Rhodan

The Euro as a Reserve Currency http://www.eurolegal.org/yurp/eurocurr.htm#TOP

In the on-going UK debate about joining the Euro, one factor which seems to be ignored is that the Euro Zone will increase in size and importance over the next 5-10 years and is likely to become increasingly important as a reserve currency.

All the 13 states which are candidates for membership of the EU have agreed to participate in the single currency of the European Union taking the population of the Euro Zone to 475 millions.

The UK has the largest foreign exchange market in the world - 31% - which is larger than the next 3 states combined (US 16%, ***an 9% and Singapore 6%) and more than that of the whole Euro Zone (13.5%). More trading in the Euro takes place in London than in the Euro Zone - $207 billion compared to $56 billion in Germany and $35 billion in France. The Euro:Dollar (€:$) is the most heavily traded currency pair on the London market.

One of the reasons why the US Dollar remains at its present levels despite the US deficits, is that the US is enabled effectively to "export" its deficit as a consequence of its reserve currency status.

With world-wide goods and services, especially petroleum, priced in US dollars, other countries have to hold dollars as part of their currency reserves - and they have to invest those dollars in the US economy.

According to David E. Spiro, The Hidden Hand of American Hegemony: Petrodollar Recycling and International Markets (Ithaca: Cornell UP, 1999):-

"In 1974 [Treasury Secretary William] Simon negotiated a secret deal so the Saudi central bank could buy U.S. Treasury securities outside of the normal auction. A few years later, Treasury Secretary Michael Blumenthal cut a secret deal with the Saudis so that OPEC would continue to price oil in dollars. These deals were secret because the United States had promised other industrialized democracies that it would not pursue such unilateral policies.

So long as OPEC oil was priced in U.S. dollars, and so long as OPEC invested the dollars in U.S. government instruments, the U.S. government enjoyed a double loan.

The first part of the loan was for oil. The government could print dollars to pay for oil, and the American economy did not have to produce goods and services in exchange for the oil until OPEC used the dollars for goods and services. Obviously, the strategy could not work if dollars were not a means of exchange for oil.

The second part of the loan was from all other economies that had to pay dollars for oil but could not print [US] currency. Those economies had to trade their goods and services for dollars in order to pay OPEC."

But this short-term strategy cannot continue indefinitely. As William Greider in The Nation (9/23/02) puts it:

"US economy's net foreign indebtedness--the accumulation of two decades of running larger and larger trade deficits--will reach nearly 25 percent of US GDP this year, or roughly $2.5 trillion. Fifteen years ago, it was zero. Before America's net balance of foreign assets turned negative, in 1988, the United States was a creditor nation itself, investing and lending vast capital to others, always more than it borrowed. Now the trend line looks most alarming. If the deficits persist around the current level of $400 billion a year or grow larger, the total US indebtedness should reach $3.5 trillion in three years or so. Within a decade, it would total 50 percent of GDP."

As a consequence of the introduction of the Euro as the single currency of the world's largest trading bloc, other countries have gradually been shifting reserves into Euro. An article in the Iran Financial News, 25/8/02, states that more than half of Iran's Forex Reserve Fund assets have been converted from dollars to euros.

According to Business Week (17th February 2003) Russia's Central Bank in the past year has doubled its euro holdings to 20 percent of its $48 billion foreign exchange reserves. According to its First Deputy Chairman Oleg Vyugin: 'Returns on dollar instruments are very low now. Other currency instruments pay more.' The article continues:-

"The story is the same across the globe. Money traders say that institutions as diverse as Bank of Canada, People's Bank of China, and Central Bank of Taiwan are giving more weight to the European currency. By the end of this year, they predict, the euro could account for 20% of global foreign currency reserves, which today amount to a cool $2.4 trillion. Little more than a year ago, the euro made up just 10%."

It must worry the Bush Administration (or at least those members of it who are economically literate), that it looks as if OPEC is set to permit Euro oil pricing: Libya has been saying for some time that oil should be priced in Euro rather than US dollars and an Iranian senior OPEC official, told a European Union seminar in April 2002 that, despite the problems raised by such a conversion:-

"I believe that OPEC will not discount entirely the possibility of adopting Euro pricing and payments in the future."

