Dollar’s reign as reserve currency will stay

When the euro was first introduced in 1995, US economists Jeffrey Frankel and Menzie Chin predicted that the new currency of the European bloc could overtake the US dollar as the dominant international currency by 2022. Following the financial crisis of 2008, they reduced their timeline to 2018 and suggested that the euro could take over from the dollar as early as 2015. Yet here we are in 2022 and the dollar is nowhere close to being dethroned as the world’s reserve currency.

So, the dream of the euro taking over as the global reserve currency has been a long-held dream, supported by various economists over the years. So much so that the erstwhile chairman of the US Federal Reserve, Alan Greenspan, had commented in 2007 that “it is absolutely conceivable that the euro will replace the dollar as the reserve currency, or will be traded as an equally important reserve currency.”

Reign of the dollar

The dollar began its rise as the world’s leading currency right after World War I. But it was officially recognised as the dominant currency by the Bretton Woods agreement of 1944. The gold standard was abandoned and central banks across the world pegged their currencies to the greenback. Since then, the dollar has been the most widely used currency for international transactions and trade. As of May 2021, over 61 per cent of all foreign bank reserves are in dollars, along with almost 40 per cent of the global debt.

In addition, as of 2021, the dollar is used in close to 80 per cent of all cross-border financial transactions. Most goods and commodities, including agricultural goods, copper, oil, etc., are traded in dollars. According to the International Monetary Fund’s report for Q1 2021, the dollar’s share of currency reserves had risen to 59.5 per cent, from 58.9 per cent in Q4 2020. On the other hand, reserves held in euros had declined 4.4 per cent, on a quarter-on-quarter basis. The euro accounted for 20.6 per cent of the currency reserves of central banks across the world in Q1 2021, down from 21.3 per cent in Q4 2020.

The only cloud hovering over the greenback is the pandemic-led weakness that it has been facing since 2020. This downward pressure came against the backdrop of the then US President, Donald Trump’s isolationist policies and the US-China trade tensions, which were already weighing on the dollar.

But this weakness hasn’t been a cause of worry for the world’s reserve currency losing its dominance. Countries that have pegged their currencies to the dollar have been growing steadily, especially the Middle East, offsetting any threat posed by either the pandemic or the decline in oil prices. Also, despite its weakness, the dollar has actually appreciated 17 per cent against the euro from 2010 to 2020.

Once all the current uncertainties have been resolved, the dollar will once again regain its strength.

What about the euro?

In his last State of the Union speech in 2018 as the president of the European Commission, Jean-Claude Junker had promised to “strengthen the international role of the euro.” But the dominance of the US dollar, both in terms of international trade and currency reserves, comes from certain features of the US financial system that most governments in the EU are unwilling to emulate. Of course, the euro does have its share of strengths, being the closest rival to the greenback, among all the world’s currencies.

The European currency is now used in about 33 per cent of all cross-border transactions, second only to the dollar. The EU bloc constitutes almost 50 per cent of all global trade, with its economy tied with China as the second-largest in the world, at about $13 trillion. The euro is also the second most commonly held foreign reserve by central banks, with the Eurozone accounting for the third-largest sovereign debt market.

Unfortunately, the euro hasn’t quite recovered from its “near-death experience”, when both Greece and Italy came frighteningly close to existing the currency during 2011-2013, rather than accept the austerity measures associated with the bailout packages for their economies. This underlined an inherent limitation with the currency — the lack of a common fiscal policy among the member states.

There also are huge differences between the nations in terms of the state of their economy. Unless there is a solution to all this disparity, the dollar will remain the most credible currency for the world markets.

Another reason for the lower appeal of the euro is the perception that the weaker economic performance of the EU nations is due to a lack of innovation but a lot of red tape. The bloc is known to only take crucial steps when it is on the brink of disaster.

The Covid-19 pandemic might have given a lethal blow to the euro’s aspirations of replacing the dollar. It exposed the weaknesses of the Eurozone, while reaffirming the role of the US as the global rescuer for monetary problems. In March 2020, when the coronavirus was declared as a global pandemic by the WHO, investors rushed out of illiquid assets and moved to the dollar. While the stock markets crashed worldwide, safe-haven assets like the dollar and gold gathered momentum.

On the other hand, the euro steadily lost favour in the forex and currency derivatives markets and lagged the dollar in international borrowing. Data released by SWIFT revealed that the European currency accounted for only 31 per cent of all global payments in 2020, a significant decline from the over 40 per cent in 2012.

For the euro to be a viable alternative to the dollar, major steps need to be taken by the euro region to raise the credibility of the European currency. For now, the dollar will continue to remain primus inter pares of the currency world.

The writer is Deputy Head of Retail Research, HDFC Securities

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