The Euro As Reserve Currency

 

The currency used by the official sector for the use as an international currency to perform operations is referred as reserve currency.There are three main components of foreign currency which are medium of exchange, store of value and unit of account.

Monetary authorities usually use this currency as exchange rate tool to obtain monetary objectives, to intervene in foreign markets and to safe keep wealth. The private sector has a separate use of foreign currency and mostly use for invoicing. The choice of international currency is not decided by Government. The private sector determines the choice of international currency to be used.

The reserve currency is dependent upon four factors:

1.      Share of the country in the international trade.

2.      Macroeconomic stability

3.      Market development in term of liquidity and breadth.

4.      Network externalities of how other countries are using any currency as reserve currency.

Status of Euro:

During post-war era Dollar was dominant because it macroeconomic stability, network externalities and financial development. In 1990 EMU started debate on the potential of the euro against dollar. Some researchers argued that the attractiveness I dollar is due to its liquidity in T-bills as compared to euro. It is believed that the major limitation on euro is to play international role is due to the obstacle in full integration of euro government bond market.

One view point is that having two currencies at a tie as international currencies would make system inefficient. Studies show that euro is more sound currency as medium of exchange than the store of value. Researchers also argued that after monetary union euro’s role would match dollar in international markets. International investors should invest in euro to diversify and hedge their macroeconomic risks.

Composition Of International Reserves:

Official reserve assets are being well diversified nowadays. The share of euro is increased after monetary union however still it is lower than dollar. In 1990 the nadir of US was 455 of reserves and deposits. By 2007 it increased to 70%. However, it declined to 59% by 2006.

The main reason of decline was adoption of euro and diversification of reserve currency. Studies show that the reserve managers in Asia respond asymmetrical to valuation effect. These managers respond to interest rate more than exchange rates fluctuations.

The reserve allocation of euro has increased significantly from 19% to 27 % from 1999 to 2003. However, the financial allocation is more in euro region than in Asia or America. Since 1970 the reserve managers tend to attract more towards instrument perceived portfolios due to risk-adjusted returns. Now reserve managers invest in longer –dated debt securities than deposits.

Role as a Medium of Exchange

Traditionally, reserve management has been guided by two basic reasons. One is to prepare for contingencies and the other is an emergent need to intervene in financial market. This requires for holding reserves in the most liquid form, which is referred to as ‘liquidity tranche’. It occurs due to the potential need to turn assets into cash on short notice and at low cost under different market conditions. This role of medium of exchange may arise in the foreign exchange market or in government securities market.

Foreign Exchange Markets

The choice of the currency for intervention in the FE market is mostly dependent upon the liquidity conditions in foreign exchange markets. Because when there is need to influence a bilateral exchange rate, it is sometimes more effective to do so in a third, more heavily traded currency. While the euro seems to be as liquid as its predecessor currencies, it is unclear whether the euro has become more or less liquid compared with the US dollar (Galati and Tsatsaronis, 2003). The results of the 2007 BIS Triennial Survey of Foreign Exchange and Derivatives Markets reveal that the euro entered on one side of 37% of all foreign exchange transactions in April 2007. The dollar’s share in foreign exchange markets was little changed between 1998 and 2007 at about 86%. Dollar/euro was by far the most traded currency pair in 2007, capturing 27% of global turnover.

Money and Government Securities Markets

The choice of intervention currency is influenced by liquidity conditions in asset markets. Reserve managers typically invest the bulk of their reserves in instruments with limited market and credit risk.

EMU increased the attractiveness of diversifying reserves from dollars into euros by creating the second largest government securities market in the world. However, there are certain advatages that Dollar has over Euro, which are discussed as under:

• US Treasury market that makes it a relatively more attractive destination for reserves is the large bill market. The short-term segment of the US Treasury market is much larger than its euro equivalent, mainly owing to the limited issuance of treasury bills in the euro area.
• The other advantage is in terms of homogeneity and high credit quality of the US Treasury market. There is one issuer, rated AAA. On the other hand, 12 different issuers participate in the euro government securities market. Furthermore, several euro area governments are rated below AAA, and so the average rating of outstanding euro government securities is AA1.
• The most important advantage the US Treasury market has over its euro or yen equivalents is its tremendous liquidity. The daily turnover of US Treasuries greatly exceeds that of any other instrument. While turnover is not synonymous with market liquidity, it can be indicative of the depth of the market, i.e. the size of the order flow that the market can accommodate without moving prices (CGFS, 2000)

Hence we can safely assume that the US dollar retains several advantages over the euro as a medium of exchange. The US dollar is more widely traded in foreign exchange markets, and dollar government securities and repo markets are more liquid than their euro counterparts. This supports the continued pre-eminence of the US dollar as a reserve currency. Therefore,  for intervention purposes the euro is an increasingly attractive alternative to holding dollars.

Role As Unit Of Account

Broadly the Unit of account characteristic of reserve currency fall in two broad categories:

• In private use this role is linked to the currency of choice for invoicing.
• In official use it is linked to the choice of an exchange rate as a monetary anchor.

This role heavily depends on the direction of trade among the countries and relative stability of the macroeconomic policies of the host country which owns the currency. In summary, evidence from exchange rate co-movements suggests that the euro plays an increasingly important gravitational role. Ceteris paribus, this would tend to boost the euro’s share of global reserves over time. The US dollar, however, is still the most important currency along this dimension. Since 2002, the US dollar has depreciated against many currencies, and so the higher co-movement of currencies with the euro may reflect temporary dollar weakness rather than a long-term increase in the euro’s influence.

ROLE AS A STORE OF VALUE

For this role of a reserve currency it is important for the reserve managers to choose a currency which has a rather reliable future in terms of its future purchasing power. Hence, this aspect mostly relies upon the future prospects of a country. The store of value aspect of reserve currency is directly related to the investment policies of the governing authority as well as the level of development of financial instruments available for investments in that currency for gaining exposure to, or hedging, these risks.

CONCLUSIONS

The main theme of this paper was to investigate how the euro’s role in international financial markets has influenced the use of euro-denominated assets as official reserves. The introduction of the euro in 1999 as a single currency for multiple countries, which were highly developed and extensively involved in trade, resulted in extensive debate in academia as well as professional circles regarding future role of Euro and fate of Dollar.  With extensive development of euro financial markets, there is a view that Dollar might lose its position as a dominant reserve currency at global level. Nevertheless, in terms of size, credit quality and liquidity, dollar financial markets still have an edge over euro markets. This is the main reason why Euro is currently not in a position to compete with Dollar in the international market.

 Author: Zarmeen Mushtaq , Sofia Khurrum