If and when oil is more widely priced in Euro, the role of the Euro as a fully-fledged reserve currency will be assured. However, there is an agreement between the USA and Saudi Arabia that it will only price oil in US dollars. That may impede moves towards wider Euro oil pricing. This is not for next year, but will be a gradual process.

The Hong Kong and Shanghai Banking Corporation published in June 2003 a very informative booklet on the Euro as a reserve currency:-

Currency Outlook: The euro as a reserve currency - limits and limitations (PDF Format 40 pages)
Extracts from HSBC's The euro as a reserve currency

Here we try to assess what proportion of global FX reserves should be held in euros. According to the IMF data for the end of 2001 the world holds 68% of its reserves directly in dollars and only 13% in euros. However, the dollar holding we estimate to be larger because with the yen at about 5% and sterling at around 3%, this leaves a shortfall of 9% that is described as "unspecified". It would be safe to assume a large proportion these “unspecified” reserves are in dollars. Adding to the argument - that the dollar number is higher - is that the large build up in reserves by the ***anese and the Chinese since end 2001 primarily in dollars. Our estimate is that the dollar amount is understated by around 7% - this would mean the World holds around three quarters of all reserves in dollars or six times as many dollars as euros. The question we pose below is - if the euro were a full reserve currency, what should the split look like ?

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The table below shows that the split is 55% in favour of the dollar and 45% for the euro rather than the current 85-15 split. This new proportion of 55-45 is calculated by either taking all our factors at equal weighting.



Even if one sums the absolute size of the different markets one still gets roughly the same results. Nevertheless this gives a feel for the relative proportions, if we were to take a conservative estimation one may assume that the market should favour the dollar over the euro in a 60-40 split. Below we examine the possible consequences of such a rebalancing and they are indeed devastating.



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We can now get a handle on how many dollars could potentially be sold if we assume a shift between dollars and euros into our 60-40 split. We have total dollar reserves, furthermore if we use the composition of central bank assets in terms of asset class shown in the table 14 above, we can also estimate the impact on the Treasury market.



It is this last point that leads us to our conclusion that US risks being damaged if the euro becomes a reserve currency in its correct proportion that we have estimated. Table 15 goes through our calculations. We looked at total world FX reserves, which are estimated at $2.3trn (IMF). We then assume that roughly 75% are held in dollars and that means around $1.75trn are held directly in dollars. This is where our 60-40 proportion calculation comes in. If we assume the world accepts the euro as a reserve currency and wants to hold it in our 60/40 proportion - our key assumption - that would not simply mean dropping the US reserves from 75% to 60% because that would "only" bolster the euro by 15% to 28%. That would mean the world held FX reserves 60% in US dollars and 28% euros - a possibility but it is not the scenario we are painting. In our scenario a 60-40 split would mean the USD would have to drop to 53% thereby bolstering the euro to 35% of world FX reserves given all the holdings in other currencies and that would then mean a 60-40 split between dollars and euros.

So a drop from 75% to 53% of holdings of US dollars as a reserve currency would entail a $506bn sale of US assets or, put another way around, 5% of GDP. If however, we assumed a 55-45 split our numbers actually suggest it would be an even larger sale of US assets - $620 billion. Indeed based on BIS data of the reserve manager’s positions that around 60% of these holdings are in Treasuries - it would mean a $304bn sale of US Treasuries.


The US administration cannot afford to have this occurring when it is going back to issuing massive amounts of debt. We think the US budget deficit could hit around $400bn this year and perhaps as high as around $500bn next year. On our calculation reserve banks currently hold around 1 trillion in US Treasuries out of a total market of around $3.2trn in other words a third of the total stock of Treasuries. This Treasury amount is calculated by taking 60% of the total dollar central bank reserves of USD 1.73trn. Furthermore, we know from the US Department of Treasury that the overseas community holds a total of 39.8% of all Treasuries – that implies that Central Banks own 85% of all the overseas holdings of US Treasuries – a staggering amount. Indeed China, Hong Kong, ***an and Korea own around nearly a fifth of the Treasury market alone and one can safely assume most of this is held by their respective reserve banks.

