The euro is the second largest reserve currency, but so far the dollar still reigns supreme
By Andreas Charalambous and Omiros Pissarides
Since the end of World War II, the US dollar has played a leading role as the number one currency for commercial transactions, as well as the primary reserve currency.
In recent years, a number of factors led to a questioning of the dollar’s dominance. Some of these factors are of a more fundamental nature and relate to: (a) the unilateral exit by the US of the ‘gold standard’ since the early 1970s, and the end of the backing of the dollar by the world’s largest sovereign gold reserves held by the Federal Reserve, (b) Washington’s tendency to use its currency as an ‘’economic weapon’’ to exercise influence and power, and (c) the excessive US public debt, which may potentially drive the superpower into temporary default. Not coincidentally, Treasury Secretary Janet Yellen warned Congress that failure to raise the government debt ceiling could have negative consequences as early as June 1.
Other factors that have impacted the dollar concern general global trends and geopolitical developments. More specifically: (a) the rapid growth of other sizeable economies, especially China, (b) the reduction in the USA’s ability to exercise global influence through the notion of Pax Americana after a series of involvements in particularly costly conflicts that did not deliver the intended result (e.g. Iraq, Afghanistan), (c) the negative consequences of the Federal Reserve’s monetary policy for emerging economies in response to the 2008 financial crisis, (d) the strengthening of the common European edifice and the euro, and, finally, (e) the recent freeze of the Russian central bank’s assets after the conflict in Ukraine, which forced a number of central banks to reduce their reserves in the currencies of the sanctioning countries and, at the same time, increase their gold reserves .
The reality, however, is that, despite the aforementioned challenges, the dollar maintains its leading position. In particular, it remains the dominant reserve currency with the latest figures, as at the end of 2022, recording the dollar’s 58 per cent share on a global scale. The euro has contributed to the dollar’s reduction as the preferred reserve currency by about 10 per cent since the beginning of the 21st century, but the euro’s share of world reserve currencies stands only at 20 per cent. It is followed by the Japanese yen at 5.5 per cent, the British sterling at 5 per cent and the Chinese yuan with 2.7 per cent. In terms of trade, the dollar maintains an even more prominent position, with more than 70 per cent of the global trade (estimated at $32 trillion in 2022) transacted in dollars over the past 30 years.
The preference for the dollar arises from the generally accepted qualities of the currency and its dominant position both in the banking sector, through the international settlement system, and the global financial markets. Turning to the numbers, US capital markets have an average daily turnover of more than $1 trillion, an amount which, on a monthly basis, is roughly equal to the annual turnover of world trade. Also, the dollar benefits from the competitiveness of the US economy. It provides the coveted and essential liquidity for the sovereign bond market and is surrounded by the necessary institutional infrastructure that creates confidence in the purchase and custody of safe assets.
However, a number of countries, notably China, Russia and Brazil, but also other countries such as Iran, are making efforts to wean themselves off the dollar. China has been steadily reducing its investment in US Treasuries (its current holdings amount to almost $850 billion from $1 trillion in 2017), while some trades between countries are now conducted in yuan and, to a lesser extent, in Russian roubles. The motivations behind this trend differ from country to country: in the case of Russia, they are about circumventing sanctions; in the case of China they encompass the vision of exercising influence and achieving increased global economic power, while in the case of countries like Iran they also relate to more deeply entrenched nationalist motives.
These developments do not seem to have a significant impact on the dollar because, as mentioned above, it is surrounded by an advanced technological and appropriate legislative infrastructure that is required of a dominant currency. Moreover, currently there is no reliable competing currency. The issuance of digital currencies and the creation of a global digital standard by central banks could affect the hegemony of the dollar but, as of now, this prospect seems to be possible only in the long term.
As for the second largest reserve currency, the Eurozone is making efforts to consolidate the role of the euro as a strategic currency of international scope. However, there are still serious limiting factors, such as the stagnation regarding the completion of the banking union, mainly due to the non-adoption of a common system for the protection of bank deposits, the delay in promoting the integration of the capital markets, as well as the lack of sufficient liquidity in the European sovereign bond market. The intended strengthening of the role of the euro presupposes a consensus for serious reforms and does not seem, at present, to threaten the dominance of the US dollar.
Andreas Charalambous and Omiros Pissarides are economists.