Can euro replace dollar as world’s dominant currency?
Reuters/ London
Should European countries want the euro to replace the dollar as the world’s dominant reserve currency, the Sino-US trade war may offer a window of opportunity.
The souring of ties between the world’s two largest economies will indicate the extent to which China can switch some of its giant reserve holdings to another hard currency and also point to the limitations the eurozone faces in providing a viable alternative.
In the post-World War Two era, no asset has ever fully matched US government bonds for size, liquidity and credit quality.
It is the closest any global security has come to being perceived as a cash-like, risk-free asset with over $16tn worth of paper in circulation.
Yet, a year into a bitter tariff war, there are some signs of Beijing’s discomfort at being both the United States’ biggest trade adversary and one of its biggest creditors.
Recent data showed China sold more US Treasuries in March than it has in any month over the past 2-1/2 years.
If that proves to be more than a one-month quirk, speculation will rise about where it is diverting those reserves, and the eurozone — the world’s biggest trading bloc — tops the list of likely spots.
On size alone, eurozone government bonds appear to provide a credible landing pad: outstanding securities are almost two-thirds of the overall Treasury market.
There are signs already of greater Chinese interest in Europe — bankers attribute record Asian demand for recent Spanish, French and Belgian debt sales to Beijing.
And China has stepped up buying debt from Europe’s quasi-sovereign entities, bankers told Reuters, in particular the European Stability Mechanism (ESM) a eurozone-guaranteed AAA/A1-rated bailout fund.
Asian investors snapped up 33% of the ESM’s recent 2bn-euro 10-year bond, data from International Financing Review shows.
Asian takeup for ESM’s euro issues last year was 4%-5%. But for Chinese reserve managers to shift hundreds of billions of dollars from Treasuries to Europe’s single currency, the euro bloc needs to address key shortcomings.
“I find it hard to square the circle how such a huge Treasury holding can be diversified away, given the landscape we are in,” said Salman Ahmed, chief investment strategist at Lombard Odier Investment Managers.
“In the eurozone there is not a big risk-free market…Twenty years down the line it may be different.”
For Ahmed, the main issue is that credit risk in the bloc is not uniform.
The 19 members each run their own fiscal policies, budget rules are too loosely policed to ensure adherence, and euro exit remains a theoretical possibility.
So wealthier members such as Germany remain net savers that run balanced budgets or even surpluses, while others, mostly in southern Europe, are dogged by high debt.
The resulting mix of credit and political risks make it harder to see the aggregate eurozone bond market as a true mirror of the US Treasury universe.
Ross Hutchison, a fund manager at Aberdeen Standard Investments, says it boils down to the fact the United States “has a federal nature that the euro area hasn’t got yet”. Additionally, distortions stemming from years of bond buying stimulus by the European Central Bank mean available euro government bonds are far fewer than may appear.
While euro government debt outstanding is around $9.5tn, the ECB is estimated to hold roughly a quarter.
And the kind of “safe” securities that reserve managers seek are even scarcer — AAA-rated debt from Germany, the Netherlands and Luxembourg totals around $2.5tn, less if ECB holdings are discounted.
Debt from slightly lower-rated France, Belgium and Austria would add another $3tn.
Italy on the other hand has the bloc’s biggest government bond market, worth $2.3tn.
But its poor debt-to-GDP ratio, sluggish economy and populist policies make its bonds riskier and its credit rating is a notch or two above junk.
So in times of stress, investors clamour for German bonds, while in Italy, yields spike, threatening to undermine local banks that hold these securities.
Italian 10-year yields are at 2.5%, versus Germany’s minus 0.22%. Such risks have chipped away at the euro’s fortunes as a reserve currency — International Monetary Fund data shows it comprises 20% of global central bank holdings, from 26% in 2009.
The decline is linked to the 2011 Greek debt crisis that then ravaged Spain, Italy, Portugal and Ireland, highlighting risks of default by a member state and redenomination of euro debt into a new currency.
European officials are keen to counter the dollar’s hegemony, and at a conference last month they debated ways to win the euro a “stronger international role”. But they made no mention of the one measure that could resolve the issue at a stroke — joint debt issuance via common eurozone bonds.
Such securities would pool the bloc’s risks, and offer safer securities than those from most individual nations.
Olli Rehn, Bank of Finland governor and an ECB governing council member, said last week a safe asset would help enhance the euro’s international role, offering hope the issue will be on the agenda of the new European Commission later this year.
A common bond “would be more significant than the creation of another TLTRO in boosting demand for euros globally and reserve managers would be part of that story,” said David Owen, chief European economist at Jefferies.
He was referring to the ECB’s cheap multi-year loans.
