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

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Will the Euro Eventually Surpass the Dollaras
Leading International Reserve Currency?

• MENZIE CHINN, University of Wisconsin
• JEFFREY FRANKEL, Harvard University
• For NBER conference on
• G7 Current Account Imbalances Sustainability and
  Adjustment
• Newport, RI, June 1-2, 2005
• Richard Clarida, Organizer

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Reserve Currency Holdings
1977-2002 data, updated IMF Internal data
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Figure 7 Reserves held by central banks as
shares of total major currencies(revised IMF
data spliced into old data after 1979) 5/2/05
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Figure 8 US Dollar Reserves held by central
banks as shares of total smaller
currenciesrevised IMF data spliced into old data
after 1979)
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Dollar-dissing is cyclical

• Historically, whenever the depreciates,
  commentators predict its demise as leading
  international currency. E.g.,1978-79 1994-95.
• So the current episode was predictable
• Sometime soon, newspaper stories will begin
  reporting that central banks in Asia and
  elsewhere are diversifying out of dollars into
  euros, and that the dollar is in danger of
  eventually losing its status as premier
  international currency. -- Frankel (2004).
• Similar speculation in the past has been
  pre-mature.
• E.g., the true stats showed a temporary upward
  trend for the in the 1990s Frankel (1995).

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But this time may be different

• What makes this time different?
• U.S. macro policy may undermine faith in the
• twin deficits
• net international debt
• monetary ease (2001-04)
• parallels with late 1960s
• Plausible rival exists, since 1999 the euro
• Eichengreen Frankel (1996) It is unlikely
  that some other currency will supplant the dollar
  as the worlds premier currency...There is no
  plausible alternative for the number one
  position But we also acknowledged the
  possibility of a single currency coming into use
  throughout Europe, which would indeed pose a
  challenge to the supremacy of the dollar.
• A very few authors had faith in the euro all
  along Bergsten (1997), Portes Rey (1998).

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Birth of euro implies a potential rival for
Shares of currencies in reserve holdings,
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Roles of Intl Currency
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Shares of Major Intl Currencies in Reserve
Holdingsrevised IMF data spliced into old data
after 1979
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Why should we care?

• 4 ADVANTAGES TO A COUNTRY OF HAVING ITS CURRENCY
  PLAY A LARGE ROLE IN THE WORLD.
• (1) Convenience for its residents.
• (2) Business for its banks other financial
  institutions.
• (3) Seignorage
• narrowly defined as willingness to hold as
  high-powered money (esp. fx reserves held by
  central banks) or
• more broadly as willingness of private investors
  to hold -denominated assets Americas
  exorbitant privilege
• (4) Political power and prestige.

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Historical precedent s loss of premier
international currency status in 20th century

• By 1919, US had passed UK in
• output (1872)
• trade (1914)
• net international creditor position (1914-19)
• Subsequently, passed as 1 reserve currency
  (1940-45)

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US overtakes UK, by trade, 1900-1957Data
sources UK Export Data Department of Trade and
Industry, UK UK exchange rate (1946-1970)
Global Financial DataUS Export Data Historical
Statistics of the United States, Colonial Times
To 1970 Published by the U.S. Census Bureau
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Cautionary tale, cont.

• UK loss of international currency paralleled loss
  of its economic pre-eminence, military hegemony,
  colonies other trappings of international
  power.
• Suez crisis of 1956 is often recalled as occasion
  on which Britain was forced under US pressure to
  abandon imperial designs.
• Often forgotten Run on the was the mechanism.
  
• Paul Kennedys (1989) suggestion -- that imperial
  overreach hypothesis might apply to US hegemony
  -- may have been essentially correct
• but 15 years premature,
• much like those in early 1990s who warned
  prematurely over
• s imminent demise (Kindleberger, 1995 The
  Economist, 1995...)

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EU GDP gt US GDP
  2003 2004
US 11.0 trillion 11.5 trillion
Euro-zone (12 countries) Euro-zone (12 countries) Euro-zone (12 countries) 8.8 tr. 9.0 tr.
EU pre-5/1/04 (15 countries) EU pre-5/1/04 (15 countries)   11.3 tr. 11.5 tr.
EU post-5/1/4 (25 countries) EU post-5/1/4 (25 countries) 11.8 tr. 12.1 tr.
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Figure 1 Currency share vs. GDP (mkt. rates).
Is the relationship linear or (e.g.) ogive?
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Explaining reserve currency shares, pre-euro
(1973-98)
Bold figs. sig. at 10 level 2 4 6
GDP ratio (y) 0.123 0.049 0.115 0.049 0.085 0.047
Inflation diff (p) -0.107 0.060 -0.143 0.063
Depreciation (?s) -0.094 0.074
Exrate var (s) -0.057 0.032 -0.055 0.032 -0.030 0.030
Fxturnover (to) 0.019 0.016 0.023 0.016 0.016 0.017
GDP leader (leader) 0.026 0.014 0.023 0.014
lagshare (sht-1) 0.944 0.020 0.904 .029 0.923 .027
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Explaining currency logit transformed shares,
pre-euro
  2 4 7
GDPratio 2.768 3.69 1.04
(y) 0.643 0.923 0.288
Inflationdiff -2.639 -2.86  
(p) 1.156 1.164  
Depreciation     -1.095
( ?s)     0.594
Exratevar -0.981 -1.395 -1.251
(s) 0.573 0.644 0.341
Fxturnoverratio 0.446 0.576 0.427
(to) 0.289 0.303 0.145
GDPleader   -0.217  
(leader)   0.156  
laglogit 0.851 0.846 0.957
log(sh t-1/1- sh t-1) 0.031 0.031 0.014
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Explaining two-currency system of logit shares,
pre-euro
GDPratio 0.762 1.015 0.974 a/
  (y) 0.247 0.773 0.688
Inflationdiff -0.554 -0.844  
  (p) 1.247 1.259  
Depreciation     -4.524 a/
  ( ?s)     3.337
Exratevar   -2.375 -2.381
  (s)   1.213 1.121
Turnover   0.489 0.652 a/
(to)   0.487 0.454
Laglogit 0.829 0.775 0.795
 log(sh t-1/ 1- sh t-1) 0.043 0.085 0.076
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Figure 9 Out-of-sample prediction of USD Euro
using logit w/o leader variable
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Figure 10 Out-of-sample prediction of GBP, JPY
and SFR using logit w/o leader variable
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Figure 11 Case 2, Scenario BSimulation of No
UK, Swe, Den, and no further change in the level
of the exchange rate after 2004.
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Figure 13 Case 2, Scenario DSimulation of No
UK, Swe., Den. And continued depreciation of
at 2001-04 rate.
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Figure 14 Case 4, Scenario DSimulation of UK
entry and continued depreciation of at
2001-04 rate.