This is a very important distinction. Naturally, the
optimum for a dominant currency is to achieve both features, but in
reality this is not always the case: sometimes one currency can be
very stable but might be losing value against another currency that
is more volatile. However, in the long run, investors tend to favour
stability over temporary strength, because by definition they are, on
average, risk averse. Importers and exporters of goods and services
and long-term savers and financial investors tend to give much more
importance to currency stability because most of them are not short-term speculators and do not want any exchange risk. Only the
more opportunistic investors favour short-term value over long-term stability.
The real test for a dominant currency is when there is a large-scale financial
crisis and risk aversion is at its highest. Then, the true dominant
currency is not always able to reach the status of a safe haven. At
times of financial stress, volatility and risk aversion, investors
tend, on the one hand, to unwind trades and return home and, on the
other, to seek a safe haven. If the country of issuance of the dominant currency is very large, then the homeward-bound effect makes
its currency appreciate versus other currencies at riskier times, but
this does not mean that it has achieved the status of safe haven, which occurs when a currency gains strength by attracting investors
who have not had a prior national attachment to that currency. This
has traditionally been the case of the Swiss franc and, sometimes, gold and commodities have also become safe havens.
Nevertheless, in the panic that broke out in September-October 2008, after Lehman’s
was allowed to go bankrupt, there was a huge flight to quality and
safety by investors world-wide, including Americans, to dollar-denominated assets. This led to a very large appreciation of
the dollar versus most other currencies and a much smaller one versus
the euro, the yen and the Swiss franc, showing that the dollar was
the safest world currency. The same happened at the turn of the millennium.
of the Euro as an International currency
An international currency is one that is used by non-residents as a means of exchange, unit of account and
measure of value. Therefore, the best way to measure the role of the
euro as an international currency is through its relative presence
and weight in three different international markets: (1) the international liability management market; (2) the international
asset management market; and (3) the foreign exchange market. The
underlying concept, based on a portfolio balance framework, is that
the international weight of a currency is determined by the balance
between the demand for assets and the supply of liabilities denominated in that currency.
International Liability Market
In the international liability market, the stock of euro-denominated securities
outstanding in the international markets has seen a very large surge
since the euro’s introduction. First, according to the ECB, in
a narrow sense –excluding domestic issuance of debt securities
at constant exchange rates, ie, adjusted by valuation effects–,
the share of euro-denominated debt securities of the total stock grew
from 20% at the start of EMU in 1998 to a peak of 33.8% in mid 2005,
although since then it has declined to 31.3% at the end of 2007 and
increased in 2008 to 32.2% of the total of a US$9.6 trillion. By contrast, the dollar’s share of the total stock outstanding
steadily decreased from 49% of the total at the start of EMU in 1998
to 41% in 2005, when its share peaked, but increased again to 44.2%
at the end of 2008, out of a total US$9.6 trillion. This has been possible thanks to the slow decrease of the share of yen-denominated
debt securities, that declined from 18% of the total in 1998 to 8% in 2008.
Secondly, measured in ‘broad or global’ terms –ie, including
domestically-issued debt securities–, the relative percentage
shares of debt securities denominated in the two currencies at the
end of 2008 were 29.5% of the total (US$24.6 trillion) in euros and
39.8% in dollars (US$33.2 trillion) out of gross total of US$83.5
trillion. The percentages in 2006 were 27.8% in euros and 42.2% in
dollars, out of a total of US$68 trillion. Hence, the share of total
debt securities in dollars has dropped by 2.4 percentage points and the share of debt in euros has risen by 1.7 percentage points.
Third, in terms of net issuance by year, in 2007 those issued in euros, US$336
billion, were less than half those issued in dollars, US$752 billion,
shares of 25.5% and 56.9% respectively. But in 2008 those issued in
euros, US$180 billion, overtook those issued in dollars, US$112
billion, respectively accounting for 47.2% and 29% of the total.
Therefore, the large drop in issuance, due to the 2008 financial
crisis, has affected the issuance of dollars relatively more than the euro issuance.
