The dominance of the dollar as an international currency is a source of US political power. Should US foreign policy put a greater emphasis on national security in light of intensifying Sino-US geostrategic competition, the EU is likely to sustain collateral damage (DGAP 2021 forthcoming). Aside from less cooperative trade, investment and technology policies, the US is bound to “weaponise” the dollar more extensively than in the past.
Often ‘reserve currency’ and ‘international currency’ are used interchangeably. Strictly speaking, a reserve currency is a currency which central bank foreign reserve assets are denominated in. ‘International currency’ is a more multi-faceted concept that includes other dimensions related to the various functions of money. Specifically, the private sector relies on an international currency with respect to international trade and financial transactions (medium of exchange), trade invoicing (unit of account) and investment (store of value). The public sector (aka central bank) relies on it for FX intervention (medium of exchange), FX pegs (unit of account) and reserve holdings (store of value) (Krugman 1991 quoted in European Parliament).
How does the euro compare to the dollar? The dollar remains the dominant international currency with respect to most of these dimensions. For central banks, the dollar remains far more important than the euro (FX pegs, FX reserves, foreign holdings of government debt). For the private sector, this is true, too, even if the euro plays a bigger role in terms of trade invoicing. Otherwise, the dollar is clearly dominant (FX market turnover, cross-border lending). If the dollar punches way above its weight given the smaller share of US trade, this is is due to the fact that global commodity trade is largely denominated in dollars. Aside from trade, the dollar dominates the field by a significant margin. A currency’s share in global central bank reserve holdings is single best proxy measure of an international currency’s importance. The dollar share amounts to more than 60%, or three times the euro share.
| FX market turnover (USD tr) | Government debt (USD tr) | Bank cross-border claims (USD tr) | Bank credit to private non-financial sector (USD tr) | Non-resident holdings of government debt (USD tr) | Trade share (% of global) | Trade invoicing (% of global) | FX anchor (number) | FX reserves (% of total) *** |
USD | 5.8 | 21.4 | 14.8 | 10.9 | 6.8 | 10 | 39* | 38 | 60.5 |
EUR | 2.1 | 18.3 | 9.8* | 11.9* | 1.2** | 37 | 48 | 25 | 20.5 |
CNY | 0.3 | 14.3 | < 5 | 23.4 | 0.7 |
|
| none | 2.1 |
JPY | 1.1 | 5.1 | 2 | 5.7 | 1.5 |
|
| none | 5.9 |
GBP | 0.8 | 2.8 | < 5 | 2.4 | 0.9 |
|
| none*** | 4.5 |
Source: BIS Triennial Central Bank Survey (2019), BIS Debt Securities Statistics, BIS Consolidated Banking Statistics, IMF 2020, IMF Annual Report on Exchange rate arrangements and exchange restrictions, IMF COFER (% of allocated reserves), National authorities * incl intra-euro area lending; ** Germany as proxy for euro area, *** not counting dependencies, **** best overall proxy for international currency dominance
The dominant international role of the dollar provides the US with leverage vis-à-vis countries that rely extensively on the dollar for international trade and financial transactions as well as for holding international financial assets. The US can prohibit US residents from engaging in (dollar-based) financial transactions with designated non-residents (primary sanctions). More importantly, the US can prohibit US residents from dealing with third party entities that engage in (dollar-based) transactions with the designated non-residents (secondary sanctions). (This prevents third parties from acting as so-called third-party spoilers and from undermining the effectiveness of the sanction measures.) Secondary sanctions effectively prevent designated entities from using the dollar, as internationally active foreign banks cannot afford to be barred from accessing the US financial system, including access to dollar clearing. The dollar is therefore a source of asymmetric vulnerability, including between the US and the EU, as targeted entities, including countries, stand to lose more from not being able to use the dollar than the US loses from these entities not using the dollar. Moreover, given the greater importance of the dollar, being barred from using the dollar is more costly to European entities than it is for US entities being barred from using the euro. Strategies to mitigate asymmetric vulnerability include autonomy, diversification and symmetry (DGAP 2021 forthcoming).
Reserve currency diversification is not a viable strategic option in the short- to medium-term. There simply is no alternative to the dollar given the dominant role it plays in the international economy. In spite of Beijing’s internationalization efforts, the renminbi will not be a rivalling the dollar as long as China is not prepared to more fully open its capital account, modernise its financial markets and improve governance (Jaeger 2010). As the third-largest international currency, the Japanese yen accounts for a mere 5% of global reserve holdings and does not offer an alternative to the dollar. Autonomy is not a realistic option as long as the dollar continues to play a dominant role in the international economy and the euro share remains relatively small, especially with respect to its role in financial transactions. Creating greater symmetry is therefore the only viable medium-term strategy and consists of proactively promoting the euro as an equal to the dollar. The more US relies on the euro and the more the euro becomes a substitute for the dollar for other countries, the more symmetrical (currency) interdependence between the US and Europe will become. Not only will greater symmetry limit the costs for Europeans in case of dollar weaponisation. It will also make using the dollar weapons both less effective and more costly for the US. Should the euro emerge as the dominant international currency in the long run, autonomy (aka not using the dollar) might become an option. But don’t hold your breath.
