The Dollar’s Future as the World’s Reserve Currency: The Challenge of the Euro
Order Code RL34083
The Dollar’s Future as the World’s Reserve
Currency: The Challenge of the Euro
July 10, 2007
Craig K. Elwell
Specialist in Macroeconomics
Government and Finance Division
The Dollar’s Future as the World’s Reserve Currency:
The Challenge of the Euro
Summary
Globally, central bank holdings of reserve currency assets have risen sharply in
recent years. These “official holdings” have nearly tripled since 1999 to reach $5
trillion by the end of 2006. Nearly $3 trillion has been amassed by developing Asia
and Japan. China, in particular, now has official reserves that exceed $1 trillion. In
addition, the oil-exporting countries have increased their official reserves by about
$700 billion. The dollar’s status as the dominant international currency has meant
that as much 70% of this large accumulation of official reserves are of some form of
dollar asset.
There are significant advantages for the United States in having the dominant
reserve currency. These advantages include reduced exchange rate risk and lower
borrowing costs. However, these large accumulations of dollar assets in foreign
official holdings also means that foreign central banks have become important
participants in and influences on U.S. financial markets and the wider U.S. economy.
Four factors — share of world output and trade, macroeconomic stability,
degree of financial market development, and network externalities — combine to
influence the choice of a reserve currency. The euro has improved its standing in all
four areas but the dollar retains significant advantages. Available data show only
modest diversification from dollar assets by foreign central banks from the time of
the euro’s introduction in 1999 through the end of 2006. The dollar’s share of total
official reserves rose through the 1990s, reaching a peak value of about 72% global
reserves in 2001. By 2003 that share fell to about 66% and remained near that level
through 2006. The euro’s share of global official reserves rose from about 18% in
1999 to 25% in 2003, but has remained near this level through 2006.
Looking to the future, the dollar’s status as the dominant reserve currency may
be challenged by the euro because it increasingly offers many of the advantages of
the dollar but fewer of the risks. The dollar’s most important advantage is the size,
quality, and stability of dollar asset markets, particularly the short-term government
securities market where central banks tend to be most active. The high liquidity of
these financial markets makes the dollar an excellent medium of exchange. A further
advantage is the power of “incumbency” conferred by the “network-externalities”
that accrue to the currency that is dominant. Together these factors make it unlikely
there will be a large or abrupt change in the dollar’s reserve currency status.
However, the euro is seen by some as poised to challenge the dollar in the store
of value function of a reserve currency. The sheer magnitude of dollar assets in the
official reserves of foreign central banks and the realistic prospect of continued, and
perhaps disorderly, depreciation of the dollar against most currencies, place central
banks at considerable risk of incurring large capital losses on their dollar asset holding.
With more than enough dollar reserves to meet liquidity needs, prudent asset
management would seem to dictate some diversification away from the dollar and
toward the euro. This report will be updated as events warrant.
Contents
The Rising International Importance of “Official Holdings” . . . . . . . . . . . . . . . . . . 1
The Roles of a Reserve Currency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Four Factors Influencing Choice of a Reserve Currency . . . . . . . . . . . . . . . . . . . . 3
The Current Currency Composition of Official Reserves . . . . . . . . . . . . . . . . . . . . 4
Euro vs. Dollar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
As a Medium of Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
As a Unit of Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
As a Store of Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
The Dollar’s Future as the World’s Reserve
Currency: The Challenge of the Euro
The Rising International Importance
of “Official Holdings”
Central bank holdings of reserve currency assets have risen sharply in recent years.
These “official holdings” have nearly tripled since 1999 to reach $5 trillion by the end
of 2006. These large accumulations of reserves have been concentrated among
countries with large global current account surpluses. Nearly $3 trillion has been
amassed by developing Asia and Japan. China, in particular, now has official reserves
that exceed $1 trillion. In addition, the oil-exporting countries have increased their
official reserves by about $700 billion.1
The dollar’s status as the dominant international currency has meant that as much
as 70% of this large accumulation of official reserves is held in some form of dollar
asset. The U.S. Treasury reports that through mid-2005, 34% of the more than $3
trillion outstanding marketable Treasury securities was being held in foreign official
reserves. (All foreign holdings, official and private, amount to 52% of all outstanding
Treasury securities.)2 These large accumulations of dollar assets in foreign official
holdings mean that foreign central banks have become important participants in U.S.
financial markets, as well as in the wider U.S. economy.3
For the United States, there are significant benefits to being the world’s reserve
currency. Central banks’ demand for the reserve currency tends not to be as volatile
as that of private investors. This stabilizes the demand for dollars and reduces the
foreign exchange risk faced by U.S. companies in their international transactions.