In narrow terms, the debt securities issued by residents and held by non residents
accounted for the largest share (12.5% of the total issued in euros),
with a total outstanding amount of €2.1 trillion. Those issued
by non residents and held by residents accounted for 8.6% of the total issued and amounted to €1.5 trillion, while those issued
by non residents and held by non residents had a share of 4.7% of the
total issued and only amounted to €791 billion. The rest, 74.3%
of the total, was not considered international since it was issued by
residents and held by residents and amounted to €12.6 trillion.
However, using the BIS figures combined with those reported by the US Treasury, the
share of securities held by non residents in dollars of the total
issued in dollars was 27%, while the share of those in euros held by
non residents was only 17% of the total issued. In the case of
entirely international debt securities –that is, issued by non
residents and held by non residents– the dollar share is higher
than the euro-denominated share and, finally, the same can be said
about the share of dollar-denominated debt securities issued in the
US and held by non residents, which are larger than those issued in the EA and held by non residents.
Within these securities the relative weight in the fixed income markets is
still far more important than in the equity markets. The reason for
this asymmetry is the persistence of national, structural and
institutional impediments to achieve a pan-European equity-trading
framework. It is true that the European equity markets are increasingly pricing company stocks on the basis of pan-European
economic factors, taking into account the industrial sector effects
more than the purely national ones, but still the ‘home
exchange bias’ remains the rule for most European shares. As a
consequence of this very slow process of integration of the European
equity markets, the EA equity markets remain smaller than their US
and sometimes than the UK counterparts, even taking into consideration the relative size of their economies. At the same time,
trading activity is thinner and transaction costs are higher both in trading and post-trade settlement.
Therefore, it is taking more time than expected to reach a relative size big
enough to compete with the US market. At the end of 2008, the market capitalisation of the US
equity market was US$9.4 trillion, down from US$13.9 trillion in 2006
(35.2% of the world total and 67% of US GDP), the EA’s was US$5.8 trillion, up from US$5.3 trillion in 2006 (21.7% of the world
total and 46% of EA GDP), while the UK alone reached US$1.8 trillion,
down from US$2.7 trillion (6.8% of the world total and 65% of UK
GDP). If the UK, Sweden and Denmark were to join the euro, the EA’s
market capitalisation would be US$7.9 trillion, closer to the US total. After the crisis, the gap between the two has decreased, given
that the rate of growth of the EA’s equity markets has been much faster, despite starting from a much lower level.
On the contrary, fixed income securities markets have been much faster in realising the greater
potential gains of introducing a single currency. The elimination of
exchange rate risk and the convergence of yield curves within the EA
have reduced the importance of economic factors that had previously
led to the segmentation of the European bond markets. Therefore, borrowers can now tap into a very large and expanded investor base
with a single issue, making the euro an attractive alternative to the
dollar as a currency of denomination for debt, and, as a result, bond
issuance has soared. EA borrowers, both public and private, have accounted for most of the increase in issuance volumes, although the
biggest shift has been the increasing share of private sector borrowers.
As in the case of debt securities, the stock of outstanding bonds and notes (excluding money market
instruments) declined in the second half of 2008, reaching lower levels than in previous years. The share of issuance by financial
institutions in the total stock of international bonds and notes denominated in euros stood at 71.3%, versus 54.4% in dollars, while
the share of sovereign issuers denominated in euros remained smaller
(6%) than in the case of those denominated in dollars (11.4%). Financial institutions located in the UK were the largest issuers of
euro-denominated bonds and notes. By residence of the issuer, the UK,
Denmark and Sweden together issued 47.5% of the total, followed by issuers resident in North America, with 23.3%. But the euro’s
share of the stock of international debt securities by region shows
that the central and eastern European EU accounts for 78.7%, the UK,
Denmark and Sweden for 58.8%, North America for 53.3% and Africa for 42.5%.
