Reserve currency status does not last forever. Euro/RMB: competing for second place?

2013 marked a return of investor confidence in euro area financial markets. Capital inflows to the euro area, a sharp reduction of yield on sovereign debt in peripheral countries, and the extended use of the single currency in central, eastern and southeastern Europe (CESEE), have created a certain optimism that the worst is over for the currency.  Yet, in the international arena, things are not going so well.  The euro’s share in global foreign exchange reserves decreased by around one percentage point in 2013.

According to the IMF, 61% of allocated foreign exchange reserve holdings are claimed in US dollars, a value equaling $11.9 trillion. The yen and pound each have about a 4% share.  The Australian and Canadian dollars both represent less than 2% of global holdings, and the euro’s share is about 24.5%, down from a record 28% in 2009.  In a Central Banking publication released on June 23rd, the euro lost 1% compared to a year earlier according to the 62% of banks surveyed.

Although the euro continued to occupy second position after the U.S. dollar in foreign exchange reserve portfolios, fresh data hints that foreign exchange managers have started branching out the euro to new entries like the Canadian and Australian dollars by less than 2%.  If the big chunk of unallocated foreign reserves is included (48%, around $10 trillion), these data seem to clearly detect an increase in risk perception among foreign reserve managers and a proactive attitude toward diversification policies, which seem to be primarily hitting the euro.  Market analysts have been pointing to euro-zone impasses as the cause; the area is still struggling with too much debt and too little growth. Worsening matters, geopolitical tensions between Russia and the West over Ukraine and other former Soviet satellites, and the situation in Iraq, are likely to predominantly affect European economies.  Energy supply shocks and expected rising energy prices could dry out households’ real disposable incomes and corporate profitability, with negative consequences for the region’s GDP growth.

The European election last may provoked political pressure for more flexible fiscal rules and more fiscal deficits, rendering it more difficult for the European Central Bank (ECB) to buy government bonds if some large member-states were relying on that to fund larger budget deficits.

However, the primary purpose of foreign exchange reserves is not to make a profit, but to protect national currencies against exchange rate fluctuations under certain circumstances.  The ECB’s unprecedented stimulus measures aimed at trimming the euro’s exchange rate to boost euro-area export performance and increase inflation to the 2% target are clearly set to backfire on the euro’s value, and on its relative position in foreign exchange reserves.

The ECB’s drastic interest rate cuts, overnight deposit charges, and liquidity programs implemented since early June to avoid deflation have made the 18-nation Euro less attractive.  Banks from JPMorgan Chase & Co. to Societè Generale SA predict that it will lose out to currencies such as South Korea’s won and the Australian dollar, favored for the higher yields paid by their bonds.  “Reserve managers are moving out of Europe into Asia” Sebastien Galy, a senior currency strategist at Societè Generale in New York said in a July 3rd phone interview with Bloomberg.  With unimpressive economic data and inflation continuing to fall, investors still expect more liquidity via purchases of asset-backed securities (ABS) and quantitative easing (QE).

The ECB, U.S. Fed and other developed countries’ central banks seem to be explicitly engaged in “competitive devaluation.”  New reserve currencies that allow investors to diversify risk – and create a system with more choice and better ability to resist shocks – should emerge.  The locus in quo for new reserve currencies will likely be Asia, the new center of global economic gravity.

In the wake of the 2008 financial crisis, Chinese authorities have implemented a flurry of policy initiatives to increase the international use of the RMB.  China’s central bank has established currency swap lines with foreign central banks, encouraged Chinese importers and exporters to settle their trade transactions in RMB, and rapidly expanded the ability of corporations to hold RMB deposits and issue bonds denominated in RMB in Hong Kong, the main offshore RMB market.

These developments have combined with public statements of concern on behalf of Chinese officials regarding the long-term value of the central bank’s large holdings of US Treasury securities and the role of the US dollar’s global dominance in the financial crisis to give rise to widespread speculation that China is ready to position the RMB as an alternative to the dollar.  Initially a trading currency that will eventually serve as a reserve currency, the increasing use of the RMB, China’s eco­nomic weight, and the large stock of foreign exchange transactions are set to reinforce the RMB’s global ambition. Although, that does not mean that the RMB will replace the dollar outright as the world’s only investment and reserve currency any time in the foreseeable future.

But, there is every indication that the RMB will dislodge the euro from its position as the second global reserve currency while continuing to play a regional role.  As the 2014 ECB’s Report details, sales of euro banknotes to regions outside the euro area increased mainly due to demand from Russia in 2013.  In value terms, net exports of euro banknotes to Russia doubled in 2013 compared to 2012.  A large share of euro banknote sales—nearly 50% of the total sales value—went to Switzerland and to the United Kingdom.  At the same time, backflows of euro banknotes (i.e. purchases from wholesale banks) stemmed mainly from EU Member States in Eastern Europe and from Turkey.

The euro’s fleeting second-place position in foreign exchanges markets is evidence that the international monetary system is changeable and ready to accommodate more than one major currency.  Due to its specific features, the euro is a natural candidate to play a regional role.

In the next 15 years, the RMB’s ascent and the consolidation of the Euro at a macro-regional level will intensify uphill currency competition in the international monetary system by opening new currencies to risk-diversification.  With the dollar’s weakening dominance, and a larger number of currencies competing to qualify as a value reserve, governments’ fiscal dominance will face more constraints from central banks, a major factor of financial stability that will affect families and businesses.