The point of this piece is to point out that massive sales of US assets could occur if the US were to share its reserve currency status with the euro. Indeed one may argue and sensibly so that these reserve moves take place over a number of years if not decades. So why worry now ? The point of this piece is to point out that massive sales of US assets could occur if the US were to share it reserve currency status with the euro. Indeed one may argue and sensibly so that these reserve moves take place over a number of years if not decades. So why worry now ?

A change to the pegged regimes and ending of interventionist regimes that at present hold their reserve assets in dollars to protect their currency regimes could cause such a change. Indeed it is these interventionist and pegged currency regimes that have built up massive reserves in the US over the last decade. In fact, they hold roughly 40% of all US dollar reserves (see chart 13b).



The conclusion of this piece must be that the US can not allow the euro to become a fully fledged reserve currency and the way it does that is to make sure Asia remains firmly tied to the dollar. This in turn should mean the US administration should tread very gingerly even if it does not approve of the actions of some Asian central banks.

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However, for the pegged regimes the US will have to tolerate them because if the US forces revaluations or free floats it would also entail the sale of US assets and a massive shift in reserve allocation. This reserve shift away from dollar assets would have potentially damaging consequences for the US. The one other danger is that if the euro keeps rising it could prompt a snowball effect of other central banks suddenly realising they are far too over-weight US assets and they too start buying euros. The impact of this on the dollar and US assets would be less devastating as these central banks will move slowly and over many years but will nevertheless put constant downward pressure on the dollar.

What is more likely to happen is the requirement for currency stability in Asia implies a rising demand for US Treasuries. We set this argument out in more detail in Global Economics Q2 “Where has all the growth gone?”. As a result, it may be possible for the US economy to avoid a major adjustment in the current account deficit even if private sector demand weakens: in effect, the Asian currency regimes should make it relatively easy for the US to issue more Treasuries without significant risk to interest rates, thereby allowing a sustainable expansion in the US budget deficit. On this basis, the US might end up moving towards a public sector-funded expansion rather than a private sector-funded expansion. Not good for profits, perhaps, but a way of preserving jobs during a difficult period for economic growth.

So long as existing currency regimes stay in place, the implications of this process appear to be particularly damaging for the eurozone economy, damaging for the US private sector economy, helpful for US fiscal expansion and potentially very supportive for liquidity conditions in Asia. The analysis here also serves as a warning for those in the US who want some type of quick fix to their current problems by complaining about the fairness of the world trade system and the pricing of various currencies within that system. If they look to enact some type of radical change the US must beware the euro as a reserve currency and the devastating impact this could have on the US.

As far as the euro is concerned it can continue to rise against the dollar and its associated pegs. The yen is likely to hold firm against the dollar with the emphasis on a slight strengthening as the ***anese continue to intervene. In essence the euro is set to rise across the board putting ever more pressure on the ECB to cut rates. However, as this happens perhaps central banks would be tempted to change their allocation away from dollars towards the rising euro but in a slow and methodical manner. As the US has no interest in shaking up the world currency regimes and neither do the Asian pegged and managed currencies - any dollar weakness will fall squarely on the shoulders of the euro. On this basis the euro has plenty of further upside potential. We have raised our year end target from 1.20 to 1.27 and expect the dollar to continue falling through next year as well - hitting 1.35 by end 2004.

Prodigal Son

Charles de Gaul noted that the US was able to run deficts at the world's expense precisely because of the dollar's role as the world's de facto currency. It's what enabled the US to fight Vietnam and have big domestic programs all without raising taxes. (hmmm...sound familiar?) We exported inflation to the rest of the world.

The big thing propping up the dollar today is the macroeconomic relationship we have with East Asia. East Asian nations buy US treasuries and prop up the dollar, which simultaneously funds our deficit and prevents our currency tumbling as a result. They do this because it props up US consumption and therefore our ability to buy their exports.

dabrownguy

ytestign

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