The euro bond market is still far from reaching its full potential. There
are several reasons for this: the legacy of its national origins
still presents some obstacles for full integration and for further
deepening; there is no central debt agency for government bonds and,
hence, no co-ordination of the new issuance schedule; and the lack of
a single benchmark yield curve in the euro bond market is symptomatic
of these factors because no single borrower can provide the necessary
volume and liquidity across the maturity spectrum in order to fulfil
this role. While swaps have provided some proxy reference for a yield
curve, it remains an imperfect one because of the less-than-perfect
link between the swap market, which is based on corporate issues, and the futures market, which is based on government issues.
As for the euro’s share in the stock of outstanding international or cross-border loan
markets, at the end of 2008 the euro’s share of total loans was
22.2%, up by one percentage point, while the dollar’s share was
51%, down one-and-a-half percentage points. The euro’s share of
the loans by EA banks to non-bank borrowers outside the EA was 38.2%
of the total, mainly to non EA Europe. By contrast, the euro’s
share of the loans made to EA borrowers stood at 56.8% of the total,
while the dollar’s was 31.6%. Finally, the euro’s share
in purely international loans was only 17.6%, versus the dollar’s 54.3%.
International Asset Management
In the international asset management market, currency diversification
has notably increased. Investors inside the EA have been keen buyers of foreign securities
denominated in euros, especially bonds, but euro-denominated assets
were less successful with non EA-based investors until 2005, although
the trend changed dramatically after that. Japanese asset managers
were initially much more attracted by euro-denominated assets, although later the fall of the euro’s relative value
discouraged them. On the contrary, investors in the EA are large-scale buyers of dollar-denominated US securities. Although
bonds are the major instruments of non-European attraction, the surge in euro equities purchases by foreigners has been increasing.
A breakdown by currency of the funds under management shows that, at
the end of 2006, the euro had a 0.7% share in the US and Canada and of 27.8% in non EA European countries (the UK, Denmark, Sweden,
Switzerland, Norway, Monaco and Liechtenstein), while the US dollar’s
share was of 97.1% in the former and of 14.4% in the latter. It is interesting that at the end of 1999 the euro’s share was only
0.2% in the US and Canada and that the dollar’s share was 26.8%
in non EA Europe; thus, the euro has seen an increase in both areas, although as a total it is still far below the dollar.
In other regions, the euro is dominant in non EA EU countries, where the average euro shares of total
portfolios are around 50% with the exception of Poland (only 22%), Romania (100%) and Switzerland (39%). By contrast, the dollar is
dominant in non Japan Asia, where its average share is more than 80%, with the exception of India (17%), Japan (44%, versus only 20% in
euros), Latin America (95%) and Russia (92%, versus only 4% in euros –but growing fast–).
The cross-border deposit markets (excluding interbank deposits) have also
dropped due to the crisis, from a peak of US$7 trillion in 2007 to US$5.8 trillion at the end of 2008. The euro’s share in the
international deposit markets was 22.4% at the end of 2008, compared with the dollar’s share of 60%. The largest share of euro
cross-border deposits was held by non EA residents in EA banks (50.8%
of the total), followed by EA residents in non EA banks (46.3%), and the euro’s share in purely international deposits by non EA
residents in non EA banks was 21.7%. The euro’s share of deposits held by OPEC countries was 18%, compared with the dollar’s
77% share. In Russia the euro’s share was much closer to the dollar’s share of 51%.
Foreign Exchange Market
The crisis has also been felt in the foreign exchange markets, prompting a halt in 2008. Using data from Reuters
and EBS, which accounted for close to 90% of all transactions and the
continuous linked settlement system (CSL), at the end of 2008 daily volumes were down from US$2.7 trillion in 2007 to US$2.4 trillion in
the last quarter of 2008. The euro’s share was 42% of the settlements of the CLS system while the dollar’s share was just
above 90%, the sum of currency percentage shares being close to 200% as both of the currencies involved in a settlement of foreign
exchange trade are counted individually. In some segments of the foreign exchange markets, the global financial turmoil resulted in a
temporary drying-up of liquidity and caused considerable dysfunctions
in normal market operations. This was particularly the case for some
interbank foreign-exchange swap markets, making it difficult for banks to refinance their foreign-exchange positions. In response to
this market disruption, some central banks established an exceptional and case-by-case reciprocal currency swap lines.