Exchange rate risk is also reduced because the United States borrows in its own
currency so that the appreciation of foreign currencies against the dollar cannot
increase debt service cost or raise default risk.
Another major benefit of being the primary international reserve currency is that
it enables the United States to borrow abroad at a lower cost then it otherwise could.
This cost advantage occurs because there will be a willingness of foreign central banks
to pay a liquidity premium to hold dollar assets.
1 International Monetary Fund, Global Financial Stability Report, World Economic and
Financial Surveys, April 2007, pp. 74-76.
2 U.S. Department of the Treasury, Treasury Bulletin (Washington: April 2007), p. 56.
3 See CRS Report RL32462, Foreign Investment in U.S. Securities, by James K. Jackson.
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Also, the dollar’s status as the world’s reserve currency raises the likelihood of
foreigners using U.S. asset markets. This added foreign involvement increases the
breadth and depth of these markets, which then tends to attract even more investors,
which then continually magnifies the benefits of being the reserve currency.
Since 2003, sharply rising capital inflows from foreign central banks have
financed on average about 50% of the U.S. current account deficit, increasing the
sustainability of the trade deficit by compensating for a sizable weakening of private
capital inflows.4 It is estimated that these recent official reserve accumulations have
kept U.S. long-term interest rates from 0.5 to 1.0 percentage points lower than
otherwise.5
Historically, a single currency has been the dominant reserve currency. In the 19th
century sterling played this role, succeeded by the dollar in the 20th century. As the 21st
century has begun to unfold the dollar has remained the dominant international
currency. But the euro, created in 1999 as part of the European monetary union
(EMU), has been seen by some economists as a potential challenger to the dollar’s
dominant position as an international currency in the 21st century.6
To the degree that the euro displaces the dollar in the official holdings of central
banks, the benefits to the United States of the dollar as a reserve currency will be
reduced. The viability of the euro as a substitute for the dollar will hinge on several
factors that determine how well it can perform the necessary roles of a reserve currency
for a central bank
The Roles of a Reserve Currency
An international currency is one used by non-residents to accomplish the three
standard roles of any currency: be a medium of exchange, a unit of value, and a store
of value. However, for central banks these three roles serve different needs than those
of the private investor:
! The medium of exchange function serves the need for foreign
exchange intervention as central banks attempt to counter unwelcome
changes in the value of their domestic currency caused by private
inflows and outflows of capital.
4 See CRS Report RS21951, The U.S. Trade Deficit: Role of Foreign Governments, Marc
Labonte and Gail Makinen.
5 See Mathew Higgens and Thomas Klitgaard, “Reserve Accumulation: Implications for
Global Capital Flows,” Federal Reserve Bank of New York, Current Issues in Economics
and Finance, vol. 10, no. 10, October 2004.
6 Barry Eichengreen, Sterling’s Past, Dollar’s Future: Historical Perspectives on Reserve
Currency Competition, National Bureau of Economic Research, Working Paper no. 11336,
April 2005.
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! The store of value function serves the need for reserve accumulation
as self-insurance against periodic balance of payments crisis and as a
public demonstration of commitment to exchange rate stability.
! The unit of account function serves the need of some countries for a
monetary anchor to bolster domestic monetary policy in combating
inflation.
Typically, the currency used as the medium of exchange will also serve as the
main store of value. Also, because of the large scale of recent reserve holdings, some
central banks may turn more attention to the currency’s ability to also provide the store
of value function of concern to private investors — steadiness of asset value and rate
of return.
The already large holdings of dollar assets and the prospect of continued
depreciation of the dollar’s exchange rate are likely to be seen by foreign central banks
as major disincentives for using dollars as their principal reserve currency. In contrast,
the appreciation of the euro exchange rate and the substantial increase in the liquidity
of the euro caused by the improvement in the breath and depth of euro financial
markets since 1999 raises the attractiveness of the euro as a reserve currency.
