Will the euro become a reserve currency?

Due to dollar weakness, HSBC economists speculate whether the euro could become a rival reserve currency to dollar.

Since its inception as an idea, the architects of the euro dreamed that one day it would jostle with the US dollar as the world's reserve currency of choice. Now with the US running twin deficits, there are some who wonder whether the current administration is more focused on near term domestic considerations (ie re-election) than longer term strategic goals (ie the dollar as a store of value). The dollar's bout of weakness (notwithstanding the very recent rally) has raised questions about its value as a reserve currency, for individuals and institutions alike.

HSBC's head of forex strategy, David Bloom thinks it is time to treat the question of the euro's rise with some seriousness and analyse the impact on the world of the fund shifts it would create.

Bloom notes that the US deficit situation is unprecedented and that even if the dollar fell by another 20% this year it would only cut the deficit by 0.5% of GDP in 2006. That sort of devaluation implies a euro/ dollar rate of 1.60 and yen/ dollar rate of 88, and even that still hardly dents the deficit.

The fact of the matter, says Bloom, is there used to be a virtuous FDI cycle in place that kept the dollar strong, but it has disappeared. Back in 2000, Eurozone companies singlehandedly acquired US companies to the value of $140 billion, thus supporting the dollar. Add in the M&A from the rest of the world and that number goes up to $260 billion. In 2002 the same number was barely $30 billion.

In its place came portfolio flows mainly from Asia - mostly central banks - which by October accounted for 87% of net portfolio inflows to the US. This directly correlated with the $370 billion of new Asian reserves that were created in the January to October time period. Those reserves went into the US treasury market.

But will it always be so? HSBC's Bloom then asks the question: What happens if the dollar is no longer the only reserve currency? He compares the position of the dollar with the euro on a number of measures to see whether such a shift to the euro as a reserve currency is merited or feasible. Is the euro mature enough to rival the dollar?

First, he notes that in terms of the swaps market they are at a level-pegging. Euro-denominated swaps amount to $26.3 trillion versus dollar-denominated swaps of $26.2 trillion.

In terms of their bond markets, the dollar bond market is clearly bigger. Bonds denominated in euro amount to $6.7 trillion versus dollar-denominated bonds of $10.1 trillion.On the equities front there is no competition. Euro-denominated equities amount to $2.3 trillion versus $9.7 trillion for the dollar.

The eurozone is, however, bigger in terms of world trade. Its world trade adds up to $2.73 trillion versus $2.45 trillion for the US. Yet as a percentage of world currency trading, the dollar makes up 45% versus 19% for the euro.

Adding all these percentages up, HSBC concludes that central banks should up their proportion of euro reserves. As of November, central banks held about 18.7% of their reserves in euros versus 64.5% in dollars. That represents a 77/23 proportional split in favour of dollars.

HSBC's analysis of the two currencies, however, suggests the proportion should be more in the order of 60/40. It then looks at what would happen if there were a shift in reserves so that central banks held a 60-40 proportion of dollars to euros.

This, it notes, would lead to the sale of half a trillion dollars of reserves (held as US dollars), and the possible selling of $380 billion of US treasuries.

HSBC admits it is difficult to predict how much this would move US interest rates. But it notes that if the Fed funds rate stays at 1% (and inflation remains unproblematic) there is a limit to how steep the yield curve can become and it believes it would be hard to see 10 year yields go above 5%.

Such a move would not be catastrophic, but the US's loss of status as the owner of the single, de facto reserve currency would be more damaging over time. And while some in the US may doubt such a thing could happen, these are probably the same people who thought Airbus could never surpass Boeing.

Should all of the above prove accurate, it clearly makes more sense to hold euros than dollars. HSBC's mid-year target for the euro is 1.35.