Potential for the euro to become a reserve currency if the UK adopts it

¶ … Euro as Reserve Currency

The position of the dollar in the world economy has seldom been questioned. Although economists feared for the currency's status as dominant reserve currency during events such as the rise of the Deutsch Mark and the Yen in comparison with the decline of the dollar, these fears proved unfounded in less than a decade. The most recent depreciation of the dollar and its subsequent decline have given rise to new concerns. The euro has shown increasing strength as opposed to dollar decline, leading to projections that the euro may eventually supplant the dollar as the dominant reserve currency in the world. The question however remains that, in the light of past trends, how realistic is such a projection? Several factors need to be taken into account when estimating the likelihood of the euro to take over from the dollar. Current trends need to be investigated in terms of the past, as well as in terms of the economic and political factors surrounding both currencies. It is by no means a simple question, which necessitates addressing the issue from various angles. This can for example include an investigation from the perspective of the history, and current trends in the economy and politics that surround both currencies, while projections can then be suggested for the future.

History

In order to determine future trends, the past needs to be examined thoroughly in its capacity as a possible predictor of the future. According to Chinn & Frankel (2005), the United States would do well to learn from the history of the British Pound: The pound declined in concomitance with political factors such as the United Kingdom's increasing loss of its colonies and military power throughout the world. This also meant an increasing loss of economic power and the devaluation of the pound. In an attempt to contain its losses, the United Kingdom continued its attempt to regain its imperial power via ever widening budget deficits. Indeed, the final fate of the pound was sealed by the Suez crisis of 1956, when U.S. pressure forced Britain to abandon its remaining imperial ambitions (Chinn & Frankel 2005: 9-10). In concomitance, the pound finally gave way to the dollar as the main global reserve currency. Some economists see a parallel between the historical imperialism of Britain and the current trends of the United States in its ambitions to control not only its own, but also foreign resources. The country's ventures into Iraq for example are seen in the same light as the British drive to colonize the world. This overly ambitious tendency led to the downfall of the British Pound, and could result in the same for the American Dollar.

In contrast, the history of the Euro appears remarkably favorable when compared with the decline of the dollar over the same period. Although the new currency is less than a decade old, its international use has increased remarkably since its inception. Specifically, its share in international debt securities has risen to above 30%, although the currency's position within all spot trades is still only about halfway towards that of the dollar (Chinn & Frankel 2005: 14).

Current Economic and Political Factors

While history is often a good indicator of the future, the current manifestations of politics and the economy also need to be taken into account when estimating the potential of other currencies to supplant the dollar in the world economy. Chinn & Frankel (2005: 2) for example identify two specific factors that might influence the potential strength of the euro: these include 1) the increased size of the euroland economy should the United Kingdom and other members join and 2) the potential inflation and depreciation of the dollar if U.S. macroeconomic policy undermines confidence in its value. Specifically, factors that influence these two points include the size of the home country, the inflation rate, the exchange rate variability, and the size of the relevant home financial center. A report by Reuters supports this finding, and emphasizes that the euro could overtake the dollar if the 13 EU members join euroland by 2020 if the current trends of dollar decline were to continue.

The Reuters (2005) report also states that foreign countries who have historically reserved the majority of their foreign currency in dollars, have shown trends towards diversification. These countries include China and Russia, with a possibility that Saudi Arabia may also follow such trends.

It is important to note that a continued concomitance of trends is necessary for the dollar to be removed from its position, and that this is not likely to occur in the very near future. At best, economists can use the likelihood of the above factors to speculate about the issue. Several authors however appear to view the euro as a significantly growing force, and a viable source of threat for the currently strong position of the euro.

Galati & Wooldridge (2006:3) appear to support the position that the euro is growing with sufficient force to eventually compete with the dollar as global reserve currency. Indeed, the authors hold that the liquidity and breadth of euro markets are sufficiently significant to compete well with those of dollar markets. In reality, however, the authors also recognize that the growth of the euro so far has had little impact upon the existing global strength of the dollar. This is substantiated by the Chinn & Frankel. According to Galati & Wooldridge (2006:3), the main contributing factors to the remaining strength of the dollar as reserve currency despite its apparent economic decline are the size of its financial markets, its credit quality and liquidity, and inertia in the use of international currencies.

