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May 17, 2005
Will The Euro Overtake The Dollar?
The first signs of the much anticipated slowdown in the accumulation of dollar-debt by foreign central banks has finally arrived, as documented yesterday by Brad Setser (via the Skeptical Spectator) and by Stumbling and Mumbling. The great timing thus got greater for a new paper from Menzie Chinn and Jeffrey Frankel titled "Will the Euro Eventually Surpass the Dollar as a Leading International Reserve Currency?" (Professor Chinn kindly sent me a copy. You can get your copy at Professor Frankel's publication page.)
Chinn and Frankel begin by documenting a set of factors that determine a nation's money's suitability as a dominant reserve currency. They are:
(1) Patterns of output and trade. The currency of a country that has a large share in international output, trade and finance has a big natural advantage...
(2) The country's financial markets. To attain international currency status, capital and money markets in the home country must be not only open and free of controls, but also deep and well-developed...
(3) Confidence in the value of the currency. Even if a key currency were used only as a unit of account, a necessary qualification would be that its value not fluctuate erratically...
(4) Network externalities An international money, like domestic money, derives its value because others are using it. It is a classic instance of network externalities. In this sense, the intrinsic characteristics of a currency are of less importance than the path-dependent historical equilibrium. There is a strong inertial bias in favor of using whatever currency has been the international currency in the past...
The goal of the project is to use the estimated parameters to forecast the shares of the dollar, euro, and other currencies in the coming decades. Under any plausible scenario, the dollar will remain far ahead of the euro and other potential challengers for many years. But we want to know if there are plausible scenarios that give a different answer for 20 or 30 years into the future and, if so, what are the variables that are most important to this outcome...
A high-euro scenario would have many European countries joining EMU by the end of this decade. Most eager to join are the ten countries that joined the EU in May 2004 (8 of which are in Central Europe). It is also possible that the three remaining long-standing EU members, and the United Kingdom might join. All these countries together would make it likely that euroland exceeds the United States in income and trade. In that case, it becomes a real possibility that the euro would gradually gain on the dollar, and eventually challenge it for the number one position.
Interestingly, the U.K. holds the key:
The key question is whether the United Kingdom joins, not just because it is the largest of them, but also because it would bring with it the London financial markets...
In a head-to-head simulated contest between the euro and the dollar:
Briefly put, if the UK joins the EMU..., the euro becomes the dominant currency. The only UK-in scenario in which it does not is when 20-year trend depreciation is assumed to drop to zero, which is unlikely in that it requires an immediate jump in the dollar’s value in 2005. If currency trends of the recent past persist... the euro not only gains dominance, but does so rapidly – by 2019.
In the other combinations, the dollar retains the lead, although the degree of dominance depends upon the assumptions underlying the scenario and rate of currency depreciation. When the US dollar retains its lead, it typically does so by about 30 to 35 percentage points. When the euro gains the lead, the lead can range from 10 percentage points (the scenario with no entry of UK, Sweden or Denmark, strong US growth, and rapid dollar depreciation combined with euro appreciation) to 65 percentage points (UK entry and rapid dollar depreciation and euro appreciation).
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