The global derivatives markets, after experiencing significant
expansion in 2007 and the first half of 2008, suffered a contraction
in the second half of 2008. Notional principal outstanding decreased
to US$650 trillion, following a peak of US$766 trillion in the second
quarter of 2008. The notional value of credit default swaps (CDS) declined to US$42 trillion from its peak in 2007 because of
operational risk problems, but the market value of outstanding CDS positions, which are a proxy to counterparty risk, increased from
US$2 trillion in 2007 to US$6 trillion at the end of 2008. The euro’s
share, net of valuation effects owing to exchange-rate fluctuations, increased over the review period. In the market for OTC-traded
interest-rate derivatives, it rose from 35.6% to 37%, reaching the same level as the dollar’s share. The euro’s share in the
OTC-traded foreign exchange derivatives increased from 37.1% to 42.1%, while the dollar remained stable at 80% of the total. The main
losers were the yen and currencies from emerging economies.
The global market for asset-backed securities (ABS) became one of the
largest in the world thanks to the increasing use of credit securitisation by banks. The traditional
securitisation of ABS reached US$18.8 trillion, while the synthetic one –that isolates the credit risk from the underlying loan,
creating a separately negotiable claim measured by the notional amounts of CDS– reached US$41.9 trillion. The US accounts for
67.9% of the total issuance, followed by the EA’s 10.6%, the UK’s 9.6%, the offshore centres’ 7.2%, Australia’s
1.7% and Japan’s 1.5%. The largest proportion, 85.4%, was in the issuer’s currency, while those issued by SPVs from offshore
centres were mainly denominated in US dollars (85.4%), euros (4%) and
Japanese yen (5.1%). Net of valuation effects owing to exchange-rate
fluctuations, the dollar’s share was 76% at the end of 2006 and fell to 38% at the end of 2008, while the euro increased its share
from 46% in 2006 and 2007 to 58.8% at the end of 2008.
The euro is also quite widely used in the invoicing and settlement of international trade in
goods and services. Taking into account only global merchandise trade, the euro’s average share in 2007 was 28.9% (up from
18.2% in 2001), of which 39.2% was for EA countries, 32.6% for non EA
EU countries and 5.4% for the rest of the world. Regarding the trade of EA member countries with non EA countries within the EU, in 2007
the euro’s share of merchandise exports ranged from 39.2% in Greece to 79% in Slovenia, while for merchandise imports the
percentages were 34.9% and 73.1%, respectively. Nevertheless, the dollar is still the dominant currency, accounting for close to 65% of
global trade. Energy and commodity exporters invoice in dollars almost 100% of their exports, Asian countries invoice over 80% of
their exports in dollars and even EU member countries invoice more than 30% of their exports in dollars.
The euro’s share of total foreign currency reserves is not easy to determine, as
around 46% of foreign exchange reserves held by developing and emerging countries cannot be allocated according to their currency
composition and another 46% of the global reserve accumulation in the last three years is unknown. Asian countries in particular do not
disclose the currency composition of their foreign-exchange reserves The IMF’s Currency Composition Official Foreign Exchange
Reserves (COFER) data remains the only official source. The latest data published by the IMF are for 2008 and show that the euro’s
share, at constant 2008 exchange rates, reached 26.6% of total global
reserves (up from 23.1% in 1999 and 25.3% in 2007), while the dollar accounted for 64% of the total (down from 66% in 1999 and 65.4% in
2007). The yen’s share was 3.3%, down from 6.4% in 1999 but up from 2.9% in 2007.
