U.S.

-EU Responses to Globalization Working Papers

Dollar versus Euro? Reserve Currency Diversification

Cinzia Alcidi and Daniel Gros
Introduction The nature of the global reserve system has been changing continuously during the last decades. Interestingly, since the Bretton Woods system collapsed1 hardly any international effort has been made to design a new arrangement. The de facto system at work has been shaped by forces most of which are based squarely on economic policy choices driven solely by national interests. The demand for reserves has responded to various logics: transaction balances has increased with trade flows, precautionary balances (to prevent or to be able to deal with currency or liquidity crisis, sudden stop) have risen with financial integration. These factors are accounted for, and potentially forecasted, in standard international economic models. However, at present it seems that a significant, perhaps even decisive, cause for reserve hoarding appears to be a side product of export-driven strategies (China) or in general the result of rapid wealth accumulation by financially repressed countries with high propensities to save. The supply of reserve assets has also changed considerably over time. Reserve assets are most commonly thought of as being supplied by the current account deficit of the reserve currency country. But this is not necessarily always the case. A deficit in its balance of private capital flows (as was the case during most of the 1960s) could also be sufficient.2 Yet over the last decade of unprecedented reserve accumulation, reserve assets were indeed provided principally by the major deficit country (the U.S.) in the form of government or government-guaranteed securities. Figure 1 illustrates flows of global demand of reserves and U.S. supply of reserve assets. Between 2000 and 2008, U.S. Treasury negotiable debt has increased by about $4 trillion and a similar increase has been experienced by GSE and Agencies securities, i.e. private debt guarantee by the U.S. government. Together they represented 50 percent of the total (government and government-guarantee) debt outstanding at the end of 2008.3 Over the same period, the increase in reserve accumulation in emerging and developing economies amounted to over $7 trillion dollars. Such paths reflect on one side over-borrowing of US private sector and, on the other, the need to allocate emerging markets savings in form of buffer-resources.

Figure 1. U.S. debt flows and changes in reserves

The Bretton Woods System (of fixed but adjustable exchange rates) collapsed when the surplus countries were no longer willing to accumulate unlimited reserves to limit the appreciation of their own currencies. 2 Financial liberalization has made the Triffin dilemma obsolete: if country A borrows in dollars to finance its current account deficit, country B will be able to accumulate reserves in dollars without the US having to run a deficit. 3 In the EA-4 (Germany, France, Italy and Spain) the raise of government debt over the same period has been of about 1 trillion euros (on average $1.35 trillion), i.e. around 25% of the total amount outstanding at the end of 2008.

US debt: flows
2,500 Government 2,000 GSE & Agencies Reserves EMEs Reserves Dev Asia

1,500

B illio n s U S D

1,000

500

0 2000

2001

2002

2003

2004

2005

2006

2007

2008

2009q2

-500

Source: WEO and Fed Z1 Even though many countries accumulate reserves to diminish the risks their economies are facing, the accumulation of reserves leads itself to an accumulation of risk, for the system as whole and for the reserve holders. For a country whose excess savings (current account surplus) are intermediated via the central bank, the main risk is the loss of (international) purchasing power of the reserves. This seems to be situation for the major reserve accumulators (China) today.4 For a country where most of the reserve accumulation arises as the counterpart of (short term or hot money) capital inflows, the nature of the risk is different. In this case, the central bank accumulates liabilities in domestic currency, while its assets are in foreign currency. An appreciation of the domestic currency then exposes the central bank to potentially very large losses. This was the situation in the surplus countries, e.g. Germany, during the late 1960s and early 1970s. A reserve system is traditionally defined by the currency around which it is centered. Strictly speaking, this currency plays two different roles: it provides a peg for the non-free-floating currencies while at the same time it is the currency in which official reserves are accumulated. Even in the absence of a clear policy design, the existing international reserve system has gravitated around the dollar. Now the declining weight of the U.S. in the global context and the instability of the U.S. economy that materialized after the crisis have led observers and policy makers to question the fact that the dollar will continue to perform this role. From the point of view of a reserve holder a weak dollar combined with a downgraded U.S. assets represent major risks undermining its international purchasing power.

In this case the central bank operates, de facto, rather like a sovereign wealth fund and should have a different investment strategy. However, in reality this does not seem to be the case.

