Can the euro ever be a global reserve currency?

1. Introduction

After the first decade of the advent of the euro, analysts have examined the prospect of the European common currency to become not only regional currency, but also its usage to spread internationally. Not only has the euro proved to be more than a powerful symbol of collective identity, but it has also provided price stability, it has been a shelter against currency crises and it has attracted new member states that wish to join the euro area. However, this positive landscape has changed in the face of the global financial crisis and the Greek budgetary crisis. Many have seen the euro only as ‘a fair weather currency’ arguing that confluence of factors facilitates the euro’s deficiency of becoming ‘bad weather currency’ such as economic divergence and internal imbalances between member states.^[1] The first section of the essay discusses the benefits and costs of issuing an international currency. By applying the three attributes of money to the euro, the second section reviews the euro’s performance as a medium of exchange, unit of account and store of value. The final section identifies factors which hinder the European common currency’s success as an international currency. These factors include: inertial forces characterising the financial markets, governance design of EMU, member states’ internal imbalances, fragmentation of financial markets, non-economic limitations and the European Union’s discouraging stance towards the euro’s international status.

2. Benefits and Costs of International Currency Status

What benefits will countries in the eurozone obtain from the wider use of the euro? This section focuses on the benefits and costs of issuing an international currency. The following advantages are commonly associated with international currency status:

1) Seignorage

The most noticeable advantages for issuing an international currency is seignorage, which is defined as the difference between the face value of the money and its production costs. The euro can benefit from a sizable gain of seigniorage, which would accrue from increased foreign holdings of euros or euro-denominated assets.^[2] When applied domestically, seignorage can be seen as the profit earned by central banks as a form of a tax levied on its residents. However, when levied abroad, foreigners must give up real goods and services, or ownership of real capital stock and this represents an actual transfer of resources. Nevertheless, Pisani-Ferry and Posen argue that seigniorage is ‘a second-order issue’ due to the marginal profit made by issuing an international currency. For example, gains are estimated at less than 0.05 percent of GDP for the euro area, as only a small fraction of the total cash in circulation (10 to 15 percent) is held by non-euro area residents. International seigniorage gains of the euro are only slightly larger for the United States, at about 0.1 percent of GDP.^[3]

2) Lower Transaction Costs

Another potential benefit to issuing a global currency is microeconomic gains stemming from low exchange rate risk and transaction costs. ‘Whether the currency is used for international trade, borrowing in the international markets, or simply tourism, the costs of conversion to a foreign currency and the exchange rate risk attached to these operations are eliminated.’^[4]

3) Liguidity premium for bond markets

A much more significant gain when issuing a global currency is associated with higher foreign holdings of and transactions in the issuer’s government bonds. The issuer of an international currency will benefit from the depth and liquidity of the government bond market and the increased demand for them.^[5]

4) ‘Exorbitant privilege’

The exorbitant privilege can be defined as ‘the excess returns on assets and the ability to avoid or deflect the burden of adjustment to current account imbalances’^[6].The American role as the ‘world's banker’ relies on its ability to finance large and prolonged current account deficits borrowing abroad in its own currency while simultaneously earning much higher returns on FDI and other investments in foreign countries. Both the United Kingdom before 1913 and the United States until the end of the 1980s were net creditors toward the rest of the world. According to Chinn and Frankel, the willingness of Asian countries to continue financing the US current account deficit in the future is related to the dollar’s continued role as premier international reserve currency.^[7]

The costs attached to issuing an international currency are associated with larger fluctuations in demand for that currency. Central banks are often concerned that internationalisation will make it more difficult to control the money stock. This explains why Japan and Germany were in the past reluctant to have their currencies held and used widely. Instability may arise from fluctuations in demand for the currency. In the 1960s and 1970s, the Japan and Germany were concerned about the prospect that if assets were made available to foreigners, an inflow of capital would cause the currency to appreciate and render exporters less competitive on world markets.^[8] This is also China’s problem today. Additional costs could be seen as a ‘burden of responsibility’. Rather than direct solely monetary policy toward domestic objectives, the monetary authorities in the country of the leading international currency have to take into account the effects of their actions on world markets. ^[9].

3. The international role of the euro: application of the three classic attributes of money

The classic attributes of money also apply to its international role. The conventional framework for analysis of international currencies distinguishes between the three functions of money: medium of exchange, unit of account and store of value.^[10] There are strong interlinkages among these functions. The present section analyses the euro’s international role in all three aspects.

Table 1: International functions of a currency

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Source: Papaioannou and Portes (2007)

3.1. Store of Value

The store of value as a function of money can be analysed in three aspects: public use of the currency in third countries as a reserve currency; firms and governments borrowing on the financial markets; and the private holdings of the euro as a parallel currency either in the form of banknotes (currency substitution) or euro-denominated bank deposits and loans (asset substitution).^[11]

Reserve Currency

Traditionally foreign exchange reserves are held in highly liquid, mainly short-term assets with the primary consideration of central banks is wealth preservation.^[12] Currently, two-thirds of reported global foreign reserves are in US assets. Since its introduction in 1999, the share of the euro has increased to 25 percent and has remained relatively stable^[13], whereas the share of the dollar has slightly fallen from 71 to 65 percent. While this partially can be explained by the weakening of the dollar, it hints that central banks may be willing to reduce their exposure to the US dollar.