At the end of 2008 the euro’s share of foreign currency reserves was 22.1% in the advanced
countries (down from 22.3% in 1999 and the same as in 2007) and 31.1%
in the emerging and developing countries (up from 24.9% in 1999 and 29.6% in 2007). The dollar’s share was 68.1% in the advanced
countries (up from 65.7% in 1999 and 66.9% in 2007) and 59.8% in the
developing countries (down from 66.9% in 1999 and 61.3% in 2007). As
a reminder, in 1998 the share of the present EA currencies was as follows: deutschemark 12.2%, French franc 1.4%, Dutch guilder 0.4%
and ECU 5%, that is, a total of 19%. Therefore, the euro’s share has increased by 7.6 percentage points since then.
According to the ECB (2008), the currency composition of global foreign exchange reserves can
reflect changes in the relative weight of individual reserve-holding countries more than changes in currency preferences. It is
conceivable that emerging-market central banks intervened to defend their currencies in the second half of 2008 mainly by selling
dollar-denominated assets, since a large share of their foreign reserves appear to be held by countries which manage their exchange
rate against the dollar. It has been shown that in 2005 two-thirds of
foreign-exchange reserves with a known currency composition were held by countries which use the dollar as a reference in their exchange
Nevertheless, since the currency composition of very large foreign currency reserve
holdings are not known, the shares are only partial and not as relevant as they were only five years ago. Fifty percent of total
reserves are disclosed, 24% are not disclosed and another 26% are held by sovereign wealth funds (SWF) and are only estimated because
they are not exactly known. It is also important to look at the euro’s share of central-bank deposits held at BIS-reporting
banks, which show that the euro’s share has increased to close to 30% coming from only 22% in 2004, while the dollar’s has
declined from 65% five years ago to only 57% at the end of 2007.
Finally, it is also important to show the euro’s share of large-banknote holdings circulating outside the EA and its
comparison with the dollar’s, that is, the use of the euro as a ‘parallel currency’ in third countries. Euro banknotes
circulating outside the EA cannot be estimated with precision. The Eurosystem regularly publishes an estimate of the lower end of the
accumulation over time of net shipments of euro banknotes by EA monetary financial institutions to destinations outside the EA.
According to this measure, around €95 billion worth of euro banknotes were estimated to be in circulation outside the EA at the
end of December 2008, that is, around 13% of total euro banknotes in circulation. Since this is an estimate at the lower end, the real
percentage could be closer to 20% rather than 13%. In March 2009 the total figure had risen to €105 billion.
Another measure can be obtained from the figures reported by 35 globally-active banknote
wholesale banks, serving most of the foreign currency market. However, other wholesale banks do not report, so the figure can only
be guessed at. According to these reports, the regional breakdown of
euro banknote purchases and sales for destinations outside the EA was as follows in 2008: (1) purchases from non EA Europe accounted for
59% of the total (of which 43% were non EU members, 12% non EA EU members and 4% from the rest of Europe), from Asia and Oceania for
23%, from the Middle East for 9% and from the rest of the world for
8%; (2) euro banknote sales to non EA Europe accounted for 89% of the
total (Eastern Europe 45% –particularly Russia, Turkey and Ukraine–), EU non EA countries for 21% (mainly the UK), the
rest of Europe for 23% (mainly Switzerland), Asia and Australia for 5%, Africa for 2%, the Middle East for 2%, North America for 1% and
Latin America for 1%.
According to FED and ECB estimates, euro banknotes overtook dollar bills in 2004 as a
percentage of domestic GDP, rising from 5.6% in 2003 to more than 7%
in 2006, while the dollar fell from 6% in 2003 to only 5.7% in 2006. The ratio of dollar bills in circulation to euro banknotes in
circulation has dropped from 1.3 in 2003 to 1.0 in 2006 at PPP exchange rates and to 0.9 at current exchange rates. The main reason
is that euro banknotes have a higher denomination (€200 and €500) than dollar bills (US$100). In any case, I believe that,
as Europeans, we should not be proud of the rapid and increasing use of large-denomination euro banknotes, because they are mostly used
for irregular or illegal activities, both in the EA and abroad.
