NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

The Impact of the Euro and Prospects for the Dollar

"In a 2005 survey of central banks, most respondents said they intended further diversification away from the dollar, and several have recently made public announcements along these lines."

Will the euro replace the dollar as the leading international currency? With two-thirds of all international reserves still held in U.S. currency, the challenge of the euro appears remote. Indeed, this was the widely held view when the euro was introduced less than a decade ago. But in Optimal Currency Shares in International Reserves: The Impact of the Euro and the Prospects for the Dollar (NBER Working Paper No. 12333), authors Elias Papaioannou, Richard Portes, and Gregorios Siourounis argue that the euro's rise to major international currency status may no longer be as implausible as many believe.

The euro's growing appeal comes from several factors: the euro zone is comparable to the U.S. economy in term of GDP and trade openness; the European Central Bank has kept inflation in check; the EU experiences nothing like America's current account deficit and external debt, which apply considerable pressures on the dollar. In a 2005 survey of central banks, most respondents said they intended further diversification away from the dollar, and several have recently made public announcements along these lines.

Papaioannou and his colleagues study the composition of central banks' foreign exchange reserves to learn how changes in the invoicing of financial and international trade transactions affect the composition of reserves. They find that the choice of reference currency, currency pegs, and the currencies of foreign exchange market intervention strongly influence the composition of reserves. All of this in turn may yield insights on other aspects of internationalization. Reserve growth in recent years has been dramatic, with emerging markets and developing countries tripling their reserves since 1998. In addition, rising prices for oil and other commodities have increased foreign reserves in fuel-exporting countries. These reserves come primarily from U.S. current account deficits. Even a limited shift out of dollar assets, the researchers say, could result in significant exchange rate movements - in particular, sizable dollar depreciation.

The analysts assess the impact of the euro on international reserve holdings via a dynamic mean-variance currency portfolio optimizer in a before-after event study framework. Making various assumptions about the returns to holding the five main international currencies (dollar, euro, Swiss franc, British pound, and Japanese yen), they obtain the optimal portfolio composition of central banks' foreign exchange reserves for the 11 years surrounding the introduction of the euro in 1999. They look at a theoretical "representative central bank" at the aggregate level and compare these estimated optimal shares with the actual aggregate shares reported by the International Monetary Fund. The results show an increase in the shares of both the dollar and the euro in recent years at the expense of other currencies, with the euro gradually becoming more important, especially in the developing world.

Among their findings, Papaioannou, Portes, and Siourounis report the following: the mean-variance optimization framework yields roughly equal allocations of the four main non-dollar currencies, and the optimal euro share is actually lower than what they observe. This suggests an increasing international role for the euro, which leads to higher reserve holdings in the European currency than optimal portfolios would show. So far, however, this increased internationalization comes primarily at the expense of the yen, Britain's pound sterling, and the Swiss franc rather than against the dollar.

In addition, in recent years the spreads on transactions in the euro have fallen sharply and have narrowed significantly for other industrial countries' currencies as well, thus making diversification away from the dollar more attractive. The researchers moreover augment the currency optimizer with constraints capturing the desire of central banks to hold sizable portions of their holdings in the currency of their external debt and in the trade invoicing currency. They perform some simulations for four emerging market countries (Brazil, Russia, India, and China) that have recently accumulated large foreign reserve assets and find larger weights for the euro than the aggregate estimate for the "representative central bank." This indicates that the euro's challenge to the dollar might occur sooner than imagined.

Finally, the authors find that the reference currency, or the choice of risk-free asset, is the chief determinant in the optimal composition of reserves in the mean-variance framework. But in practice, where there is a managed exchange rate regime, the reference currency is naturally the currency or currencies to which a country's own currency is pegged. This suggests a major challenge to the dollar if more countries move away from managing their exchange rates with respect to the dollar and adopt euro-based anchors or baskets in which the euro figures strongly.

The researchers' results also suggest, however, that a substantial increase in the euro's share of central bank reserves would require that more countries include the euro in their currency pegs (the composition of debt and trade having smaller effects than the choice of reference currency) and that the scope for active central bank management of their portfolios widen by permitting them to take short positions (which becomes increasingly important with the observed trend to increased co-movement of the major currencies).

-- Matt Nesvisky

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