International/ reserve currency status is underpinned by a number of prerequisites (Cohen 2018).
(1) Economic size: For a currency to be used extensively by the foreign private and official sector, the issuing country needs to have a large economy and extensively engage in international trade and/ or finance. Economic size also matters because foreigners want to hold risk-free assets denominated in the reserve country’s currency. Only a large country can issue a sufficiently large amount of liabilities to meet foreign demand without suffering from a debt overhang and thereby undermining the currency.
(2) Financial development: A sophisticated and developed financial system is necessary in order to entice foreigners to transact in the currency and/ or hold financial assets denominated in it. At the very least, foreign central banks require safe (aka sovereign) assets of high creditworthiness and strong liquidity. The private sector is also more inclined to hold and transact in assets if financial markets are well developed and offer a range of investable assets.
(3) Closely related is the issue of predictability and stability (aka “effective governance”). This condition comprises issues such as political stability, property rights, rule of law as well as general economic stability. Foreigners are quite unlikely to hold a large share of their foreign assets in a country characterised by a high degree of political, financial and/ or economic risk (or where risks can be priced).
(4) Foreign policy ties. A country that has adversarial political relations with other countries will find it more difficult to get other countries to invest in it. An adversarial relationship with country A will make country B think twice before holding large amounts of assets that are the liability of country A (e.g. US-USSR during Cold War). The political risk of asset freezes and perhaps even debt repudiation would be too high, thereby reducing the attractiveness of the currency to country B in terms liquidity and solvency.
(5) Military reach. Military power provides foreign asset holders with assurance that the country will not be overrun militarily (and default on its liabilities). Sometimes military power can also be used to lean on other, typically friendly countries politically to support the reserve currency (e.g. Blessing letter).
How do the dollar, the euro, the yuan and other international reserve currencies compare in terms of these five pre-requisites? The US continues to have the largest economy and the largest capital markets. In terms of international trade, it is roughly comparable to both EU and China. While Chinese bond markets are not that much smaller than US market, the renminbi continues to suffer from restricted convertibility, limited liquidity and governance challenges. Euro area government bond markets are only about half the size of US markets – and even smaller if non-investment-grade debt is excluded. The data do not capture the level of development of financial markets. Not only is the US more attractive size-wise, but also in terms of market sophistication, development and liquidity, including tightness, immediacy, depth, breadth and resiliency (IMF 2020). Structurally speaking, however, both the renminbi and the euro do have a potential to become international currencies rivalling the dollar. As suggested, the Japanese yen does not. Neither does the British pound.
| Gross domestic product (USD tr) | International Trade (US tr) | Gov’t bonds (USD tr) | Corporate bonds (USD tr) | Market cap of listed domestic companies(USD tr) | Convertiblity | Governance (= stability, rule of law) | Military power & foreign policy ties |
US | 21.4 | 4.9 | 23.0 | 22.6 | 30.4 | High | High | High |
Euro Area | 18.3 | 5.4* | 10.2 | 9.9 | 5.6 | High | High | High |
China | 14.3 | 4.3 | 15.2 | 9.3 | 8.5 | Low | Medium | High |
Japan | 5.1 | 1.6 | 10 | 3.5 | 6.2 | High | High | High |
UK | 2.8 | 1.6 | 3.2 | 3.3 | 1.9 | High | High | High |
Source: WTO, BIS, IMF, World Bank, Bloomberg * EU-28, not EA-19 (excl. intra-EU)
The euro area largely meets the conditions that are necessary for the euro to become a dominant international currency. After all, it is already an important reserve currency. (3) Good governance, rule of law and respect of property rights are all in place and do not represent obstacles to further growth. (4) EU foreign policy ties may be somewhat weaker than those of the US. But its foreign policy ties are sufficiently strong so as not to represent an obstacle to the rise of the euro as international currency. (5) Similarly, the EU, let alone the euro area, is not a military power comparable to the US. But the EU is a militarily sufficiently strong actor to alleviate concerns about its geopolitical position and stability. To the extent that becoming the dominant reserve currency is akin to a reverse beauty pageant, strengthening Europe in some of these areas would nonetheless be helpful. The main obstacles, however, are to be found elsewhere.