The Euro’s Future as a Global Currency
During the past two years papers and articles have tried to prove that the euro
will overtake the dollar sooner rather than later. They look at the historical evidence of how the dollar slowly overtook sterling
between 1897 and 1945, consider that the same might now happen between the euro and the dollar and conclude that the first might
overtake the second within the next two decades. According to them, sterling’s decline was part of a wider pattern whereby the UK
lost its economic pre-eminence, including colonies, military power and other trappings of the international economy. Now they see the
same happening to the US, which might have reached a state of imperial over-stretch, as the UK did before. On the one hand, they
see the euro as a more serious challenger to the dollar than any other previous currency; on the other, they see that, as with the UK
and sterling before, the US is on a 25-year long trend of depreciation of its currency.
Most papers take the euro’s increasing share in the total foreign exchange reserves held by
central banks as a measure of its international role, because they believe that similar considerations might apply to the other criteria
of international currency status, such as trade invoicing, debt and equity, cash and deposits and foreign exchange transactions
denomination. They have chosen foreign currency reserves because of their huge growth in recent years in emerging countries and their
need to diversify their large holdings through different currencies. Global foreign exchange reserves have risen by 160% since 2000,
mainly due to global imbalances. For instance, China now has three times and Japan twice the reserves the EA has, whose volume has
already been matched by Russia.
Their argument is based, on the one hand, on the expected fact that these foreign central banks cannot keep
supporting the dollar indefinitely and that they will eventually diversify part of their huge dollar holdings into alternative
currencies. The recent monetary policy followed by the FED, aimed at averting a financial stability crisis, might cause an increase in
inflation that will make it difficult for all the foreign currencies pegged to the dollar to be able to maintain it. One way to do so
would be to peg to a basket of euros and dollars, while another would
be to drop the peg altogether. On the other hand, a new reality has emerged: for the first time, these countries now have in the euro a
real and credible alternative to the dollar, since it also complies with most of the exclusive characteristics of an international
currency, such as stability, reliability and increasing network externalities. Moreover, the EA’s total GDP is now similar to
that of the US, due to the dollar’s weakening, but is also growing faster thanks to the adoption by new and future EU of the
euro and, later on, to its potential adoption by the UK, which would
give the EA a huge boost, since it would make London the world’s largest euro financial centre.
There are two question marks in this argument. The first is that by diversifying
away from the dollar, they might provoke an appreciation of their own currencies which are pegged to it. However, they consider that the
end result might not affect their currencies on a trade-weighted basis, but only in nominal terms. The second is that if they
diversify by selling dollars and buying euros they might cause a significant drop in the dollar and a loss in value of their
dollar-denominated stocks of central-bank reserves and sovereign wealth fund holdings. Nevertheless, they consider this issue
inevitable since their decisions to sell tend to be individual and not collective and coordinated, so that it might be less negative for
these central banks to follow the herd rather than to be at the tail-end. The main reason is that the network externalities that have
helped the dollar to become increasingly used by economic agents could now start favouring the euro. Therefore, network externalities
can change from developing centripetal forces in favour of the dollar to developing centrifugal forces in the euro’s favour.
To become the issuer of the leading global currency brings large benefits but
also large responsibilities. The benefits tend to be exorbitant according to these two papers. First, the EA will be able to increase
its seigniorage in a major way, because it can issue even more billions of high-denomination €200 and €500 banknotes than
it is issuing at present, that are equivalent to an un-nominated perpetual debt that pays no interest. Secondly, the EA will take over
from the dollar its role as banker to the world in the sense that it will be able accept short-term deposits at low interest rates in
return for long-term investments at high average rates of return. That is, it will tend to achieve permanently higher returns on its
foreign assets than the return paid for its liabilities, because foreigners will be willing to accept lower returns on their euro
investments as a trade-off for security and reliability. Third, as a
consequence, it will also gain the privilege of being able to finance large current account deficits for long periods of time, as the US
has been doing for so many years.