On this ground, some questions arise. First, will reserve accumulation continue to grow? Second, can the dollar be replaced or supplemented in its role of store of value by another currency, the euro being presently the most plausible candidate5? The next two sections address these two questions. In the last section we offer some conclusions. The Future Path for Reserve Holdings Looking forward to the possible evolution of the global reserve system, the first question is the pace at which reserves will continue to grow. The factors at work here are numerous, but if the experience of the past decade is of any guide, the evolution of saving and investment propensities in the emerging world will have a central role: demographics, expected changes in welfare and income policies, development of the local financial systems, public infrastructure policies as well as the price of key commodities, oil in particular, will all play a role in determining their current account surpluses. The latest IMF World Economic Outlook (October 2009) does not forecast any radical change on this front. On the contrary, as shown in

Figure 2 the current account of the developing Asia group is projected to increase by more than $200 billion over the next five years to close to $800 billion in 2014, while the current account of the Middle East group should rebound to reach roughly $300 billion in 2014. Those trends give a first idea of the magnitude of the coming demand for reserves. Countries which until recently had large current account deficits (principally Emerging Europe), however, have just suffered balance of payment problems and had to go to the IMF. These countries might react as the Asian countries did after the crisis of the late 1990s. If their reaction is never again, they might now start accumulating substantial reserves. The amounts involved could be non-negligible.6 If one adds to the Middle East and Asia current account surpluses, this additional demand for precautionary reserves estimated at close to $200 billion, one arrives at a potential pace of reserves accumulation of over $1.2 trillion in 2014 (
5 6

The horizon at which the SDR could play such a role seems more distant. The IMF estimates that, as consequence of the crisis and reserves draining, the long term need for reserves of emerging developing countries (excluding China and fuel exporters) will reach $900 billions over the next 5 years and 1.3-2 trillions for the next 10 years (IMF, 2009). This would translate in an annual accumulation of reserves of about $180 billion for the next five years.

Figure 2).

Figure 2. Current Account Balance and Reserves: Developing Asia Group and China.
1400

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Billion dollar

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Developing Asia reserves Developing Asia CA balance Middle East CA balance Middle East change reserves Emerging markets change reserves

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0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Developing Asia includes newly industrialized Asian economies.

Reserves changes for emerging countries are estimated as developing Asia and Middle East current accounts increased by $180 billion each year (see footnote 6 ). Source: World Economic Outlook, October 2009 Of course, capital exports from China and some other emerging market economies do not necessarily have to coincide with the amount of reserves these countries will accumulate. The attitude towards risk-taking of both the public and private agents of those economies as well as the management of capital controls (in China and some other countries) will also shape the speed of accumulation of reserves. Since 2000 the reserve accumulation of this group of countries has consistently been larger than their combined current account surplus. Though uncertainty is high, there is little reason to expect a reduced pace of reserve accumulation in developing Asia. Of course the alternative is that, as domestic financial systems develop in these countries, reserve accumulation is less linked to the current account, but this could happen in two ways: 1. Increasing accumulation of foreign assets by private or sovereign wealth funds, which would tend to diminish the accumulation of reserves by central banks. 2. Increasing inflows of short term private foreign capital in anticipation of the eventual revaluation of currencies like the Chinese renminbi (RMB). As during the last years of the Bretton Woods System, this would tend to increase the accumulation of reserves. Since it is not possible to predict which factor will be stronger, it seems safe to expect not only an increase in reserve accumulation, but also an increase in its variability. What Currency? As explained above, a large part of the exceptional reserve accumulation of the last ten years has taken place in dollars. Since the onset of the crisis some commentators have argued that a switch into another currency will occur, with the euro being the first candidate. Here we develop two arguments suggesting that even though the role of the euro as reserve currency will grow it will remain limited in the countries which are in the vicinity of the euro area or have institutional links with the euro area. A global shift towards the euro is not likely to occur any time soon. The first argument is based on the evidence that the lower degree of liquidity of the euro financial markets and the existence of a strong asymmetry in the international banking system in favor of the dollar make it impossible for the euro to substitute for the dollar at the global level in the near future. The second argument is based on a thought experiment that considers whether and how the shift of large reserve holdings towards the euro could actually occur. Financial Markets and the International Banking System When considering the function of store of value of an international currency there is arguably a tendency to focus exclusively on its use by officials. From this point of view, the currency provides a peg-anchor for the non-free-floating currencies and it is the currency in which official reserves are accumulated. Though this is the prevailing approach, more attention should be devoted to its private use, i.e. the role of a currency in the financial markets and in the banking system. In fact the private use of a currency largely affects the degree of liquidity of a certain market and this is a crucial factor in the choice of the reserve currency. The dollar dominance as reserve currency largely depends on the high degree of liquidity and breadth of the dollar markets, not only U.S. markets.