“Maybe there will be more focus on pushing forward this agenda and taking advantage of the US and China having this trade spat,” Owen added.
Others, however, note that wealthier states oppose any common bond programme, fearing they will end up footing the bill.
Also, across Europe populist and anti-establishment movements are on the rise, with the agenda of slowing integration and returning power to national capitals.
Such groups grabbed a greater share of the vote in EU parliamentary elections last month, albeit less than expected.
“If anything, the trend is towards decentralisation of power,” Ahmed said.
NEW YORK – This month marks the 75th anniversary of the signing of the Bretton Woods agreement, which established the International Monetary Fund and the World Bank. For the IMF, it also marks the start of the process of selecting a new managing director to succeed Christine Lagarde, who has resigned following her nomination to be European Central Bank president. There is no better moment to reconsider the IMF’s global role.
The most positive role that the IMF has played throughout its history has been to provide crucial financial support to countries during balance-of-payments crises. But the conditionality attached to that support has often been controversial. In particular, the policies that the IMF demanded of Latin American countries in the 1980s and in Eastern Europe and East Asia in the 1990s saddled the Fund’s programs with a stigma that triggers adverse reactions to this day.
It can be argued that the recessionary effects of IMF programs are less harmful than adjustments under the pre-Bretton Woods gold standard. Nonetheless, the IMF’s next managing director should oversee the continued review and streamlining of conditionality, as occurred in 2002 and 2009.
The IMF has made another valuable contribution by helping to strengthen global macroeconomic cooperation. This has proved particularly important during periods of turmoil, including in the 1970s, following the abandonment of the Bretton Woods fixed-exchange-rate system, and in 2007-2009, during the global financial crisis. (The IMF also led the gold-demonetization process in the 1970s and 1980s.)
But, increasingly, the IMF has been relegated to a secondary role in macroeconomic cooperation, which has tended to be led by ad hoc groupings of major economies – the G10, the G7, and, more recently, the G20 – even as the Fund has provided indispensable support, including analyses of global macro conditions. The IMF, not just the “Gs,” should serve as a leading forum for international coordination of macroeconomic policies.
At the same time, the IMF should promote the creation of new mechanisms for monetary cooperation, including regional and inter-regional reserve funds. In fact, the IMF of the future should be the hub of a network of such funds. Such a network would underpin the “global financial safety net” that has increasingly featured in discussions of international monetary issues.
The IMF should also be credited for its prudent handling of international capital flows. The Bretton Woods agreement committed countries gradually to reduce controls on trade and other current-account payments, but not on capital flows. An attempt to force countries to liberalize their capital accounts was defeated in 1997. And, since the global financial crisis, the IMF has recommended the use of some capital-account regulations as a “macroprudential” tool to manage external-financing booms and busts.
Yet some IMF initiatives, though important, have not had the impact they should have had. Consider Special Drawing Rights, the only truly global currency, which was created in 1969. Although SDR allocations have played an important role in creating liquidity and supplementing member countries’ official reserves during major crises, including in 2009, the instrument has remained underused.
The IMF should rely on SDRs more actively, especially in terms of its own lending programs, treating unused SDRs as “deposits” that can be used to finance loans to countries. This would be particularly important when there is a significant increase in demand for its resources during crises, because it would effectively enable the IMF to “print money,” much like central banks do during crises, but at the international level.
This should be matched by the creation of new lending instruments – a process that ought to build on the reforms that were adopted in the wake of the global financial crisis. As IMF staff have proposed – and as the G20 Eminent Persons Group on Global Financial Governance recommended last year – the Fund should establish a currency-swap arrangement for short-term lending during crises. Central banks from developed countries often enter into bilateral swap arrangements, but these arrangements generally marginalize emerging and developing economies.
Then there are the IMF initiatives that have failed altogether. Notably, in 2001-2003, attempts to agree on a sovereign debt-workout mechanism collapsed, due to opposition from the United States and some major emerging economies.
To be sure, the IMF has made important contributions with regard to sovereign debt crises, offering regular analysis of the capacity of countries in crisis to repay, and advising them to restructure debt that is unsustainable. But a debt-workout mechanism is still needed, and should be put back on the agenda.
Finally, the IMF needs ambitious governance reforms. Most important, building on reforms that were approved in 2010, but went into effect only in 2016, the Fund should ensure that quotas and voting power better reflect the growing influence of emerging and developing economies. To this end, the IMF must end its practice of appointing only European managing directors, just as the World Bank must start considering non-US citizens to be its president.
Lagarde’s departure represents a golden opportunity to put the IMF on the path toward a more effective and inclusive future. Seizing it means more than welcoming a new face at the top.