This inertia, according to Ron Paul (2007), is however fast showing signs of decline. While its economic reserve position is still second to that of the dollar, the euro is reported to be the most widely used form of cash internationally; and is also used by most European nations. Indeed, there are more euros in worldwide circulation than dollars, which is significant for a currency of such a young age. This lends some substance to the projection that the euro might eventually become the global reserve currency instead of the dollar. Indeed, Paul holds that the international rise of the euro provides evidence that the dollar is showing an increasingly weakening trend exacerbated by factors such as oil is increasingly bought and sold in euros.

Still, the author notes that 65% of foreign central bank exchange reserves remain in dollars., while only 25% are held in euros. In addition, the European Central Bank is also subject to such inflationary pressures as the Federal Reserve Bank of the United States. In essence, Paul blames politics for the potential devaluation not only of the dollar, but also of the euro within an environment where politicians are under great pressure to spend more than they have, inflate their currency, with the ultimate result of devaluation.

It appears however that, in a competition between the dollar and the euro, the latter will be the ultimate victor. Paul identifies a variety of factors in this regard: One of these is the quota of U.S. dollars in the banks of countries such as China and Japan, as well as other Asian countries. Historically, this area has been one of the greatest benefactors of the dollar in terms of bank reserves. The latest tendency has however been towards diversifying their reserve currency holdings. Paul warns that the favor enjoyed by the American dollar will probably diminish over time, creating more expensive borrowing fees for both American citizens and Congress.

A further factor is that the large current American trade deficit can only be maintained with an equally large number of dollars in reserve currency. America can only borrow what is available; when reserve dollars are no longer available in foreign banks, the United States' debt deficit will become problematic in terms of repayment, and will concomitantly lower in value. This will leave the market open for the euro.

Interestingly, the Paul further notes that the underground economic community such as drug dealers and money launderers also prefer to deal in euros rather than dollars. According to the author, this sector, although questionable, provides a reliable indication of a currency's status, as they prefer to use the most stable and valuable paper currency for their business dealings.

This point is substantiated by Daniel Gross, even as early as 2004. In addition to the steady rise of euro use throughout the foreign community such as Russia, drug dealers have found the use of the euro currency for their transactions much more convenient than the collar. Indeed, Gross notes that the euro has become easier to carry, store and hide since the European Central Bank has started printing 200- and 500-euro bills, as opposed to the U.S. currency, whose largest bill denomination is $100. Hence greater amounts of money can be stored in smaller packages, and for those whose aims are underhanded and shadowy, euros are the obvious choice for their potential to escape attention more easily than the bulkier dollar amounts. In demonstration, Gross notes the anecdote of a drug mule traveling from Spain to Colombia, in whose stomach officials found $197,000 in euro notes (Gross 2007).

While the underground economy serves as an indicator of stability and value for the currency market, this stability and value are influenced by a confluence of further economic factors in addition to the ones already mentioned above. Chinn & Frankel (2005:15) focus on four specific factors that influence the future probability of euro dominance over the dollar.

The first of these is patterns of output and trade. This relates to the already-mentioned amount of market presence of a certain currency. Currently, the U.S. dollar enjoys the greatest presence in the world economy. Interestingly, the authors hold that, if output and trade are regarded as measures of a country's economy, Japan should be the second in the world. However, other factors such as economic size and natural resources also play a role in the country's economic position. Japan is much smaller in terms of population size, land area and natural resources, while the euro on the other hand is used to the exclusion of all other currencies in 12 countries, whose combined economic size is far greater than that of either Germany or Japan. Because of this fact, the euro more than any other currency has the potential to override the U.S. dollar in economic importance. Indeed, the authors hold that only the addition of the United Kingdom, Sweden, and Denmark to the EMU is needed to equal the economic size of the United States, while the addition of the other 10 would result in euroland surpassing the United States. The authors however note that this is also dependent upon the growth rates of the different economies, as well as trading volume.