In what follows we will abstract from standard macroeconomic determinants of a currency as store of value and focus first on the markets of those assets7 that are the target of reserve holders. Second, we will investigate the relative use of dollar and euro in the international banking system. Reserves being held in rather risk-free assets, the availability of deep and liquid markets for such assets denominated in the potential reserve currencies is a precondition for diversification. If we assume that bank deposits fit into this category, there does not seem to be any constraint on their availability: in principle big international banks accept indifferently deposits in dollars or euros. But, in normal times at least, the remuneration on those assets will be lower than on marketable securities. Moreover, this crisis has shown that bank deposits are not always without risk. If one looks at the size of the market for the kind of short term, safe and liquid securities required by central banks for their currency reserves the advantage of the dollar become quickly apparent. However, in terms of sheer size of the markets of euro-denominated government debt securities, the amounts for the euro area are quite comparable to those available in the U.S. (See the Appendix for details and why the Japanese yen is not a contender for global currency status). In addition, the reserve management services provided by the European Central Bank to the reserve holders look quite similar to those offered by the Federal Reserve. But the U.S. market of quasirisk-free securities (Government debt securities, GSE debt and Agency-backed mortgage pools), which are the target of reserves holders, is much larger than any quasi-risk-free euro market.8

Figure 3 is self-explanatory in this respect: the dollar market is more than double the size of that of the market(s) in euro-denominated quasi-risk-free assets.

Figure 3. Quasi-risk-free Securities at End of 2008.

Large scale currency diversification implies a practical question stemming from the amount of reserves already accumulated: would a significant move out of the dollar into other currencies (the euro in particular) have disruptive consequences? The size of the international portfolios in place makes this much less likely than just a few decades ago: in recent years cross-border capital flows intensified and the size of the balance sheets of the different economies increased significantly. Shifting part of the huge amount of reserves accumulated, for instance from the dollar to the euro, would of course put downward pressure on the dollar. But, provided such a move does not provoke a brutal change in exchange rate expectations -- i.e., that it takes place in an orderly fashion -- this pressure does not have to lead to a deep fall of the dollar against the euro. With unchanged expected returns, the private portfolio rebalancing effects triggered by a moderate fall of the dollar should be powerful enough to help absorb the pressure generated by a reasonable diversification of official reserves. 8 As explained in greater detail in the Appendix, the quasi-risk-free securities European market includes Government securities and covered bonds.

United States Euro area - 4 Germany Italy France Spain 0 2,742 1,919 1,794 956 5,000 10,000 Billion dollars 15,000 7,411

16,739

20,000

Various sources: see details in the appendix Furthermore, the European market for public debt is fragmented, and so are the markets for European covered-bonds (see Appendix). In reality one should thus compare the market size for the U.S. (close to $17 trillion) to that of the biggest market in euro, that of Germany, whose size is below $3 trillion. Even if one lumps together the only two significant AAA rated governments in Europe (Germany and France), one arrives at a market (in reality still two quite distinct markets) which together is about one-fourth of the size of the dollar market for safe assets. These elements represent important deterrents to the attractiveness of euro-dominated assets from the point of view of a reserve holder. Gelati and Wooldridge9 compare the liquidity conditions of dollar and euro instruments in government securities markets as well as in the money markets to assess the relative importance of the two currencies as mediums of exchange; this comparison is also relevant to understand the choice of a currency as store of value. On average, their findings suggest that dollar markets are more liquid than euro markets, particularly with regard to government securities (in line with our argument) and repo markets. But the derivatives segment of the euro government securities markets (future market on German bonds, in particular) is as liquid as the U.S. Treasury market and unsecured deposits in the euro markets exhibit a high degree of liquidity, with the wholesale market in euros larger than the one in dollars. The bottom line: given the characteristics of the euro financial markets, the euro can become increasingly attractive as an alternative to dollar holdings, but the dollar still maintains important advantages. As anticipated above, there is also another dimension to be considered. The recent crisis highlights the importance of liquidity for a well-functioning global financial system. It also highlights a huge asymmetry. European banks need liquidity denominated in dollars far more than U.S. banks need euros. Figure 4 provides an idea of the asymmetry between the U.S. and European banking system in terms of currency denomination of their assets. About one-third of euro area banks claims on foreigners are denominated in dollars, while the share of eurodenominated claims on foreigners of U.S. banks is negligible.

