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February 24, 2007
The Euro Vs. The Dollar
Although I've not written much about the topic lately, I have been monitoring the debate of the last several months about the rise of the euro, and the related question of whether it will eventually emerge as the world's dominant international money. The discussion has been prompted in part by the fact that euro appreciated by about 11 percent from December 2005 to December 2006, but also by some really splashy news: The observation that the value of euro notes in circulation has surpassed the value of dollar notes, the reported desire of oil-producing countries to diversify their foreign-exchange reserves, and the fact that euro-denominated debt has become a larger share of the global cross-border total than dollar-denominated debt. Yesterday Brad Setser published some ruminations about whether the Japanese yen can ever be the "un-dollar", but the reality is that the euro remains the only real contender for the foreseeable future.
A couple of pictures (constructed by my colleague Owen Humpage) helps to put things in perspective. To begin with, international currency reserves are still dollar dominated:
There are definitely some problems with those statistics -- see, for example, the picture provided by Brad Setser, provided by Menzie Chinn -- but here is another relevant fact: The overwhelming share of foreign exchange transactions involve dollars:
It seems pretty clear that most of the euro activity is still taking place on the European stage. That could change -- there is an interesting discussion about the expanding importance of the export sector being conducted at Eurointelligence and at Eurozone Watch -- but my guess is that the "tipping point" for the euro depends critically on whether the eurozone ultimately expands.
As I have noted in the past, the research of Menzie Chinn and Jeffrey Frankel suggests that the wildcard involves the UK's designs on the euro. But the incorporation of the so-called "accession countries" is at issue as well. For that reason, this, from the Financial Times, got my attention:
On Monday Standard & Poor’s lowered the outlook for Latvia’s long-term sovereign debt from stable to negative. The country has a huge current account deficit, accelerating inflation and loose monetary policy, just like Thailand in 1997. And, as in Asia a decade ago, the symptoms are not limited to one country. As growth has accelerated in the European Union’s 10 newest central and eastern members, it has become unbalanced, propelled by consumers rather than exports. The results are predictable – worsening trade imbalances, mounting inflation and wage pressures. Only Poland and the Czech Republic currently meet the inflation requirement for euro membership, while current account deficits in six of the EU-10 hover near or beyond 10 per cent of gross domestic product. Meanwhile, credit is expanding dramatically – at more than 50 per cent year-on-year in Latvia, Lithuania and Romania, according to Danske Bank.
If the EU were to fracture, the natural fault-line would be the edge of the euro zone, as Toomas Hendrik Ilves, Estonia ’s thoughtful president, has observed...
The common currency includes most of old Europe, but excludes most of the new democracies (including his). What would happen to the outsiders? It would be nice to think, as a worst-case scenario, that the single market would hang together, and that the baker's dozen of countries outside the euro zone would at least remain part of this thriving free-trade area...
Probably, however, the unraveling would go further. The EU already finds it a huge effort to make the Poles, for example, abide by European competition law. Without a seat at the top table in Brussels, no Polish government would allow foreigners to claim full national treatment, especially when it came to buying the country’s big companies. With that, the single market would unravel too.
That all may be a bit alarmist -- the worst-case scenario is important to think about, but it rarely happens. The point is that, despite the challenges that undeniably confront policy makers in the United States, there are equal, if not more daunting, challenges elsewhere. I have my doubts that the "exorbitant privilege" of being the world's dominant currency is likely to pass from the dollar any time soon.
UPDATE: Export activity in Germany (and Japan) is also on the mind of Edward Hugh, at Bonobo Land.
UPDATE II: Claus Vistesen uncovers an article from the Financial Times suggesting that central bankers are chasing yield by by taking on more risk, as well as by diversifying the currencies in their reserve portfolios. My sense is that this sort of motivation drives "investment" decisions at the margin, but that core portfolio choices are still driven by "fundamentals" related to trade flows, financial market activity, and internal exchange rate policies. But as the FT article notes, central bankers are "a secretive bunch," so there is a lot we -- or at least I -- don't know.
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