Table 2: Dollar and Euro Shares of Official Foreign-Exchange Reserves

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Source: Cohen (2009)

What determines the currency composition of foreign exchange reserves? There is a broad agreement in the literature that the choice of international reserve currency depends primarily on currency stability in terms of inflation and exchange rate as well as the size of the economy and the country’s role in world trade.^[14] Other factors which determine the share of foreign reserve currency are the currency of the peg, the direction of international trade, and the currency of foreign debt. In addition, non-economic factors such as quality of governance and geopolitical positions are perceived as having equal weight.^[15]

Eichengreen and Mathieson find evidence that there is a strong regionalism in international reserve holdings.^[16] In the case of the euro, this is confirmed by evidence from the ECB. For example, between 1999 and 2007, the rise in the share of the euro in the central bank reserves of central and eastern European EU Member States was mainly driven by a shift towards exchange rate arrangements using the euro as a point of reference and an increasing weight of the euro in the denomination of external debt.^[17]

inancial Markets

The advent of the euro promised to create the largest single-currency capital market, with a vast pool of savings and attractive transactions costs. European bond and equity markets have been growing in size and liquidity with a significant increase in use of the euro for international bonds and notes. With increased market size, from 1999 to 2008 the outstanding amount of euro-denominated issuance as a share of all issuance increased from 21 to 32 percent. Meanwhile, the share of US dollar denominated issuance dropped from 49 to 45 percent.^[18]

Figure 1: Outstanding amounts of international debt securities (relative share)

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Source: ECB (2009)

The Euro as a Parallel Currency in Third Countries

The euro’s function as a store value in private uses can be estimated in terms of currency substitution and asset substitution. According to the ECB, around €95 billion worth of euro banknotes were estimated to be in circulation outside the euro area, around 13 percent of the euro banknotes in circulation.^[19] Euroization (the use of euro banknotes outside the euro area) continues to be concentrated in the eurozone’s neighbouring regions. This is due to the expectation that the euro will become legal tender in some of these countries, and traditions, in particular concerning the use of the DeutscheMark.^[20] In other parts of the world the use of euro banknotes has remained uneven. The same trend can be observed in asset substitution as the share of the euro in total deposits has tended to increase in most central and eastern EU Member States and candidate countries.

3.2. Medium of Exchange

This section provides an overview of the euro’s performance as a medium of exchange in terms of foreign exchange trading and trade invoicing.

Foreign Exchange Trading

The share of the euro as a vehicle currency for foreign exchange trading has been stable since the start of EMU at around 40 percent.^[21] The share of the euro in 2001 was much smaller than the sum of the shares of its constituent currencies, which reflects the elimination of exchange rate transactions among the currencies that joined the eurozone. In comparison to the euro, the pre-eminence of the dollar has been unchallenged. Beyond the European hinterland, euro turnover is low at 20 percent.^[22] In contrast, the share of the dollar, is much more equally distributed across regions. Why has the US dollar remained the beneficiary of a natural advantage of incumbency? Theories of network externalities and scale economies play a significant role determining currency preferences.^[23] Inertia forces determine the stickiness of user preferences called ‘hysteresis’ or ‘ratchet effects’. Trading costs for the euro have decreased sharply since its launch and are now roughly matching those for the US dollar.^[24] However, since no significant price advantage is offered by the euro, ‘ingrained habit and institutional rigidities have favoured continued use of the dollar’^[25].

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^[1] Pisani-Ferry and Sapir (2009), p.69

^[2] Cohen (2009), p.751

^[3] Smaghi (2009), p.25

^[4] Smaghi (2009), p.24

^[5] Smaghi (2009), p.25

^[6] Papaioannou and Portes (2007), p.19

^[7] Chinn and Frankel (2006), p.6

^[8] Chinn and Frankel p.9

^[9] Ibid.

^[10] Baldwin and Wyplosz (2006), p.442

^[11] ECB (2009), p.43

^[12] Papaioannou and Portes (2007) p.9

^[13] ECB (2009), p.72

^[14] Smaghi(2009), Papaioannou and Portes (2007)

^[15] Cohen(2009); Chinn and Frankel (2006)

^[16] Barry and Mathieson (2000), p.10

^[17] ECB (2009), p.57

^[18] Bonds issued in a currency other than the currency of the country in which the borrower resides.

^[19] ECB (2009), p.50

^[20] Ibid.

^[21]

^[22] Cohen (2009), p.9

^[23] Baldwin and Wyplosz (2006), p. 443

^[24] Cohen (2009), p. 8

^[25] Cohen (2009), p.9