European Affairs

Protected by the ECB’s pledge to do ”whatever it took” to defend the euro, peripheral Euro governments endured austerity and debt reduction programs which enabled Ireland, Portugal, Spain and even Greece to make significant progress and gain credibility with markets. Their government bond yield spreads over the benchmark German bund yield (the best indicator of debt stresses) have dropped sharply from crisis highs. Euro equity and bond markets rose in 2012 (when Greek government bonds were among the best performing financial assets) and in 2013. Forex markets treated the euro with growing respect after it hit a crisis low of only $1.19 in June 2010. In fact, the USD:EUR rate has averaged a solid $1.33 since late 2009 (and $1.22 since the euro’s inception). The improvement of these key financial indicators reflects the Euro-zone’s notable structural and governance reforms . (See Footnote 1.)

On its 15th birthday, perhaps it is time to consider whether the euro is, or can remain, a viable reserve currency. But first, what is a reserve currency ? First, it must be a currency important and credible enough to be used widely for international trade and capital transactions between countries other than the one issuing the currency. Second, the currency must be supported by a large and stable economy; and a government whose fiscal and monetary policies inspire the confidence of international traders and investors. Third, the currency’s exchange value must be relatively stable and predictable enough so that the world’s central banks are willing to accumulate and hold the currency in their official foreign exchange reserves.

Finally, a reserve currency must be regarded as a “store of value,” usually measured by its purchasing power in terms of the holder’s own currency. If it is not, central banks and other international investors will not hold that currency for a significant time and it will not be a reserve currency. In 1944, the Bretton Woods agreement codified these standards and made the dollar the official reserve currency of the new international monetary system that replaced the gold standard that had failed after WW I.

Despite the Euro-zone crisis, the euro remains the second largest reserve currency, as demonstrated by the 145 central banks reporting to the IMF their official foreign exchange reserves. Each quarter, the IMF estimates the “Currency Composition of Official Foreign Exchange Reserves (COFER)” as shown in the table (Fig. 1) below. [2][3] Of the “allocated reserves” (those whose currency denomination is identified) totaling $6 trillion, the EUR accounted for 24% vs. 61% for the USD.


Figure 1.


(Source: IMF COFER Dec. 31, 2013)

It is assumed the USD accounts for the lion’s share of the “unallocated reserves” totaling another $4.7 trillion. Most striking, however, is the difference in the rate of accumulation or reduction of the two principal reserve currencies. The chart below (Fig. 2) shows how the Euro crisis only slowed the growing share of EUR-denominated reserves in the COFER total of world reserves. The decline of USD-denominated reserves in the COFER total paused during the financial and Euro crises but has since continued to decline. The accelerating decline in USD reserves since 2002 suggests international investors, central banks and or private sector, are increasingly wary of the dollar, especially as a reliable reserve currency, particularly as a result of political brinksmanship in the U.S. Congress on funding the government and raising the debt ceiling.

Figure 2.



The IMF data clearly establishes the euro is the world’s No. 2 reserve currency, albeit it well behind the dollar. There are good reasons why the relatively young currency is considered a reserve currency. The euro is based on the Euro-zone’s (estimated) GDP of $13 trillion in 2013, compared with U.S. GDP of $16.8 trillion and $17.6 trillion for the overall EU (euro and non-euro countries). Inflation (as measured by consumer prices), an important feature of a reserve currency’s credibility as a store of value, averaged an annual 2.2% in the Euro-zone since 2000, compared with 2.4% in the same period for the U.S. Inflation expectations today are muted in both. The balance of payments, as measured by the current account (C/A) is also important since a chronic C/A deficit must be financed by capital inflows if the country’s exchange rate is not to weaken or national interest rates to rise. The Euro-zone’s C/A averaged an annual surplus of approximately 0.4% of GDP since 2004, compared with a U.S. deficit of about 3.5% of GDP per year since 2004 (and a chronic deficit since 1981). Total U.S. net external debt is approximately $4.1 trillion. Another measure of a reserve currency is the amount of currency in circulation. In November 2013, over EUR 951 billion in euro notes and coins was in circulation, more than the dollar.

Today, the euro is used by the institutions of the EU’s 28 member states and is the official currency of 18 Euro-zone countries. Non-euro countries pegged to it include: Bulgaria, Denmark, Lithuania, Kosovo, Bosnia-Herzegovina, Macedonia and Montenegro; plus some 20 African and Pacific countries once in the French franc zone. In addition to the Euro-zone’s 340 million people, another 220 million are estimated to be directly linked to the euro. Nevertheless, the euro cannot compete with the ubiquity of the USD, which is used for pricing most international trade in energy, commodities, food and industrial materials. The population of countries using the dollar or currencies pegged or closely linked (such as China, OPEC and Latin American countries) to the USD represent close to half the world’s population.

Since central banks, institutional investors and corporations active in international transactions are the key actors in determining reserve currency preferences, the question of whether a currency is a “store of value” becomes crucial, especially if a long-term weakening trend is perceived for a currency, as is the case with the USD. When China and Japan accumulate dollar-denominated reserves, those become national savings, meaning those countries are sensitive to the purchasing power of those reserves translated into their own currency. A reserve currency’s exchange rate trend thus becomes a critical factor in other countries’ willingness to hold it in its official reserves. This is especially true for the real exchange rate. The trade-weighted index for the dollar, measured in real terms against our major trading partners, has declined over 30% since its high point in mid-1985. The euro’s comparable index is up approximately 10% from 2000, although it has had substantial fluctuations since inception.

