The global credit crisis, which has led to a steep fall in the value of the US dollar and a rise in the value of the euro, poses the intriguing question - will the euro replace the US dollar as the world’s reserve currency?
The question has been posed before. In 1995, two US economists, Jeffery Frankel and Menzie Chinn, suggested that if US deficits continued to undermine the dollar then the euro could rival it as leading international currency by 2022.
In a recent paper they reduced this horizon to 2018, with the suggestion that it could even happen as early as 2015.
The idea that the euro could challenge the dollar currently has support from leading financial commentators. The former US Federal Reserve chairman Alan Greenspan said late last year that “it is absolutely conceivable that the euro will replace the dollar as reserve currency, or will be traded as an equally important reserve currency”.
Back in 1995, econometrical analysis suggested the euro could replace the dollar as the major reserve currency by 2020 if two conditions were satisfied.
The first condition was that the remaining EU members, including the UK, would adopt the euro by 2020.
This condition looks unlikely to be fulfilled. Under its current political leadership, the chances of the UK joining the euro at any time in the near future are remote (although some commentators have mischievously suggested that the right time is when sterling reaches parity with the euro).
The second condition was that the depreciation trend of the dollar should continue into the future. Again, the report of the death of the dollar may have been exaggerated.
In the past, the press has reported that central banks in Asia and elsewhere have diversified out of dollars into euros, and that the dollar is in danger of eventually losing its status as premier international currency. Yet, as Frankel and Chinn point out, the statistics showed a temporary upward trend for dollar in the mid 1990s, despite the gloomy commentary.
No currency other than the euro poses a threat to the dollar’s pole position. In the past, the yen and the deutschmark never had the potential to challenge the dollar as the leading international currency, largely because their home economies were smaller than the US, and the financial markets of Tokyo and Frankfurt were less developed than New York. Looking ahead, the Chinese renminbi it is still light years away from being an international currency.
So the euro remains the only credible challenger to the dollar. The euro is currently the second most commonly held reserve currency, being approximately a quarter of allocated holdings. The euro-zone is roughly as big as the US, and the euro has held its value better than the dollar.
So will the euro overtake the dollar in the foreseeable future? And should the European Central Bank (ECB) act to relieve the upward pressure on the euro? We wanted your views.
Your overall response suggests that the dollar has little to fear, at least for the moment. Changes in the status of currency happen with the slowness of glaciers rather than the suddenness of shifts in tectonic plates
Most of the managers (64%) who responded to our survey said they do not believe that the credit crisis has created a situation where the euro could, sooner rather than later, replace the US dollar as the global reserve currency.
Some, however, feel that the continuing weakness of the US dollar will help the euro become at least an equally important reserve currency.
There is a sense that Europe is too disparate monetarily to pose a threat. One manager remarks that “the split between monetary authority and financial supervision is spread even more heterogeneously within the 25 member states of the EU than in the 50 states of the US”.
There is also the objection that the EU is an economic rather than a political union, “which is a pre-condition for a global reserve currency”.
Could the euro could surpass the US dollar as a reserve currency within 10 years? Opinion is evenly divided here with a small majority (56%) thinking that it will. Yet there are doubts that events can move so fast. “These developments take more than 20 years, if they happen at all,” one manager remarks.
This is borne out by history. Frankel and Chinn point out that rankings of international currencies change only very slowly. Although the US overtook the UK in economic size in 1872, in exports in 1915, and as a net creditor in 1917, the dollar did not surpass the pound as the leading international currency until 1945.
A shorter timeframe is seen as even less likely. The suggestion that the euro could overtake the US dollar as a reserve currency as early as 2015 draws support from only a minority (43%).
Opinion here is equally divided on whether a currency other than the euro will replace the US dollar as the world’s premier currency. One manager points out that no other currency is backed by a sufficient financial and economic infrastructure to be able to challenge the dollar.
“There are three conditions for a role switch - an economy, a financial sector (including supervision) and a political/military presence. The development of the financial sector takes decades, and a developed financial sector which has endured financial crises of different kinds, is certainly not seen outside the US, Europe and Japan.”
Could the political unpopularity of the US accelerate the flight from the dollar? Frankel points out that, in the past, US deficits have been manageable because allies have been willing to pay a financial price to support US global leadership.
In the 1960s, Germany was willing to forego the costs of stationing US troops in the country to save the US from a balance of payments deficit. Similarly, Japan was willing to buy dollars to prevent the US currency from depreciating in the 1960s, the 1970s and the 1980s.
Most of the managers who responded to the survey think that the US can continue to count on foreign financial support. An overwhelming majority disagree with the suggestion that the post-Iraq unpopularity of the US will discourage central banks in Europe and Japan from supporting the dollar.
One manager observes that “foreign policy, certainly international economic policy, is not about sentiment but state interests, and a dollar collapse is in no one’s interest”. Opinion is divided on the significance of the strong euro, and only a small majority (55%) thinks that it reflects the economic fundamentals of the euro-zone. Some however, feel that it reflects the relatively better shape of European economic policy compared with that of the US.
One manager suggests that “for the most part, the strong euro reflects the present business cycle in which the budgetary policy of the EU - even the heavily criticised Stability and Growth Pact - looks less tarnished than that of the US. Certainly the monetary policy, at least in the euro area, is more effective.”
The weak dollar makes a strong argument for breaking the link between the dollar and the renminbi. A large majority of managers (86%) thinks that Asian economies such as China, should no longer peg their currencies to the dollar.
“It will certainly happen, because they need a real appreciation of their currencies,” one manager points out. “If you cap nominal appreciation you will get inflation.”
In the short term, whether the euro continues to rise against the dollar will depend on whether the ECB decides to cut interest rates. The US has called on Europe to follow its own fiscal stimulus plan. The ECB has steadfastly resisted this call, since its sole purpose is maintaining price stability. A strong euro helps keep down imported inflation at a time of soaring commodity prices.
Most of the managers who responded to our survey agree with the stance of the ECB. Almost three quarters (71%) do not think that the ECB should follow the US Fed and cut interest rates immediately.
Nor do they feel that the ECB should be given a broader mandate to support economic growth as well as fight inflation. Two-thirds of the managers (67%) feel that financial stability should be the sole aim of the ECB.