The attached responsibilities of a dominant international currency are also
important. First, the euro will have to continue being very stable for a long time. It will have to avoid a build-up of inflation
expectations, sometimes at the expense of the EA’s growth rate, in order to keep intact its hegemonic status as an international
currency. As shown by recent US experience, the consequences of higher inflation in the EA could tend to be doubly negative, since
not only will it tend to depreciate the euro, making it difficult for other pegged countries to maintain their pegs, but also result in
even higher inflation in the EA because of the euro’s depreciation.
But symmetrically, if the ECB goes too far in keeping inflation expectations under
control, it might produce financial crises in other countries or even
provoke deflation in the EA and the rest of the world. Moreover, the EA will not be able to abuse its privileges of issuing the leading
international currency or indulge in maintaining long-term current-account deficits, as the US has done, because it could lead
to the beginning of the end of the euro’s hegemonic. The US has been absorbing three-quarters of all net international capital
movements, which is an oxymoron for a leading international currency.
Secondly, another important responsibility inherent to being a dominant
international currency is that the EA will eventually also need to take up the US’s role as the world’s political leader
and, perhaps, even as its military gendarme. Unfortunately, that would be extremely difficult and uncertain because the EU’s
political governance, based on 27 national governments adopting majority decisions is totally at odds with the fast decision-making
of a single federal government as in the US.
The ECB’s present policy of neutrality with regards to the euro’s
international role is the right one. The ECB should try to make the euro the most stable currency by maintaining long-term price and
financial stability. It is a hard enough task for the ECB to make the
euro attractive as an international currency. The reason is that the euro’s international role is the outcome of a market-driven
process and not the result of interference by central banks and political authorities. To try to impose invoicing in euros to
importers and/or exporters of major commodities, such as oil and gas,
as proposed by some politicians, would be perceived by the markets as an intolerable interference. Private companies engaged in these
activities know better than anybody else which is the optimal (and workable) currency to use in each transaction. Hence, they would only
change the currency they now use if they thought it convenient to their efficiency, competitiveness and transaction costs or because of
issues concerning their confidence in its long-term value and stability.
In the meantime, if the EA’s economic authorities aim to achieve a hegemonic
international status for the euro, they should try to concentrate on integrating their still segmented banking and capital markets to
achieve a larger and more competitive market size in order to be able
to attract more issuers and investors from the rest of the world and compete on equal terms with the US financial markets, as they have
already done in the money markets. Unfortunately, so far, the dominant political view in the EA’s member states is still
short-sighted and short-termist, derived from an old fashioned and nationalistic attitude and understanding of the financial markets
that is completely at odds with an increasingly globalised economy and the huge and increasing interdependence of the financial markets.
This nationalistic approach is retarding the euro’s emergence as an international currency in accordance with the weight of the
EA’s GDP and share in world trade.
A recent experience, during the financial panic following
Lehman’s bankruptcy, has made evident the dollar’s strength as the world’s most trusted currency, since investors
seeking a safe haven turned massively towards US Treasury bills and bonds, while low-income individuals in both developed and developing
countries largely tried to grab up greenbacks to feel safer. It was a
very rational decision because most other currencies weakened against
the dollar –even the euro weakened slightly, although it still
retained its role as challenger–. The question now is: has the
euro any chance of replacing the dollar as a global currency in the future when last year –after US regulators and supervisors
failed in their duties and after a huge drop in financial and real estate assets– the dollar attracted more investment from the
rest of the world than ever before?
The main problem is that there is a major difference in the governance
framework of the two currencies’ issuers. The US is a federal nation with one government and one treasury, while the EU is a loose
confederation of independent nations with 27 different governments and treasuries (and the EA still has only 16 members out of the 27).
Had the EU had a single treasury issuing euro bonds instead of 27, the recent financial panic would have been different and the euro
bonds would have competed on good terms with the US Treasury in attracting investors fleeing to safe haven nations and currencies.
