Reserve Currency Competition

I think not

Hall of Fame Member
Apr 12, 2005
The Evil Empire
Report on "Will the Euro Eventually Surpass the Dollar As Leading International Reserve Currency?", a Working Paper by Menzie D. Chinn (University of Wisconsin, Madison and NBER) Jeffrey A. Frankel (Kennedy School of Government, Harvard University and NBER)

At Issue- The US dollar is still the international reserve currency most used by central banks. What factors determine the shares of major currencies in the asset portfolios of central banks? Is the dollar's primacy going to last? A serious competitor, the euro, is on the scene now. Will Europe's common currency overtake the dollar? Over the next ten or twenty years which is the most likely scenario?

Approach - The authors adopt an econometric approach to measure the main determinants of central banks’ holdings of international currency reserves, using annual data covering the pre-euro, 1973-1998 period. After checking the strength of their results by assessing the predictive performance of the estimated equation over 1999-2003, forecasts of the future currency shares of dollar and euro are produced under alternative macroeconomic scenarios.

Findings - Central banks prefer to hold currencies of large economies characterized by low inflation and low exchange rate volatility - signs of currency stability. Whether the euro will overtake the dollar as the leading reserve currency crucially depends on the adoption of the euro by the United Kingdom, and to a lesser extent by other member countries of the European Union. The persistence of the dollar's recent depreciating trend and the slow pace at which central banks change the composition of their asset portfolios will also play an important role in the competition between euro and dollar.

Novelty - The theory of international reserve holdings is well-established but empirical analyses of the determinants and future evolution of central banks’ foreign reserves are lacking. The paper fills this gap, addressing the issue in a novel way. The results of the econometric analysis of the past are combined with carefully designed future scenarios concerning the enlargement of the European Union and US macroeconomic policies to produce long-run forecasts of currency shares.

The importance of the US dollar as an international reserve currency, measured by its share of central banks’ foreign currency holdings, steadily declined in the 1970s and 1980s, from about 80% in 1977 down to 49% in 1992. The shares of Japanese yen and German mark rose rapidly over the same period. In the 1990s this downward trend was reversed and by 2003 the dollar share was back up to 64%. Moreover, the prolonged Japanese recession had considerably weakened the yen, and the mark had disappeared altogether. However, there is one unprecedented novelty on the international financial scene: the euro. It began to circulate in physical form in 2002, is now actively traded on financial markets and is increasingly used by central banks as a reserve currency - its share reaching almost 20% in 2003.

The recent strong appreciation of the European currency has added credibility to the euro as a serious alternative to the dollar in central banks’ portfolios. Many commentators and policymakers began wondering not whether but when the euro will overtake the dollar as the main international reserve currency. Is this a likely scenario? And if the end of the “dollar era” is a plausible event, will it occur within the next five, ten or twenty years?

In order to make reliable predictions, the authors take a preliminary step by asking why international currency status is an important economic issue, especially for the United States, and then by looking at the fundamental determinants of international currency holdings by central banks.

The key role of the dollar as a reserve currency is extremely relevant for the United States because the sustainability of the American current account deficit - which recently reached 6% of gross domestic product (GDP) - depends on the willingness of foreign central banks to accumulate increasing amounts of dollar-denominated assets. In fact, in recent years the major source of financing of the US trade deficit was the purchase of US bonds by Asian central banks. The role of the dollar as the leading international reserve currency is therefore crucial in ensuring a steady demand for dollar assets that will be able to finance the current account deficit in coming years.

Central banks now see the euro as a valid alternative to the dollar. The European currency has rapidly gained acceptance in international payments and in international securities markets, and is much more widespread than the yen as a reserve currency. What will be of the competition between euro and dollar? The authors’ deep understanding of the determinants of foreign currency holdings highlights several factors.

The size of the economy, for one. The United States is the world’s largest economy in terms of domestic output and foreign trade, but the euro area does not lag far behind. In the foreseeable future, if the United Kingdom, Denmark and Sweden will join the euro, the European Union's overall economic weight will be as large as that of the United States. A second important factor is central banks' confidence in the value of the currency. A stable currency, with no risks of depreciation caused by a high domestic inflation rate or by a large trade deficit, is much preferred as a reserve asset. The US inflation performance since 1990 is very good, but the large and increasing current account deficit is likely to put a downward pressure on the value of the dollar. Under this light, the euro seems a better alternative.

A final factor, in favor of the dollar, is the strong inertial bias towards the use of whatever currency was inherited from the past and still remains the most widely used. This tendency - a “network externality”, in economists’ jargon - implies that gradual changes in the determinants of currency holdings (size of the economy, stability, low inflation) in favor of the euro will contribute to threaten the dollar as number one reserve currency only in the long run.

These ideas are translated into a state-of-the-art econometric model of central banks’ currency holdings, applied to the data of the pre-euro period: 1973-1998. The results support the theoretical analysis: the currency of a larger economy will receive a larger share as international reserve, whereas domestic inflation rate and exchange rate volatility tend to reduce the currency’s share. The advantage of the dollar as incumbent leading international reserve currency is confirmed too. The authors’ estimates are also very good at predicting the direction of currency shares' movements in the 1999-2003 period, after the birth of the euro: downward for yen and dollar and upward for euro and pound.

What about the future? A simple, mechanical extrapolation of past trends will not offer a relevant answer. The authors therefore pursue a novel strategy, combining their econometric results with different macroeconomic scenarios defined by alternative assumptions. The assumptions mainly concern the enlargement process of the European Union, the adoption of the common currency by the United Kingdom and the other current members of the Union, and the relative output growth rates of Europe and the United States. Such different hypotheses are then combined with different assumptions about the speed and extent of dollar depreciation. The shares of dollars and euros in central banks’ international reserve holdings are simulated for each scenario until year 2040.

The simulation shows that, under most scenarios, the dollar retains its dominant role as a reserve currency. However, there are some instances in which the euro will overtake the dollar. Most importantly, if the United Kingdom joins the euro area by 2020 and the dollar depreciation persists at the current annual rate of 4%, then the euro will surpass the dollar as the leading currency by 2022. Finally the paper offers an explicit message: future developments in the international currency competition crucially depend on the United Kingdom's political choices in the next ten or fifteen years.


the universe is electric
Jan 26, 2006
RR1 Distopia 666 Discordia
RE: Reserve Currency Comp

This is an interesting piece ITN , in that it nowhere deals with what actually drives the American economy and that,s the big military machine.


Hubba Hubba
Apr 18, 2005
Das Kapital
Re: RE: Reserve Currency Comp

darkbeaver said:
This is an interesting piece ITN , in that it nowhere deals with what actually drives the American economy and that,s the big military machine.

And what about the EU economy, arms sales? Subsidies that suck the eastern bloc dry? Get real, pal.