Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?

Abstract

Might the dollar eventually follow the precedent of the pound and cede its status as leading international reserve currency? Unlike ten years ago, there now exists a credible competitor: the euro. This paper econometrically estimates determinants of the shares of major currencies in the reserve holdings of the world's central banks. Significant factors include: size of the home country, inflation rate (or lagged depreciation trend), exchange rate variability, and size of the relevant home financial center (as measured by the turnover in its foreign exchange market). We have not found that net international debt position is an important determinant. Network externality theories would predict a tipping phenomenon. Indeed we find that the relationship between currency shares and their determinants is nonlinear (which we try to capture with a logistic function, or else with a dummy "leader" variable for the largest country). But changes are felt only with a long lag (we estimate a weight on the preceding year's currency share around .9). The advent of the euro interrupts the continuity of the historical data set. So we estimate parameters on pre-1999 data, and then use them to forecast the EMU era. The equation correctly predicts a (small) narrowing in the gap between the dollar and euro over the period [1999][2000][2001][2002][2003][2004]. Whether the euro might in the future rival or surpass the dollar as the world's leading international reserve currency appears to depend on two things: (1) do the United Kingdom and enough other EU members join euroland so that it becomes larger than the US economy, and (2) does US macroeconomic policy eventually undermine confidence in the value of the dollar, in the form of inflation and depreciation. What we learn about functional form and parameter values helps us forecast, contingent on these two developments, how quickly the euro might rise to challenge the dollar. Under two important scenarios the remaining EU members, including the UK, join EMU by 2020 or else the recent depreciation trend of the dollar persists into the future the euro may surpass the dollar as leading international reserve currency by 2022. Might the dollar lose its status as unrivaled international reserve currency? Could it be "going the way of sterling, the guilder, the ducat and the bezant." 1 Some authors argued as much ten years ago. 2 The international use of the yen and mark had risen rapidly in the 1970s and 1980s, reducing the share of the dollar. (See Table A or Figure 7.) Some in the early 1990s suggested that the yen or mark might eventually overtake the dollar as the lead international currency. Menzie Chinn Department of EconomicsBy the turn of the millennium, that idea had come to sound far-fetched. In the meantime, both Japan and Germany had undergone a decade of remarkably low economic growth, the yen had declined, and the mark had disappeared altogether. Fears that the international currency status of the dollar was under challenge were premature, as should have been obvious ...

Stability or Upheaval? The Currency Composition of International Reserves in the Long Run

“…29 This will be evident from the increase in the number of observations. 30 Chinn and Frankel (2007), and other authors following them, suggest that the relationship between reserves in a particular currency and the issuer's relative economic size should be nonlinear, an effect which they seek to capture with a logistic transformation of the dependent variable. A logistic transformation of the dependent variable is not practical here because such a nonlinear transformation may lead to inconsistent estimates (especially when reserve currency shares are set to zero).…”

The Impact of Economic Factors on the Foreign Exchange Rates between USA and Four Big Emerging Countries: China, India, Brazil and Mexico

“…When the European Central Bank starts operating in 1999 and the single currency is issued in 2002, important shifts were expected in the reserve portfolios of central banks. It was believed that the advent of Euro would create an integrated monetary and financial zone larger than the United States (Hartmann, 1996;Bergsten, 1997;Schinasi, & Prati, 1997;Greenspan, 2001;Gaspar, 2004;Papaioannou, Portes & Siourounis, 2006;Chinn & Frankel, 2007;Cohen, 2012). Moreover, it was expected that it would quickly come to rival and even surpass the dollar as the leading International Finance and Banking ISSN 2374-20892016 reserves by the central banks (Eichengreen, 1998).…”

On the Determinants of International Currency Choice: Will the Euro Dominate the World?

“…Chinn and Frankel (2005) interpret the prolonged dominance of the pound after the First World War as an inertia effect despite the fact that England had lost its dominant economic role and its dominant role as the global center for trade and finance. Inertia suggests that there may be some stability in currency choice over time.…”

“…As outlined in Chinn and Frankel (2005), the currency of a country that has a large share in international output has a significant natural advantage in terms of economy of scale to further the use of its currency in an international setting. We therefore employ the GDP of the country pertaining to each of the five currencies as a measure of economic size.…”

“…His prediction turned out to be close to the mark, as the Financial Times (January 14, 2007) reports,"The Euro displaces the Dollar in bond markets." 3 Krugman (1980) and(1984), Eichengreen and Mathieson (2000), Chinn and Frankel (2005), and Papaioannu et al (2006). 4 In January 2000, 11 currencies were replaced by the Euro.…”