The Dollar’s Future as the World’s Reserve Currency: The Challenge of the Euro

The Dollar's Future as the World's Reserve Currency:The Challenge of the Euro SummaryGlobally, central bank holdings of reserve currency assets have risen sharply in recent years.These "official holdings" have nearly tripled since 1999 to reach $5 trillion by the end of 2006.Nearly $3 trillion has been amassed by developing Asia and Japan.China, in particular, now has official reserves that exceed $1 trillion.In addition, the oil-exporting countries have increased their official reserves by about $700 billion.The dollar's status as the dominant international currency has meant that as much 70% of this large accumulation of official reserves are of some form of dollar asset.There are significant advantages for the United States in having the dominant reserve currency.These advantages include reduced exchange rate risk and lower borrowing costs.However, these large accumulations of dollar assets in foreign official holdings also means that foreign central banks have become important participants in and influences on U.S. financial markets and the wider U.S. economy.Four factors -share of world output and trade, macroeconomic stability, degree of financial market development, and network externalities -combine to influence the choice of a reserve currency.The euro has improved its standing in all four areas but the dollar retains significant advantages.Available data show only modest diversification from dollar assets by foreign central banks from the time of the euro's introduction in 1999 through the end of 2006.The dollar's share of total official reserves rose through the 1990s, reaching a peak value of about 72% global reserves in 2001.By 2003 that share fell to about 66% and remained near that level through 2006.The euro's share of global official reserves rose from about 18% in 1999 to 25% in 2003, but has remained near this level through 2006.Looking to the future, the dollar's status as the dominant reserve currency may be challenged by the euro because it increasingly offers many of the advantages of the dollar but fewer of the risks.The dollar's most important advantage is the size, quality, and stability of dollar asset markets, particularly the short-term government securities market where central banks tend to be most active.The high liquidity of these financial markets makes the dollar an excellent medium of exchange.A further advantage is the power of "incumbency" conferred by the "network-externalities" that accrue to the currency that is dominant.Together these factors make it unlikely there will be a large or abrupt change in the dollar's reserve currency status.However, the euro is seen by some as poised to challenge the dollar in the store of value function of a reserve currency.The sheer magnitude of dollar assets in the official reserves of foreign central banks and the realistic prospect of continued, and perhaps disorderly, depreciation of the dollar against most currencies, place central banks at considerable risk of incurring large capital losses on their dollar asset holding.With more than enough dollar reserves to meet liquidity needs, prudent asset management would seem to dictate some diversification away from the dollar and toward the euro.This report will be updated as events warrant.