Back in 2005, Jeff Frankel and I presented a series of projections about the dollar’s role as the world’s dominant reserve currency. We concluded:
…Whether the euro might in the future rival or surpass the dollar as the world’s leading international reserve currency appears to depend on two things: (1) do enough other EU members join euroland so that it becomes larger than the US economy, and (2) does US macroeconomic policy eventually undermine confidence in the value of the dollar, in the form of inflation and depreciation.
(Source: NBER Working Paper 11510).
This paper was published in 2007 in a conference volume edited by Rich Clarida, entitled G-7 Current Account Imbalances. As Brad Setser talks about a “sudden stop”, is it time to reappraise how well our predictions have held up?
First, consider our Case 2, Scenario D, Simulation of No UK, Sweden and Denmark in the euro area, and continued depreciation of the exchange rate at the 2001-04 rate (Figure 8-11 in the chapter, Figure 11 in the paper).
Source: Figure 8-11 from Chinn and Frankel (2007), Figure 11 from Chinn and Frankel (2005).
Note that in this figure, the US dollar and euro shares are expressed as a ratio to the sum of dollar and euro reserve holdings. One difficulty in evaluating how well the data fit is the fact that the IMF no longer reports the data in this form. Whereas in the past, the IMF reported USD and EUR shares incorporating estimates dollar holdings of central banks that do not report the currency composition of their holdings, the IMF now places those reserves into the “unallocated” category.
What one can do is to check by graphing the dollar ratio to the sum of announced dollar plus euro reserves (and similarly for euro). When one does this, one obtains the following picture.
Figure 1: USD to (USD+EUR) ratio (blue) and EUR to (USD+EUR) ratio (red). Source: IMF COFER release of September 28, 2007, and author’s calculations.
One has to take care in comparing the two graphs; Figure 1 extends from 1999Q1-2007Q2, and so stretches out the time scale as compared to Figure 8-11 (which spans 65 years, versus the 8 years). But the shares as of 2007Q2 are remarkably similar to those we projected for end-2007.
Does this mean that we expect the dollar to continue losing ground? It’s important to recall that this projection is conditioned on depreciation at the rate experienced over the 2001-04 period. Despite the events of the last few months, that seems unlikely to persist indefinitely. Hence, the short answer to the question is no. But one never knows what will happen. In particular, the fact that so much euro-related financial activity occurs in London, despite the fact the UK has kept out of EMU, means that perhaps we have underestimated the prospects for the euro toppling the dollar’s role as the world’s key reserve currency.
More to come…