Four Factors Influencing Choice
of a Reserve Currency
Economists have identified four factors that will jointly influence how well a
currency can serve central banks as a medium of exchange, as a store of value, and as
a unit of account.
First, the larger a country’s share of world output and trade the more likely it is
that other countries will use it as a monetary anchor or in external transactions. This
factor tends to raise the likelihood that other countries will hold liabilities denominated
in its currency and therefore tends to also hold more of its assets in the same currency.
The euro is probably not at any sizable disadvantage relative to the dollar in this
category.
Second, macroeconomic stability, particularly price stability, is needed to
establish confidence in the currency’s value. Without this confidence a currency’s
ability to play its role as a unit of account and as a store of value is undermined. The
dollar’s status in this category may be eroded by the prospect of long-term exchange
rate depreciation.
Third, a high degree of financial market development, offering large size and high
liquidity, makes it more likely that a country’s currency will be used by foreign central
banks as the medium of exchange for currency intervention. Also, a broad and deep
financial sector tends to reinforce overall economic stability. In this area, the dollar has
been singularly attractive. But the development of euro area financial markets has
advanced steadily since its 1999 introduction.
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Fourth, network externalities create a self-generating demand for a dominant
currency. The more often a currency is used as a medium of exchange, the more liquid
it becomes and the lower are the costs of transacting in it, leading, in turn, to it
becoming even more attractive to new users. Network externalities create a tendency
toward having one dominant currency and confer a substantial incumbency advantage
to the dollar over the euro.7
None of these influences on the choice of a reserve currency is likely to change
quickly, acting to make any shift in the status of the dominant reserve currency a slow
process, with substantial changes most often emerging over decades.8
The Current Currency Composition
of Official Reserves
Data on the currency composition of official reserves is imperfect. The most
comprehensive source is the International Monetary Fund’s (IMF) currency
composition of foreign exchange reserves (COFER) database.9 Included in this series
are monetary authorities’ claims on non-residents in the form of banknotes, bank
deposits, treasury bills, short-term and long-term government securities, and other
claims usable to meet balance of payments needs. However, COFER data do not
include the holdings of currency by the issuing country. Also, the COFER data only
provides national currency specific information for about 70% of total global reserves
because the reserves of many emerging economies are missing from the tally. Despite
these limitations, the COFER data will most likely reveal basic trends in holdings of
the dollar and euro in global official reserves.
The COFER data show only modest diversification from dollar assets by foreign
central banks from the time of the euro’s introduction in 1999 through the end of 2006.
The dollar’s share of total official reserves was at its lowest point in the early 1990s at
about 45%. Through the 1990s that share rose, in large measure because of
accumulation of dollar reserves by emerging economies, reaching a peak value of about
72% global reserves in 2001. By 2003, that share fell to about 66% and has remained
near this level through 2006. The euro’s share of global official reserves rose from
about 18% in 1999 to 25% in 2003, but has remained near this level through 2006.
Again, the source of much of the change in both the level of official reserves and
their distribution among currencies was central banks in developing countries,
accounting for 58% of the growth of total foreign exchange holdings in this period, and
also decreasing their share of dollar holdings from 70% to 60%, and increasing their
7 See B.J. Cohen, Life at the Top: International Currencies in the 21st Century, Princeton
Essays in International Finance No. 221 (Princeton: December 2000).
8 A fuller discussion of these four considerations can be found in Barry Eichengreen and
Donald Mathieson, The Currency Composition of Foreign Exchange Reserves - Retrospect
and Prospect, IMF Working Paper no. 00/131, July 2000.
9 IMF Statistics Department, COFER database.
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share of euro holdings from 19% to 30%. In contrast, among industrial economies the
dollar share of holdings held steady and the share of euro holdings increased modestly.
Another interesting change in the 1999-2006 period was a fall in the share of yen
assets in official reserves (down from 6% to 3%) and a rise in the share of pounds
sterling (up from 2.7% to 4.4%). This relatively small increase in the international
status of the pound may be insignificant by itself, but could very significant for the
status of the euro if the United Kingdom were to join the EMU.
