Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?

NBER Working Paper No. 11510
Issued in August 2005
NBER Program(s): IFM

---- Abstract -----

Might the dollar eventually follow the precedent of the pound and cede its status as leading

international reserve currency? Unlike ten years ago, there now exists a credible competitor: the

euro. This paper econometrically estimates determinants of the shares of major currencies in the

reserve holdings of the world’s central banks. Significant factors include: size of the home country,

inflation rate (or lagged depreciation trend), exchange rate variability, and size of the relevant home

financial center (as measured by the turnover in its foreign exchange market). We have not found

that net international debt position is an important determinant. Network externality theories would

predict a tipping phenomenon. Indeed we find that the relationship between currency shares and

their determinants is nonlinear (which we try to capture with a logistic function, or else with a

dummy “leader” variable for the largest country). But changes are felt only with a long lag (we

estimate a weight on the preceding year’s currency share around .9). The advent of the euro

interrupts the continuity of the historical data set. So we estimate parameters on pre-1999 data, and

then use them to forecast the EMU era. The equation correctly predicts a (small) narrowing in the

gap between the dollar and euro over the period 1999-2004. 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 the United Kingdom and 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. What we learn about

functional form and parameter values helps us forecast, contingent on these two developments, how

quickly the euro might rise to challenge the dollar. Under two important scenarios the remaining

EU members, including the UK, join EMU by 2020 or else the recent depreciation trend of the dollar

persists into the future the euro may surpass the dollar as leading international reserve currency

by 2022.

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