Dollar dominance: Can the euro compete as a reserve currency?
17:03, 14 June 2022
Two years after the European Monetary Union was established in 1993, two economists, Jeffrey Frankel and Menzie Chin, predicted the euro would surpass the dollar as the world's main reserve currency by 2022.
Things did not turn out as the two economists predicted – the euro appears to be long off the mark.
The US dollar has been the dominant global reserve currency following World War II, with its preeminence essentially stable for the past 20 years.
As of the end of 2021, around 60% of all central bank reserves are in dollars, while just 20% are in euros, and the US dollar remains the dominant currency in international business, accounting for 80% of all cross-border financial transactions.
What conditions, then, may cause the dollar to cede its status as the world's reserve currency to other currencies, such as the euro or the Chinese renminbi?
Global reserve currency – four most important characteristics
The qualities of a world reserve currency are defined by four criteria laid out in a study by the Bank for International Settlements (BIS).1
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- High share in world output and trade: The higher a country's weight in the economy and international trade, the more its currency is used as a mean of exchange and store of value.
- Macroeconomic stability: The expansion and preservation of a currency's global reserve status require price stability and economic growth. A currency's ability to serve as both a unit of account and a store of value relies heavily on public trust in the currency's value.
- Financial market development: Foreign exchange market size and liquidity are extremely critical in preserving a currency's international position. When financial markets are large and liquid, the currency is widely used by other countries to engage reserve management activities.
- Network externalities: When there are lower transaction costs, then a currency is more often used as a medium of exchange around the world. This also makes the currency more appealing to people who aren't already using it, expanding its global presence.
What factors contribute to the dollar dominance as reserve currency today?
In an exclusive interview with Capital.com, former global Wall Street strategist David Woo, currently CEO of Davidwoounbound, talked about these characteristics in a film on the possibility of a US dollar crash and what it would mean to the world.
According to Woo, the dollar's international dominance depends on a few key factors:
- Geography: The United States is a continent unto itself, with few disputes with neighbours, and this already gives the US dollar an competitive edge.
- Resource rich: The United States is the world's largest producer of crude oil, and it is also extremely rich in agricultural resources.
- Trust: People have faith in the United States, and no one is concerned that the US government will default.
- External attractiveness of US assets: People all around the world find the US dollar and US assets extremely attractive. Capital inflows enable the United States to maintain a trade imbalance and continue to invest for future economic growth.
- Technological leadership: The dollar's biggest strength is the United States' supremacy in the technology industry. The US stock market (S&P 500) has vastly outperformed the worldwide stock market over the last decade, thanks to the spectacular performance of US tech stocks (US Tech 100).
What could cause the dollar to crash?
The US technological dominance is both the major strength and the potential Achilles heel that might threaten the greenback's global hegemony, according to Woo.
Woo contends that in order to challenge the dollar's global currency status, China must threaten US technological superiority. If China and Russia join together and pool their skill, size, and technology, they may form a formidable team, according to the analyst.
Nonetheless, in the medium term Woo believes that King Dollar will reign supreme thanks to its technological edge.
1. Galati, Gabriele, and Philip Wooldridge. "The Euro as a Reserve Currency: A Challenge to the Pre‐eminence of the US dollar?." International Journal of Finance & Economics 14.1 (2009): 1-23.
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