The Euro alternative?

The Euro currently accounts for about 10 percent of international global reserves and is probably considered (by monetary authorities wishing to diversify their reserve holdings) the most attractive alternative to the dollar.

The ultimate source of strength of any currency is the economy supporting that currency, and the sluggish performance of the Eurozone economies in 2004 and 2005 raise serious doubts about the willingness of global monetary authorities to enlarge their Euro reserve holdings.

In 2004 the 12 Eurozone economies experienced average economic growth of only 2 percent. A similar or slightly stronger growth performance was anticipated this year but in early April, European officials lowered their estimate of average real GDP growth this year to 1.6 percent. Even this modest growth objective may not be achieved if the European Central Bank decides to react to accelerating money supply growth and potential inflationary pressures by raising the refinancing rate from a two year low of 2 percent this fall.

The future of the Euro as a reserve currency could also be significantly influenced by a critical late-May referendum in France on a new constitution for the European Union. Public opinion polls suggest French voters might reject the new constitution, which clearly would undermine the Euro and possibly jeopardize the future political stability of the EU.

Diversification is the traditional response to financial risks associated with any portfolio of assets, so it would not be surprising if global monetary authorities diversify their existing reserve holdings to compensate for the risks associated with a three-year dollar downtrend. The critical questions for future dollar stability are the scope of diversification programs and how quickly they are implemented.

Given questionable growth prospectsin Europe and Japan and the lack of attractive non-dollar investments, reserve diversification by global monetary authorities will likely proceed at a gradual pace, and annual shrinkage in the percentage of dollar assets in central bank reserves should decline by only one or two percent over the next several years. Central banks will not sell their existing dollar assets but will purchase additional Treasuries at a slower pace.

Within the next five years, it would not be surprising to see the percentage of dollars held by monetary authorities decline by 4 or 5 percent to slightly less than 60 percent of total reserves. Prudent monetary authorities may gradually add Euros to their reserves, but it is unlikely central banks will aggressively build up their holdings of Euros unless European politicians are willing to undertake unpopular structural reforms designed to improve the growth performances of the major European economies.

The American dollar no longer enjoys the widespread confidence and appeal it possessed in the immediate postwar period but that doesn’t mean that global traders, investors, or central bankers are ready to dethrone the greenback as the pre-eminent international currency.

The Euro seems destined to play a greater role in the global financial system, but recent economic and political problems within the Eurozone suggest it may be some time before the Euro gains widespread acceptance and wins the confidence of the global community.

Recent dollar weakness is undoubtedly a concern to central bankers but the greenback is not necessarily experiencing a major crisis of confidence at the present time — especially given the largely unanticipated strength of the dollar so far this year.

Bearish dollar sentiment recently dissipated as the greenback edged upward against the Euro and the yen, prompting some currency analysts to speculate the dollar is bottoming out after a three-year downslide and may be poised to trend upward. However, a sustained dollar upturn seems unlikely as long as U.S. trade deficits continue to widen. Traders and investors have temporarily shifted their attention to the supportive benefits of U.S. rate increases, but in the mediumterm, dollar selling pressures will likely resume, especially if Fed policy shifts from a restrictive to a neutral posture as the pace of U.S. economic expansion slackens. As in 2004, the dollar will likely slump in the closing months of 2005, dropping 3 to 5 percent on a trade-weighted basis.