(1) Promoting the use of the euro in international trade. The extent to which countries use a currency for international trade invoicing largely reflects an economy’s importance as a trading partner. The choice is typically between one’s own and the trading partner’s currency. (If two non-reserve-currency countries with one another, they will have to choose in what reserve currency to transact.) As for using the dollar or the euro, countries whose primary trade partner is the US will not switch to the euro. Central banks will not make dramatic changes to their currency preferences either, whether in terms currency pegs or reserve holdings – at least not on account of its use in international trade. Only increasing economic size and the euro area’s importance in international trade can help lend support. However, the main reason why the dollar seems to be more prominent in international trade is not due to the size of US trade but its role in commodity markets in dollar. Given network effects, it will be difficult to get economic agents to switch from dollars to euros. In order to do so, the euro needs to be made a more attractive currency more generally.
(2) Promoting the use of the euro in international finance. First of all, it is essential to create a large pool of safe and liquid assets. Euro-denominated government bond markets are too fragmented, a sizeable share is too lowly rated, liquidity is much lower than in the US bond market and investors may have residual concerns about the long-term stability of the euro area as a whole. This calls for completing monetary union and creating a pan-euro area government bond market backed by the full faith and credit of the euro area governments. It is difficult to see how this can be done without supra-national taxation powers. Completing monetary union would make it more attractive for foreign central banks to hold euro-denominated government bonds.
(3) Integrating euro capital markets. Creating a safe asset also helps lay the foundation for creating truly European financial markets. European capital markets are too fragmented. National regulation makes it more difficult and burdensome for euro-area banks, financial service firms and investors to operate in and prevents the scale, efficiency and diversification necessary to compete with US capital markets.
If the EU wants to lessen its asymmetric vulnerability vis-à-vis the US, it needs to complete monetary union and create a pan-European capital market. The euro area needs to create a safe asset of sufficient quantity and of sufficient liquidity. As the euro becomes a real substitute to the dollar, the US private sector and other foreign entities will face increasing incentives to hold and transact in euros. This would help transform what is today an asymmetrical interdependent relationship between the US and the EU into a more symmetrical one, thereby rendering the use of the dollar weapon more costly and less effective – whether it is used for primary or secondary sanctions purposes.
In terms of diversification, autonomy and symmetry, creating greater symmetry is also the least costly strategic choice if the goal is to reduce European asymmetric vulnerability. Symmetry typically allows to preserve the benefits of cooperation, while reducing the potential vulnerability risks associated with it (DGAP 2021 forthcoming). (Diversification is also often a cost-effective way to reduce asymmetric vulnerability, while autonomy typically carries often significant opportunity costs.) Nonetheless, issuing a reserve currency does carry potential costs, including an overvalued currency, potential debt overhang and policy responsibility. To the extent that the euro becomes a more prominent international currency, these costs may increase from today’s levels. But it also confers important potential benefits such as lower transaction costs, seigniorage, increased macroeconomic flexibility, and – crucially from the point of view of asymmetric interdependence – leverage due to non-residents relying on the reserve currency (Cooper 2009, Jaeger 2012, Jaeger 2013).
Unless the EU is prepared to foist the euro on other countries through political means, it will need to make the euro an attractive and effective substitute to the dollar in terms of store of value, denomination and medium of exchange. The euro area already meets good governance and political stability criteria. In order to promote the euro, it will need to create a truly risk-free assets and increase the attractiveness of euro financial markets. Once private sector increases its reliance on the euro, central banks are likely to adjust their reserve holdings in favour of the euro. To get there, the euro area/ EU needs to take very important and far-reaching decisions with respect to sovereignty, fiscal integration, banking and capital market union. How this can best be done is outside the scope of this Policy Brief.
International monetary regimes have historically been characterised by unipolarity or at least a clear-cut dominance by one currency – with the possible exception of the interwar period. The ‘multipolar’ character of the international monetary system is often blamed for its rapid demise (Kindleberger 1973) – though this is debatable. There is little theoretical reason to believe that a bi- or even tri-polar regime is necessarily unstable. They may be economically less efficient. However, by enhancing diversification and creating greater symmetry, such a system would also be more difficult to exploit by any one state.
Historically, Germany sought to prevent the deutschmark from becoming an international currency for fear of losing control over monetary policy and due to its potential impact on export competitiveness – and perhaps due to an intelllectual commitment to ordo-liberalism. Proactively promoting the euro would represent an important shift in attitude (Frankel 2012). Economically, the successful promotion of the euro as an international currency to a position co-equal with the dollar has economic costs and benefits. Politically, it would reduce the degree of asymmetric vulnerability vis-à-vis Washington and it would help insulate Europe somewhat in case Washington shifts towards a more extensive use of the dollar weapon. Promoting the euro as an international currency is the only realistic option to blunt, if not necessarily to neutralise the dollar weapon.