Thursday, April 12, 2012

The decline of the euro as a reserve currency

Central Banks globally have been reducing their holdings of the euro as a reserve currency. Several years back it looked as though the euro was on a path to replace the US dollar as the dominant component of global foreign reserves. But with the start of the Eurozone crisis the euro's attractiveness as a reserve currency waned.

Central banks invest a great deal of their reserve currency into asset denominated in that currency, usually government bonds. The amount of government debt in the Eurozone that central banks feel comfortable holding has diminished markedly since the start of the crisis. There is only so much that India, China, Brazil, etc. can invest in bunds, just given the the overall size of the German government market. The universe of "safe" (by central bank standards) bonds outside of Germany has become limited.
Barclays Capital: The attractiveness of the EUR as a reserve currency has decreased as there are increasing doubts over the stability of the monetary union. The risk of future sovereign restructurings will likely reduce foreign demand for European government bonds and an increasingly fragmented bond market also raises questions over the EUR’s status as a reserve currency. This is reflected in the reduced size of flows into the EUR over the past few quarters and in our view will be a medium-term negative for the currency.
% allocation of global central bank reserves by currency (Source: Barclays Capital)

The beneficiaries of this rotation have been the US dollar as well some of the less traditional reserve currencies such as AUD, CAD, etc. As Barclays points out, this trend is likely to continue over time, further reducing demand for Eurozone government debt. The one possible action by the Eurozone that can stem this decline would be the creation of the Eurozone Bond that has "joint and multiple" guarantees of the member states. That would create an equivalent of the US treasury market giving central banks more room to increase the EUR reserves. But for now the possibility of such action seems extremely remote because it would require significantly ratifying the EU Treaties.
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