The world’s two biggest holders of FX reserves are China and Japan, so their currency preferences have a major influence on which currencies must be considered reserve currencies. As China’s economy expands steadily toward being the world’s biggest, it had accumulated, by end-2013, total official FX reserves equivalent to $3.8 trillion, of which about 65% was estimated to be USD-denominated and 25% in EUR. These proportions mirror the currency preferences of the world’s central banks reporting COFER data to the IMF. Japan held $1.26 trillion in FX reserves at end-2013, but is thought to hold a smaller proportion in EUR-denominated assets since Tokyo targets primarily the Yen-dollar exchange rate.

Despite the Euro crisis, neither Beijing nor Tokyo is thought to have sold EUR-denominated reserves. To have done so would have only aggravated the euro crisis and caused further depreciation of the purchasing power of China’s and Japan’s reserves in euro. In fact, both countries may have supported the euro at times. It is not known, however, whether China or Japan altered the national composition of their euro-denominated sovereign debt securities, reducing, for instance, the bonds of peripheral Euro governments in favor of German and Dutch bonds. On the other hand, it is reported that the U.S. dollar’s continuing long-term depreciation and the recent political obstructionism that threatened disruption of U.S. Treasury financing operations led the People’s Bank of China to significantly shorten the average maturity of its portfolio of U.S. Treasury securities.

The IMF’s COFER data on central banks’ holdings of dollar and euro assets confirms that the euro is the world’s No. 2 reserve currency despite the Euro crisis and worries about the institutional and economic structure underpinning the single currency. But we recognize that the euro, and hence its future as a de facto reserve currency, remains vulnerable to potential problems that could reduce its future attractiveness as an alternative to the dollar, or eventually, China’s renminbi. A short list would have to include the following.

  • Euro-zone banking remains fragile. The “doom loop” in which peripheral Euro countries’ banks use low-cost ECB funding to buy their government’s high-yielding bonds, leaves those banks vulnerable to another crisis that causes those peripheral bonds to lose value.
  • The planned Euro-zone banking union is incomplete because of national resistance to Euro-wide capital standards and tough supervision overseen by the ECB. How to share the cost of winding down Euro-zone TBTF banks and non-banks is also contentious.
  • “Fiscal union” with the European Commission review (with right of veto) of Euro countries’ national budgets for viability and respect of deficit and debt ratios, remains difficult to achieve because of the political sensitivity of surrendering sovereign control over taxing and spending.
  • Fundamental economic competitiveness gaps are widening between Euro-zone countries, notably Germany vs. France and Italy (not to mention Greece). But Spain and Ireland demonstrate, however, that painful belt-tightening can dramatically improve growth of productivity, exports and their economies.
  • Sub-par economic growth that causes record unemployment, notably among the young, is a fundamental threat to the single currency if the Euro-zone fails to stimulate demand and improve external competitiveness.
  • Political and cultural differences. Prosperous and competitive northern Euro countries are understandably wary of bailing out “Club Med” countries. Ancient cultural differences and stereotypes make political compromises on management of budgets, economies and finance very difficult and are contributing to the resurgence of populist and anti-Euro political movements in some Euro-zone countries, a trend that may be confirmed in the European Parliamentary elections in May.

Despite all these challenges, however, we are happy to report that on its 15th birthday, the euro is the world’s No. 2 reserve currency. We remain confident that future market and economic pressures on the euro will force Euro governments, the ECB and other institutions to take whatever action is necessary to defend the euro and hence its reserve currency status. And to the extent that the U.S. mismanages its “exorbitant privilege” of being the No. 1 reserve currency, the euro will benefit as the only alternative to the dollar.

J. Paul Horne is an Independent International Market Economist based in Alexandria, VA and Paris where he was chief international economist for Smith Barney for 24 years. He retired as a Managing Director of Salomon Smith Barney/Citigroup in 2001 but remains active with the National Association for Business Economics, the Global Interdependence Center and the Société d’Economie Politique in Paris.

[1] See: The Euro Crisis Update – “Thank you, Greece, for Saving the euro!” (Jan. 2, 2013); ; “Cyprus: The mouse that roared at the Euro Zone ‘Troika’” (Mar 2013); ; “Why IS the damned euro so damn strong ?” Dec. 2, 2011;

[2] The 1944 Bretton Woods system obliged the allied countries to adopt monetary policies that maintained exchange rates through linkage to the U.S. dollar (theoretically redeemable in U.S. gold), the official reserve currency; and the authority of the new IMF to bridge temporary payments imbalances. On Aug. 15, 1971, the U.S. unilaterally terminated the dollar’s convertibility into gold, effectively ending the Bretton Woods system by making the dollar into fiat (paper) currency. This did not change, however, the dollar’s reserve currency role, especially as the U.S. economy remained the principal economy in the world; and U.S. democratic institutions were still trusted by most free-market countries. Following the U.S. action, many other key currencies became free-floating, their exchange rates set by market forces, except at moments of exceptional stress when concerted G-7 intervention was required to stabilize FX markets.

[3] COFER FX data does not include a country’s holdings of its own currency, i.e.: USD-denominated assets held by the Federal Reserve or EUR assets at the ECB or those of EU central banks not in the euro-zone as well as those banks within the euro-zone.