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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 notesthe 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.

The difficulties of integrating new-Europe and old-Europe are also on the radar at The Economist (via Edward Lucas and Claus Vistesen):

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.

February 24, 2007 in Europe, Exchange Rates and the Dollar | Permalink


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David -- the Humpage chart on the $ share of the fx reserves of emerging economies is based on the COFER data, and to be clear, I have no specific problem with that data. Or no problem with it other than the fact that it is incomplete -- many emerging economies don't report data to the IMF, including China. Personally, I think the countries that do not report (China, a lot in the middle east) have a higher dollar share than those that do. Which reinforces your argument --

the problem here is that we don't know whether the countries that don't report have also been holding the dollar share of their reserves constant. my guess is generally speaking their dollar share is trending down but very, very slowly -- almost imperceptably.

The data that I think is off is the BEA data on official inflows, which, if my argument above is right, significantly understates central bank inflows. moreover, the BEA in principle captures all official inflows -- Temasek of singapore, norway's government fund, the oil inv. funds of the middle east. So when you look at total official asset growth (@$900b in 06, based on the numbers I track), the BEA's recorded inflows (@$300b) look a bit too low.

My critique of the Humpage chart would be a bit different -- it looks at shares, when the real story is the growth in the stock. Emerging economies are holding more reserves of all kinds right now -- and their reserves are growing at an exceptional pace, something which a chart that just shows the share doesn't really capture. the stock of euro reserves held by central banks today is probably far larger than the stock of $ reserves held by central banks ten years ago, simply b/c the overall stock of reserves has gone up so much. incidentally, recent offiical sector inflows into euros and pounds (@$300b in 05, probably more like $200b in 06, based on my estimates which try to flesh out the hidden parts of the COFER data set) are very large absolutely -- they would top $ reserve growth in say 2000 or 2001. they only don't seem big b/c in say 2006, i would bet the central banks added $550b to their dollar reserves (counting SAMA foreign assets and PBoC swaps as part of reserves -- there are a lot definitional issues)

Posted by: brad setser | February 25, 2007 at 10:24 AM

Brad -- Thanks. I should have been clear that the issue with the data is incompleteness. I'm not sure I follow your position concerning shares vs. levels, at least not in the context of the post. Because the share of official reserves held in euro has beem rising, it has to be the case that the growth in euro levels has been greater than the growth in dollars. No argument there. It is also true that the growth in levels is a lot bigger than can be accounted for by a simple cut on the growth in trade -- at which point we may proceed to debates about dark matter, global saving gluts, fiscal deficits, and so on. But for the narrower question of which currency is the dominant reserve vehicle, it seems to me that shares are the appropriate thing to be thinking about.

Posted by: Dave Altig | February 26, 2007 at 08:08 AM

Hi Dave,

Thanks for the plug (both of them that is :))

In terms of central bank management I take your point that this move into riskier assets occurs on the margin as it were on the reserves but then again what are the 'margins' of a reserve portfolio in for example China or any of the other dollar peggers. I guess the question here is to what extent these CB portfolios will end up being major market movers in equity markets too?

As for the dollar v euro question ... well well, that is a question for you is it not :)?

It is very difficult for me to see the Euro taking up the slack of the dollar. This of course has some imminent implications since ...

1. I don't think the dollar is headed for any crash soon at least not so long that the Breton Woods II persists. We won't see any major cb reserve diversification into Euros I think.

2. Even in a long term structural perspective I do not see the Euro replacing the dollar as the global reserve currency, that honour is going to go to the Indian Rupee or the Yuan I think.

Of course this may very well change if the Eurozone expands as you say but then again there are notable challenges associated with such an expansion and in fact even the current Euro zone setup seems to have enough structural difficulties as it is.

Posted by: claus vistesen | February 27, 2007 at 03:21 PM

Claus -- I think we are in agreement on this one. Cheers.

Posted by: Dave Altig | February 28, 2007 at 09:18 AM

The EUR/USD continues to flirt with the 1.440 price handle, teasing the forex market with an initial push higher, only to fall back exhausted in later trading, and today's price action has replicated this once again, promising much in the morning, only to fail to deliver later in the day. However before we assume that this level may prove to be an immovable barrier to any move higher for the euro vs dollar, it is important to note the role of the 40 day moving average, as once again yesterday it provided the platform for a push higher following the wide spread down bar of the previous day, and creating once again a series of lower highers as we edge on up towards this price level. Yesterday's candle also closed above the 14 day moving average, but marginally below the 9 day average. If today's candle holds firm then in my view this will be another in a long series of failures to break through the 1.44 barrier, and each time we see a failed attempt on the daily chart then this adds to the likelihood of a move lower in the medium term.

Posted by: Anna Coulling | September 08, 2009 at 04:45 AM

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