Euro vs. Dollar
In the framework of the three functions of a reserve currency: being a medium of
exchange, a store of value, and a unit of account, how does the euro stack-up against
the dollar?10
As a Medium of Exchange
This is typically the most important one to be fulfilled by any well functioning
currency. For central banks, this role will revolve around use of the currency for
intervention in foreign exchange markets. Intervention is a task that places a premium
on liquidity, the capability — on short notice, possibly in adverse conditions — of
turning assets quickly into cash with little or no impact on the asset’s price. The
liquidity of a currency in both foreign exchange markets and asset markets is important.
In foreign exchange markets, the Bank of International Settlements’ (BIS) most
recent Triennial Survey of Foreign Exchange and Derivatives Markets shows that on
April of 2004 the euro entered on one-side of 37% of all foreign exchange transactions.
The dollar’s share of transactions on foreign exchange markets fell from 94% in 1998
to 89% in 2004.11
In asset markets, central banks invest in instruments with limited risk, making
conditions in the country’s government security markets the most relevant for the
choice of an intervention currency. The attractiveness of the euro has been increased
by the formation of the EMU, creating the world’s second largest government
securities market. In 2005, the outstanding stock of government securities of the
several euro area governments totaled $4.7 trillion. This compares to $4.2 trillion of
outstanding U.S. treasury securities. Suggesting that more than size may matter, the
largest government securities market is Japan, but the holding of yen-denominated
reserves has declined in recent years.
10 This discussion in this section closely follows the analysis in a recent BIS study. See
Gabriele Galati and Phillip Woodbridge, The Euro as a Reserve Currency: The Challenge
to the Pre-Eminence of the U.S. Dollar, Bank for International Settlements, BIS Working
Papers no. 218, October 2006.
11 BIS, Central Bank Survey of Foreign Exchange and Derivatives Markets Activity (Basel:
March 2005)
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Despite the greater size and rising attractiveness of the euro area’s government
securities market, the U.S. Treasury market has several advantages that continue to
enhance its attractiveness to foreign central banks. First, the short-term segment of the
U.S. Treasury market, composed of about $950 billion U.S. Treasury bills with terms
of three months to one year, is about twice as large as the euro area counterpart.
Treasury bills are a low risk and highly liquid instrument that are well suited to the
reserve currency needs of central banks.
Second, U.S. Treasury securities have a single issuer and the euro area has twelve.
The several issuers of euro assets are not of uniform credit worthiness. U.S. Treasury
securities carry a AAA credit rating but some euro area economies government
securities have a lower credit rating.
Third, the U.S. Treasury market appears to offer far greater liquidity than the euro
area government securities markets. One indicator of this is a daily turnover in U.S.
government securities markets of nearly $500 billion. Japan is second largest at $150
billion per day. Turnover is an indicator of how easily a market can absorb large
transactions without changing the asset’s price. The superior (small) bid-ask spreads
found in the U.S. government securities market are further evidence of their very high
liquidity.
As a Unit of Account
In official use this role is largely linked to the selection of an exchange rate as a
monetary anchor. In recent years, the euro has increased in importance in fulfilling this
role. In 2004, the IMF reported that out of 150 pegged currencies, 40 used the euro as
an anchor currency. However, because of incomplete reporting, this type of tally may
understate the true degree of attachment — “gravitational pull” — of one currency to
another.
An alternative approach is to examine the actual co-movements of currencies to
determine how closely currency’s track the euro and the dollar. This currency
sensitivity evidence suggests that the euro’s gravitational importance is rising.
European countries outside of the EMU, such as Switzerland, Sweden, Norway, as well
as eastern and central Europe move very closely with the euro. In Latin America, as
well, there is evidence of the increasing gravitational pull of the euro, particularly in
Brazil and Chile. One other very notable change has been for the traditional dollar-
influenced currencies of Australia, Canada, and New Zealand mirroring from one-half
to two-thirds of the euro’s movement. In contrast, the currencies of emerging
economies in Asia generally follow the dollar quite closely.
Thus, while the dollar is still the most important currency as a monetary anchor,
the euro has become a viable international competitor to the dollar in its role as a unit
of account for central banks. However, some caution in judging the degree of
convergence is called for because the depreciation of the dollar since 2002 makes it
difficult to separate temporary changes from permanent changes. Have central banks
moved away from the dollar as a monetary anchor only until the dollar stabilizes again
or has the structure of demand for the currency changed permanently?
