Will the euro break the dollar’s hegemony?

The hegemony of a currency could be the outcome of a multitude of factors — international monetary system, political muscle of the country issuing the currency, collective faith in a currency (or, what the former US Fed Chairman Ben Bernanke termed as “network externality”) and above all, the baggage of history.

In this context, the emergence of the Euro as the official currency of 19 of the 27 member states of the European Union in 1999 generated great expectations that finally a currency has come that can challenge the hegemony of the US dollar.

Despite the initial exuberance and favourable outcomes, first, the global financial crisis and then the euro area crisis threw sand in the wheels of progress of the Euro. In particular, as ECB President Christine Lagarde commented in a recent article of June 2021, while “the euro’s share in outstanding international loans, in the stock of international debt securities and as an invoicing currency for extra-euro area imports of goods remained broadly stable”, its share in global foreign exchange reserves and in foreign currency-denominated debt issuance declined.

The changing tide

In this context, a silent reversal is getting unfolded in recent times. The latest NextGenerationEU (NGEU) Stimulus programme is perhaps energising Euro and helping it come out of the earlier impasse.

What is the NGEU Programme? As elsewhere in the world, in euro area too, there has been a substantial stimulus to counter the recessionary problems due to the pandemic. The EU’s official description of the programme is somewhat dramatic as it goes on to say, “It is a once in a lifetime chance to emerge stronger from the pandemic, transform our economies, create opportunities and jobs for the Europe where we want to live …. We have the vision, we have the plan, and we have agreed to invest together €806.9 billion”.

On June 15, 2021, the EU issued the first tranche of bonds, about €100-billion-worth of 10-year debt, under the NGEU programme. These bonds are unique because, unlike national bonds, they are backed by all the countries of the EU, which makes them a safe asset with minimal credit risk. The volume of the programme is reflected in a sizeable initial bond issue and reportedly received orders from more than 600 investors globally. But what is more interesting is that the exuberance in buying the bond also have longer-term positive implications for the Euro's role as a safe asset.

But, why is it so? First, while the NGEU programme is introduced as a temporary facility, with a mandate to raise funds up to 2026, given its sheer size, it is widely expected to lay the foundations of a deep, liquid and continuous safe asset for the Euro.

Second, 6-monthly communication on the funding plan’s key parameters is expected to offer transparency and predictability to investors. Third, the multiplicity of funding instruments (medium- and long-term bonds, green bonds, and EU-Bills) could maintain the flexibility of the market. Finally, a combination of auctions and syndications is expected to ensure cost-efficient access to the bond market.

The net effect of this introduction of highly-rated euro bonds is that it can lead to a shift towards more EU-denominated assets among global investors, especially among the official foreign exchange reserve managers. Generally, there is a strong dollar bias among the holders of foreign exchange reserves, and according to data of December 2020, close to 59 per cent of global forex reserves are held in US dollars. The share of the Euro is around 21 per cent for the same period.

This overwhelming dominance of the US dollar is mainly due to the safety and liquidity provided by the US Treasury Bonds. If the global forex managers perceive these Euro bonds to be as safe and liquid as the US Treasury Bills, then there is a strong case for more diversification of funds towards these Euro denominated assets. There can be two broad reasons behind this.

Two factors

First, the low level of interest rates in developed countries is a significant concern for these fund managers, and the depreciating US dollar is further eroding the value of the foreign exchange reserves held in US dollar-denominated assets. While the yield of the Euro bonds is also low, but the Euro is proving to be a more resilient currency than the US dollar in the present context.

Secondly, the ongoing state of the US foreign political and economic policies could have made some of the global portfolio managers diversify risk by allocating some funds away from the dollar-denominated assets. The new Euro bonds look like a good candidate for such diversification.

The global financial system is possibly at the cusp of a major change. Many central banks are contemplating moves to introduce central bank digital currency (CBDC). It is widely perceived that the introduction and more widespread adoption of CBDC may change the notion of the standard currency in the years to come.

This innovation may alter the age-old idea of a single dominant standard currency in international finance and may pave the way for multiple standard currencies. In the days to come, the EU, as the second most important currency in the global financial system, will possibly have a more important role to play. The new Euro bonds may act as a catalyst for this transition.

Ray is the Director of National Institute of Bank Management Pune, and Pal is a Professor at IIM Calcutta

COMMENT NOW