Figure 4. Claims on Foreigners.

G. Gelati and P. Wooldridge, The Euro as a Reserve Currency: a Challenge to the Pre-Eminence of the US Dollar? BIS Working Papers No. 218 (2006).
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Euro Area MFIs (Selected) Claims on foreigners: currency breakdow

4000
5000

US banks: claims on foreigners

3500 USD 3000

Claims in EUR Claims in USD

EUR
4000

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2000

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Source: TIC and ECB As shown in Figure 5, data for Japan give an intermediate picture, with euro-denominated assets representing about one-third of dollar denominated assets. Figure 5. Japan: Bank Assets in Foreign Currency (June 2009).
Japan: banks assets in foreign currency

169

Others

387

EUR

CHF

16 83

Pound USD

1,172

Source: Bank of Japan Overall the data suggest a strong lop-sidedness between the dollar and the euro in the global markets and therefore a difference in the depth of the two markets that goes beyond what suggested by the analysis of the specific markets. Of course one explanation for the large European holdings in dollar is that an important part of the products of the securitization, held by European banks, are denominated in U.S. dollars. It could be argued that this kind of assets is not attractive for reserve holders and therefore those data are irrelevant for the understanding of the reserve system. Yet the figures above are surprising because of the quasi-absence of euros in the portfolio of U.S. banks, in comparison with the relatively strong exposure of European banks to dollar-denominated assets. In effect, these figures offer evidence that the euro does not have markets outside the euro area (unfortunately data for the UK are not available). This asymmetry

03 20 Q 1 03 20 Q 2 03 20 Q 3 03 20 Q 4 04 20 Q 1 04 20 Q 2 04 20 Q 3 04 20 Q 4 05 20 Q 1 05 20 Q 2 05 20 Q 3 05 20 Q 4 06 20 Q 1 06 20 Q 2 06 20 Q 3 06 20 Q 4 07 20 Q 1 07 20 Q 2 07 20 Q 3 07 20 Q 4 08 20 Q 1 08 20 Q 2 08 20 Q 3 08 20 Q 4 09 20 Q 1 09 Q2

99

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reinforces the argument that a shift away from the dollar implies a cost in terms of giving up a larger and more liquid market. A thought experiment: from dollars to euros and vice-versa We have argued that the dollar is likely to stay the dominant reserve currency. But what would happen if the central banks of emerging market economies decided to partially10 shift their holdings into euros? A thought experience might help. Assume that half of the approximately $4 trillion in dollar reserves of emerging and developing economies is to be shifted from dollars into euros. The most direct solution would be for the major deficit country, the U.S., to issue euro-denominated bonds. But this is not likely to happen for the foreseeable future. Reserve diversification by Asian central banks would thus translate into an increase in the demand for euro-area government debt securities. The main target of this operation would be AAA government bonds, i.e. French and German debt. The total marketable debt for the two countries is about $3 trillion, in principle more than enough to satisfy the demand of the reserve holders. But that entire amount is not readily available to international customers. For instance, important tranches of government securities are held by national pension funds or similar institutions and not available on the market. Therefore only new debt and debt held by the domestic private sector could be bought by central banks of emerging market economies. In that case, domestic holders of Franco-German debt would have to be supplied with a valid alternative and convinced to exchange it with their assets. Supposing that U.S. Treasury securities are perfect substitute for the Franco-German debt, one could imagine an instantaneous super-swap of U.S. government securities against Franco-German debt securities taking place between emerging market economies and the European private sector, with no impact on the exchange rates and China free from the dollar trap. The problem with this operation is that somebody has to take the dollar/euro exchange rate risk, which presumably domestic savers in France and Germany will not be willing to take. Conclusion Our analysis suggests that the policies that commonly held to foster the international role of the euro will have at most a marginal impact. For example, enlargement of the euro area will have almost no effect on the liquidity of the market in euro-area securities. The new member countries represent in general small economies with relatively small financial markets. Even Poland accounts for less than 5 percent of the present euro areas GDP, and liquidity in its tradable public and even less private debt is very low. Hence euro-area enlargement will not make the euro a more useful reserve currency. Fostering growth in the euro area through structural reforms is of course a laudable goal, but even if these reforms increased the potential growth rate they would not change the limited size and liquidity of the various national markets for public and private debt denominated in euros. The euro can be expected to become a more important reserve currency only if a deep market in safe and liquid euro-denominated assets is created. The issuance of joint euro- area public debt
The fact that a number of emerging and developing countries use the dollar as anchor-peg implies that the dollar will maintain a large role in the currency composition of the reserves.
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would of course have a big impact. But this is not possible because it would require a joint and several guarantee by all member countries, which is a non-starter for obvious political reasons.

