According to DBR the Euro is the world's solid number two reserve currency, but well behind the US dollar. The dollar share in global official forex reserve holdings declined to about 64 % at the end of 2003. The Euro has caught up: its share rose from 13.5 % in 1999 to almost 20 % in 2003.
While DBR sees "rumours of the death of the international role of the dollar are greatly exaggerated," the paper points out that about 50 small and medium-sized countries in Europe, the Mediterranean and Africa have pegged their currency to the Euro or orient their exchange rate policy towards the Euro. Accordingly, they have accumulated euros as reserve currency.
"The above-mentioned roughly 50 small and medium-sized countries with a Euro peg or a euro orientation for their currency need to hold official Euro reserves in order to boost confidence in their peg and/or their exchange rate policy and to be able to intervene in the Euro foreign exchange market if necessary," DBR concludes.
Euro holdings are not restricted to the international dwarfs though. The non-Euro G-7 countries - the US, Japan, the UK and Canada - basically need euro reserve holdings so they can stick to the G7 promise, repeatedly given by joint communique's, "to monitor exchange markets closely and cooperate as appropriate" in order to ensure orderly market conditions. This cooperation includes joint interventions in the foreign exchange market, for instance, by selling Euros to support the dollar. This implies that the US and the UK should also hold official reserves in euros although both countries are particularly reluctant to intervene in the foreign exchange market.
Potential To Challenge The Dollar
DBR sees reasons that the Euro has the potential to challenge the dollar for its ability to fulfill two major preconditions.
Firstly Euroland is the second largest economy behind the USA and well ahead of Japan. "Although Euroland has a larger population than the US it only produces the equivalent of 75 % of US GDP at current exchange rates. Euroland is the most important global exporter, shipping about 13 % of the world's exports. But it absorbs only about 12 % of world imports, i.e. much less that the US with its 17 % share reflecting the US role as a global growth engine. Euroland produces about 21% of world GDP, compared with 27 % in the US. With a ratio of goods exports (extra-EMU) to GDP of about 13 % Euroland's degree of openness is higher than that of the US or Japan."
Secondly the introduction of the Euro led to a greater integration of European financial markets, bringing higher liquidity in both sovereign and corporate debt markets. This fact was also acknowleged in a recent survey among central banks, DBR notes.
The researchers believe that the dollar will hold on to ist dominant position in this decade but they expect the Euro's share as a reserve currency to roughly double to 40 percent by 2010.
"Given the rising uncertainty surrounding the US current account deficit and the dollar exchange rate it is compelling for central banks with large dollar holdings to check the currency composition of their reserves. One way to tackle the issue is to differentiate between two types of accounts for official foreign exchange reserves:DBR sees especially Asian central banks in an asset management dilemma as most of their forex holdings are denominated in dollars. Any quick move would lead to portfolio losses which leads DBR to the expectation that diversification will follow a slow but steady path.
On the one hand, an 'intervention account' where funds must be available at short notice in order to be able to intervene flexibly. This account will be solely a policy tool and only focus on macroeconomic targets.
On the other hand, a 'monetary wealth account' that will absorb the remaining official foreign exchange reserves. Funds in this account will be invested with the microeconomic aim of achieving an optimal return on investment in order to enhance the national monetary wealth."
NOTE: For a longer term outlook about the fight of dominance in global financial markets read the post "What will be the next big reserve currency?"