For the first time in a decade, the world’s central banks are looking beyond the dollar to build their currency reserves.
With US protectionism on the rise, a number of Wall Street strategists say the case for the euro has rarely been better. Existential crises that hobbled the European experiment have receded. A resurgent economy has spurred talk the region’s central bank will curb policies that drove euro yields below zero. And as President Donald Trump threatens a trade war with China, the European Union is pursuing free-trade deals all across Asia and Latin America.
Of course, the dollar commands the lion’s share of the world’s $11.3 trillion of international reserves and most expect it to remain that way. But even a small shift — whether as a hedge against Trump’s trade policies or in the name of diversification — could have big consequences. After shunning the common currency for years because of negative interest rates and the region’s persistent turmoil, reserve managers at some of the biggest central banks are now looking to add more euros, according to two heads of foreign-exchange strategy who’ve held regular discussions with them.
“A lot of countries around the world are turning to Europe for increased partnership in trade,’’ said Jens Nordvig, who was Wall Street’s top-ranked currency strategist for five years running before setting up Exante Data a little over a year ago. “It’s not crazy to think that’s also going to be happening in the area of capital markets and reserve allocations. The bottom line is, this trade stance the U.S. has now is not helpful in terms of making the dollar attractive” for central banks that hold billions in reserves.
Nordvig estimates a half-trillion dollars could flow into the euro in the next two years, equal to a 25 percent boost in the currency’s share of reserves.
Developing countries and oil-exporting nations in the Middle East, which rely heavily on international trade, are the most likely to lift their euro allocations, he said. Six emerging economies — China, Saudi Arabia, Taiwan, India, South Korea and Brazil — hold almost half the world’s reserves, data compiled by Bloomberg show. China alone has amassed over $3 trillion in foreign exchange — primarily as a result of its cheap exports to the U.S.
Top Foreign Reserve Holders by Assets Current ($ bln) China $3,134.48 Japan $1,198.86 Switzerland $785.70 Saudi Arabia $494.49 Taiwan $456.72 Hong Kong $443.50 India $396.33 South Korea $394.80 Brazil $382.77 Russia $373.06
The ramifications of such a shift are significant. For over a half century, the dollar has been the reserve currency of choice for most of the world’s central banks because of its depth and stability in global markets. That status has given the U.S. some notable advantages. It has helped America keep a lid on funding costs, allowing it to run budget deficits, as trading partners park their dollars in U.S. government bonds.
The benefits also extend to American companies because the widespread use of dollars in global trade, such as for oil and commodities, often makes it cheaper for U.S. multinationals to borrow vis-a-vis many of their overseas competitors.
Currently, about 64 percent of the global reserves are denominated in dollars. The euro, the only other primary reserve currency, has remained a distant second, accounting for 20 percent of official allocated reserves, or $1.93 trillion. (The remainder comprises a mix of other national currencies like the British pound, Japanese yen and Canadian dollar.)
There’s been plenty of talk over the years about the need to loosen the dollar’s hegemony over the global economy, and the euro’s introduction in 1999 preceded a decade-long decline in dollar reserves. But for much of the past decade, there was little reason to think the euro would be the answer.
After the euro’s share peaked at almost 28 percent in 2009, a succession of humbling setbacks, from the European debt crisis, to Greece’s meltdown and the U.K.’s decision to leave the EU, has eroded confidence in the currency. Start-stop growth and repeated bouts of deflation didn’t help either.
As the European Central Bank enacted emergency measures that drove euro-area sovereign bond yields below zero, reserve managers who typically seek steady income had little incentive to hold euros. From 2010 to 2016, the euro lost roughly 30 percent of its value against the dollar.
Composition of Foreign Reserve Assets Current ($ bln) % of Total Allocated U.S. Dollars $6,125.63 63.50% Euros $1,932.84 20.04% Japanese Yen $435.98 4.52% British Pound $433.47 4.49% Canadian Dollars $192.81 2.00% Australian Dollars $171.13 1.77% Chinese Renminbi $107.94 1.12%
Now, two big reasons suggest the euro is about to have its moment.
The one everyone wants to talk about is the economy and how it’s back from the brink. Last year, the euro area expanded 2.3 percent. While that might not sound like much, it was the most in a decade and almost four times the average over that span. The brightening outlook has spurred speculation the ECB will pare back its stimulus. And politically, the union is more sound than it’s been in years, especially after the French election of Emmanuel Macron in May beat back a rising tide of anti-EU sentiment.
But just as important, perhaps, is the Trump factor. While Wall Street strategists were loath to point fingers at the Trump administration’s “America First” trade policies, there’s little doubt that over the long term, U.S. protectionism could undermine the dollar’s global standing.
In early March, Trump tweeted that “trade wars are good, and easy to win” and made good on his promise to hit back at China by enacting up to $60 billion of tariffs. The administration has also dropped more than a few hints it prefers a weaker dollar to help U.S. manufacturers.
China, which holds more U.S. government debt than any other foreign creditor, responded with levies of its own and signaled that “all options,” including scaling back its purchases of Treasuries, were on the table.
If the administration “not only abandoned the strong dollar policy but were intent on pushing the dollar down aggressively to secure trade advantages, that would diminish the currency’s luster as a reserve asset,’’ said Barry Eichengreen, an economics professor at the University of California at Berkeley and co-author of “How Global Currencies Work.”
Like all investors, “reserve managers are trying to read the political tea leaves as well as the financial arithmetic to figure out what’s next.’’
Contrast Trump’s rhetoric with Europe’s recent moves to forge closer trade ties with Japan, China and much of Latin America, including Mexico and Brazil. The EU’s total trade with China has jumped almost 75 percent in the past decade to $590 billion in 2016, IMF figures compiled by Bloomberg show. On that basis, the EU is on the cusp of eclipsing the U.S. as China’s biggest trade partner.
Some still aren’t totally convinced. Even as the euro staged its biggest rally against the dollar since 2003 on the back of stronger growth, central banks pared their euro holdings last year, according to Goldman Sachs. The rise of populism across Europe — notably, far-right nationalist Marine Le Pen’s surprising run in France’s presidential election and the stunning victories by anti-establishment parties in Italy — may explain why reserve managers are reluctant to dive in, according to Eurizon SLJ Capital’s Stephen Jen.
Nordvig argues it won’t take much to move the needle. Central banks were so down on the euro that many eliminated the currency from their reserves altogether. In 2016, Brazil — the 10th-largest holder of reserves — held no euros. Saudi Arabia, the fourth-largest, had slightly more than 10 percent of its portfolio in euros, far less than the average.
“We think a pick-up in reserve demand is right around the corner,” said Zach Pandl, Goldman’s co-head of global FX strategy, who predicts central banks may funnel $300 billion into the euro over the next one to three years. “A lot of the preconditions that needed to be met are starting to come into view.” — Bloomberg