Therefore, a single euro bond issuer should be the first step the EU should take in order
to increase the euro’s probabilities of competing more successfully with the US dollar. Having a single bond issuer would
have many advantages. A common euro bond would create one of the world’s most liquid financial and would also heavily reduce the
cost of funding the 27 member-state treasuries and would attract more buyers because of its larger diversification. Furthermore, a joint
guaranty from the 27 would further reduce the funding costs for not only the 26 member states but also for their benchmark, Germany.
However, a joint guaranty, by which of all members guarantee the total, instead of each country guaranteeing its own tranche of the
bond, would require a stricter fiscal framework for all members. The Stability and Growth Pact is insufficient because it takes several
years for conditions to become binding. An alternative would be to set up a framework of transfers whereby the member states who most
reduce their funding costs make transfers to those that reduce them less.
Not to have any kind of guaranty is not a solution either, since it would heighten
the likelihood of a member state –or several of them– engaging in moral hazard. Another way to overcoming these problems
would be to split the euro bond into senior and junior tranches, allowing weaker credits to issue bonds with a higher rating, reducing
the costs for the better-credit countries by making some of the debt
senior to all others could increase the rating of part of the debt.
Moreover, the present situation of the two leading currencies, the dollar as dominant and the euro as the
candidate to replace it one day, might change in the future. There is
an emerging competitor, the renminbi and also increasing pressure from many emerging economies in favour of a world currency.
Nevertheless, these options are still far from being any real possibility. On the one hand, the renminbi would only be a possible
contender if by mid-century China becomes –as expected and if its political transition is well managed– the world’s
largest economy in current dollars. However, even then, it will take time for it to catch up with the euro first and the dollar after
The Governor of the Peoples Bank of China, Zhou Xiaochuan –in a speech in
March 2009 on the reform of the international monetary system– proposed the adoption of the SDR as the global reserve currency. He
considered a national currency unsuitable for the role due to the ‘Triffin dilemma’ –ie, the problem of the issuer
making compatible his domestic monetary policy objectives with the other countries’ demand for a reserve currency– and
because he thought that Keynes’s ‘bancor’ is too far-fetched. The problem with the SDR is that it is not a currency
but a basket of currencies in which the dollar has the greatest weighting, followed by the euro, and between the two they account for
more than 85% of the total. The ‘bancor’ was a true international currency based on 30 basic types of merchandise,
including gold, and was designed to be used only as the sole currency in international trade in order to maintain stable prices.
In any case, it is interesting to see how much things have changed in the
international debt markets in the last decade. Before, creditors –ie,
the developed countries– wanted a very stable global currency in order to keep the value of their assets constant, while debtors
–ie, the developing countries– wanted a depreciating global currency and more inflation to reduce the value of their
liabilities. Now it is exactly the other way round, China and the commodity-exporting countries are worried about the dollar’s
stability and object to inflation because they are the large-scale creditors, while in the US many experts and some politicians are
advocating more inflation to devalue and liquefy their debts.
To sum up, unless the EU can construct a political governance system similar to that of
a federal state it will be very difficult for the euro to overtake the dollar as the world’s dominant currency or, eventually, to
maintain its status as the leading candidate to replace the dollar, although it could still be the dominant regional European currency.
Were the EU to approve a European Federal constitution, the euro would have a chance of replacing the dollar as the global currency in
this century. Meanwhile, the euro will continue to increase its global share of foreign currency reserves, financial and trade
transactions and even exchange rate pegs and baskets in the coming years, but only as the second-best global currency.
Guillermo de la Dehesa
Chairman of the Centre for Economic Policy Research (CEPR, London), Chairman of the
Observatorio del Banco Central Europeo (OBCE, Madrid), Monetary Expert of the ECON Committee of the European Parliament (Brussels),
Member of the Group of Thirty (G30, Washington), Member of the Euro50
Group (Brussels) and Member of the Scientific Council of the Elcano Royal Institute (Madrid)
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