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As a Store of Value
The critical criterion for a currency to be a good store of value is the ability to
maintain real purchasing power over time. That ability will be closely tied to a country
pursuing stable and sustainable macroeconomic policies. Although the United States
has in recent years consistently maintained vigorous economic growth and relatively
low inflation, large current account deficits and the prospect of substantial and,
perhaps, disorderly depreciation of the dollar’s exchange value may erode the dollar’s
ability to serve as an international store of value.
Since early 2002, the dollar has fallen in value by about 30% or about 5% per
year. That depreciation more or less erases any positive yield on treasury securities held
by foreign central banks. The bilateral comparison shows even greater depreciation
against certain currencies, with the dollar down 11% against the euro in 2006 alone.
The ultra-high liquidity of U.S. asset markets has perhaps provided sufficient
advantage to compensate for the eroding effect of the depreciating dollar on the rate of
return on dollar assets.
But, because the large scale of worldwide official holding seems to exceed the
amount needed for intervention purposes, central banks may begin to focus more on
expected rate of return and less on liquidity in managing their holdings. Nominal rates
of return have been generally higher on dollar assets than euro assets, however,
expected depreciation of the dollar relative to the euro likely erases this advantage.
Therefore, with the steady growth in the depth and breadth of euro area asset markets
providing investment alternatives to the dollar, there is likely to be a rising incentive
for central banks to use a greater share of the more stable euro to meet their store of
value objectives.
However, diversification away from the dollar by central banks may be
constrained by the need to maintain a balance between the currency composition of
their assets and its countries’ external liabilities because many countries borrow in
dollars. Asset-liability currency balance, particularly for emerging economies, tends to
reduce the prospect for balance sheet mismatches in times of crisis and improves the
foreign investors evaluation of the country’s credit worthiness. Data for emerging
market economies for the 2003-2005 period show the dollar’s share of external
liabilities to be about 66% and its share of reserves assets to be only 59%. In contrast,
the euro’s share of external liabilities was 24% and share of reserves was 31%.
Therefore, by this criterion the dollar is under represented in official reserves and the
euro is over represented.
In addition, it is possible to diversify across asset types within a particular
currency so as to improve likely risk adjusted returns. There has been an increase in
foreign official holdings of U.S. agency bonds, particularly mortgage backed securities
issued by Fannie Mae and Freddie Mac, and U.S. corporate bonds, according to the
New York Fed. Given the typically conservative investment behavior of most central
banks, there is likely only limited scope for this type of diversification.
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Conclusion
The dollar’s status as the dominant reserve currency may be challenged by the
euro because it increasingly offers many of the advantages of the dollar but fewer of
the risks. Nevertheless, the dollar retains significant advantages. The most important
advantage is the size, quality, and stability of dollar asset markets, particularly the
short-term government securities market where central banks tend to be most active.
The high liquidity of these financial markets makes the dollar an excellent medium of
exchange for foreign central banks.
A further advantage is the power of “incumbency” conferred by the important
“network-externalities” that accrue to the currency that is currently dominant. Together
these factors make it unlikely there will be a large or abrupt change in the dollar’s
reserve currency status.
However, the euro does seem poised to challenge the dollar in the store of value
function of a reserve currency. The sheer magnitude of dollar assets in the official
reserves of foreign central banks, and the prospect of continued sizable, and perhaps
disorderly, depreciation of the dollar against most currencies, places central banks at
considerable risk of incurring large capital losses on their dollar asset holding. With
more than enough dollar reserves to meet liquidity needs, prudent asset management
would seem to dictate some diversification away from the dollar and toward the euro.
Any sizable weakening in the demand for dollar assets by foreign central banks
would tend to push down their price and push up U.S. interest rates. This can be
expected to have a dampening effect on interest sensitive activities such as business
investment, housing, and consumer durables. On the other hand, the selling off of
dollar assets would tend to depreciate the dollar’s exchange rate and provide a boost
to exchange rate sensitive activities of exporting and import-competing industries.
From the standpoint of the global economy the efficiency advantages of primarily using
dollar reserves may be offset by the enhanced stability of more diversified official
holdings.12
12 Many economists argue that it would be preferable to have one international currency
rather than a national currency playing that role. Special Drawing Rights (SDR) is a
currency created by the IMF in 1969 as a substitute for the dollar and gold (or any other
national currency) as a reserve currency. It has never assumed a major role in international
finance, however.