The second factor addressed by Chinn and Frankel is the financial markets within a country. International currency status is dependent upon the freedom of control and the development level of the capital and money markets in the home country. In this, the dollar enjoys precedence over the euro, while the large financial marketplace in London benefits the pound rather than the euro. Currently, New York and London represent the largest financial centers. If the United Kingdom were to adopt he euro, it is clear that it would become a significant rival for the dollar currency. In terms of political factors, the authors cite that a strong central bank and large financial sector are necessary in order to counter political influences in order to maintain the strength of the currency. The political sector often has its own agenda in terms of either appreciating or depreciating the currency. A large financial sector will then be able to resist such influences.

The third factor relates to external factors such as the confidence in the currency value (Chinn & Frankel 16). Value confidence relates to the stability of a currency. Here the underground market provides an indicator of confidence, as mentioned above. This confidence is dependent upon a variety of factors, including that the value of a currency should not fluctuate erratically. Stability of inflation and future value is critical for the success of the currency. During the 1980s, the United States have shown a higher inflation rate that Japan, Germany and Switzerland, but a lower one than the United Kingdom, France and Italy. The 1990s however showed a better inflation performance for the United States. This is however set against the fact that the United States has incurred large-scale debts, which may result in downward pressure upon the dollar. These fears lead to both potential instability in the dollar market, as well as the unattractiveness of investing in this market.

A fourth important factor, as noted by Chinn & Frankel (17), is network externalities. Here also the inertia mentioned by Galati and Woodridge plays an important role. In terms of network externalities, inertia means that, whatever currency was used most frequently in the past continues to be prominent in the marketplace simply because this is the economic habit. Change is the path of greater resistance, and hence, unless there is a particularly strong incentive to do otherwise, the greatest likelihood is that the most popular currency will continue to be used. The assumption is that this is the most likely currency to be used by others. This assumption then drives the continued use of the dollar, regardless of other potentially negative factors related to the currency.

As noted above, the authors assert that any change within the major currency is not likely to occur within the near or sudden future, because of inertia and habit. Indeed, the factors in favor of the euro identified above are but minor changes that are not in themselves sufficiently significant to bring about major changes in the dominant reserve currency. Furthermore, the authors note the presence of unforeseen phenomena: unforeseen factors may result in unforeseen changes in the market, making it difficult to predict particular changes in the market.

It is also however important to note that the changes and trends are indeed important in the long run, particularly when seen in terms of the political future. As substantiation, the authors note the continued dominance of the pound even decades after the decline of the home country itself. While inertia was responsible for this, the dollar did eventually follow its home country in becoming a dominant global force.

The Future

According to Galati & Wooldridge (2006:8) further factors that need to be considered when estimating the future importance of the Euro as reserve currency is the manner of its use. In this, the authors distinguish between the official and private use of the international currency. In the official sector, for example, foreign currency might be held for the purpose of supporting their use of the exchange rate, to intervene in the foreign exchange market, or to safe keep wealth. Individual use on the other hand might relate to functions such as invoicing or trading; in other words, these uses relate more directly to private business dealings for financial profit. Official use is generally related to the reserve of foreign currency for a country.

Interestingly, the authors note that the reserve use of a currency in the official sector depends not so much upon governmental intervention as it does upon the private use trend. When the private business sector tends towards using the dollar, for example, this would drive the official use of the dollar as well. The increasing private use of the euro therefore substantiates projections for increasing official use of this currency as well. Concomitantly, the authors note that the reverse could also be true: the official use of a currency may also drive its private use. Most likely, the two sectors have a mutual effect upon each other, while also driven by the above-mentioned inertia factor that currently tends to favor the dollar.

Apart from specific official and private use, Galati and Wooldridge also hold that macroeconomic stability is a primarily important factor in the continued use of a certain currency. Price stability is an important factor in this, and also drives the confidence in the value of the currency. Current trends, as seen above favors the euro rather than the dollar in this regard. Neither the private nor the official sector will be likely to use a currency that is fundamentally unstable or shows itself to be weak within the marketplace. This is one of the factors that have fuelled the debate regarding the possible replacement of the dollar with the euro as the global reserve currency.

According to the authors, the above stability of the foreign currency will also induce inertia. The four factors relating to the international status of a currency change slowly. This induces both inertia and stability, meaning that the currency will maintain its position for as long as it can promise a non-sudden evolution, inducing confidence in the currency.