Appendix According to BIS data, as of December 2008 the outstanding amount of domestic government securities issued by euro-area countries11 represented 22 percent of the total public debt market, while Japan represented 30.6 percent and the U.S. 26.5 percent.
Domestic debt securities: Governments
10000 9000 8000 7000 US Billions USD 6000 5000 4000 3000 2000 1000 0 Dec.2000 Dec.2001 Dec.2002 Dec.2003 Dec.2004 Dec.2005 Dec.2006 Dec.2007 Dec.2008 Japan EA-11

Source BIS. Governments includes central government, local and state government and central bank. As shown in the chart above, the sheer sizes of Japanese and euro government debt security markets are comparable to that of the U.S. and, seem to represent plausible alternatives to the U.S. Treasury security market for foreign reserve holders. Yet this is a quite misleading picture. Despite its huge size, Japan government debt market is globally limited. Two main reasons explain this phenomenon. First, Japans prolonged current account surpluses have made it possible for Government debt to be held domestically. Second, public debt is largely intermediated by the domestic (private and public) banking system and widely used as social security investment instrument. Once this is taken into account, the size and the liquidity of the Japanese government bonds market are dramatically reduced, and its attractiveness for foreign investors diminishes. Even though the European market of government debt is smaller, its size and liquidity could compete with that of the United States. However, the U.S. market of quasi-risk-free securities, which is the target of reserve holders, is much larger than the one of government securities. In the U.S., debt issued by agencies and government-sponsored enterprises (GSE) is not backed by the full faith and credit of the federal government, but investors generally treat the securities as if they had no credit risk, similarly to Treasury bonds. The market resulting from the aggregation of government debt, GSE securities and agency-backed mortgage pools is huge and much larger than any quasi-risk free European market.

11

Euro area 11 countries, data for Luxembourg are not available from the BIS database.

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In Europe, GSE do not exist, but Pfandbrief-style12 debt instruments can be considered as carrying almost no risk, similarly to government debt, and therefore belonging to the class of quasi-risk-free securities. Even accounting for covered bonds, which, strictly speaking, are a larger set than Pfandbrief-style securities, the table below shows that the U.S. market is more than twice as large as the European one. Table A1. Market of quasi-risk-free securities as of end 2008 ($ billions). EA-4 U.S. Total outstanding government securities 5,427 8,594 Total outstanding quasi-risk-free securities 7,411 16,739

EA-4 includes France, Germany, Italy and Spain. Total is the sum of general government securities in form of bonds, notes, and other short term securities, in domestic and foreign currency, as reported by national authorities (Agence France Tresor, Bundesbank, Dipartimento del Tesoro and Direccion General de Tesoro). The EA-4 accounts for about two-thirds of the total government debt securities of the EA. Data on Covered Bonds are from European Covered Bonds Council (Provisional statistics for Issuance and outstanding covered bonds, August 2009). The EA-4 accounts for almost 90% of the total euro area outstanding amount. U.S. government securities include federal, state and local government. U.S. quasi-risk-free securities also include GSE and agency- and GSE-backed mortgage pools (Source: Fed Z1). Euro-dollar exchange rate as of end of 2008 (ECB): 1.4 dollars = 1 euro. Furthermore, the European public debt market is fragmented and this contributes to undermine the role of euro as possible rival to the dollar as reserve currency. The heterogeneity of the market reflects national differences in terms of Quality: different risks are attached to the different governments within the euro area. Maturity structures: although the average maturity of the debt is very similar across countries, at the end of 2008, in Germany less than 4 percent of total securities had less than 1 year maturity, while in Spain was 7 percent, in Italy 11 percent and in France about 14 percent. Size of issuances, depending on national need and rules.

12 The total in the table considers covered bonds that include German Pfandbriefe and Spanish, French and Italian securities that are similar, but not necessarily with the same features. They are different in terms of issuers and assets used to secure the debt. The latter range from public sector loans, very relevant in Germany, to mortgage loans, the large majority in Spain. In Spain, within the class of covered bonds, only the so-called Cdulas Hipotecarias have standards similar to Pfandbriefe; here data are for the most extensive group of quasi-risk-free securities.

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