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Greek Crisis Doesn’t Erase Euro’s Status as Reserve Currency

Continued central bank diversification will ultimately enhance the currency’s status, assuming no Grexit and an end to QE.

The latest iteration of Greece’s debt crisis will likely prove to be a tempest in a teapot in terms of its impact on the euro’s status as a reserve currency.

The euro’s importance as a reserve currency has diminished since Europe’s debt crisis in late 2009. The euro’s share of global central bank reserves slid to 21 percent at the end of this year’s first quarter, the lowest level since 2002. The dollar’s share climbed to 64 percent, from 63 percent at the end of the fourth quarter.

“The Greek crisis is part of a regional crisis that has been dragging down the euro’s appeal,” says Jacob Funk Kirkegaard, a senior fellow at the Peterson Institute for International Economics in Washington. “But I don’t think Greece will drag it down further.”

Greece and its European creditors continue to work on an agreement to restructure the beleaguered nation’s debt. One interesting dynamic of Greece’s recent crisis is that it didn’t depress financial markets beyond the country itself. The euro has stayed above $1.10 for most of the past month.

“Financial markets seem to be signaling that the risk for cross-border contagion out of Greece is very low,” Kirkegaard says. “So I don’t expect what’s going on in Greece now to have an effect on the euro as a reserve currency.”

Investors, including central banks, aren’t fazed by what’s taking place in Greece, which is not surprising, given that its gross domestic product accounts for less than 2 percent of the euro zone’s total, he says.

From 2002 until the 2008 financial crisis, the euro’s share of central bank reserves increased, as central bankers sought to diversify from the dollar. And many experts believe that diversification to the euro from the dollar will ultimately resume.

“As long as there is quantitative easing by the European Central Bank and uncertainty about Greece, central banks will reduce their euro holdings further, but QE isn’t forever,” says Athanasios Vamvakidis, head of European G-10 foreign exchange strategy for Bank of America Merrill Lynch. The ECB is scheduled to buy 60 billion euros of bonds a month through September 2016.

Once the ECB reaches its inflation target of just under 2 percent (from 0.3 percent now) and the Greek crisis is resolved, assuming it doesn’t involve a messy Greek exit from the euro zone, central banks will begin increasing the euro’s weighting in their reserves again, he says.

“In the long term, we think the euro will lose its reserve currency status only if there is contagion from Greece — a full-blown European crisis,” says Vamvakidis. “And that’s not our baseline scenario.”

Kirkegaard also thinks use of the euro as a reserve currency will ultimately expand. The currency’s share of central bank reserves could rise to 30 percent from the current 21 percent level, he says. It’s more a risk management–diversification issue than anything else, he says.

“In the long run, most reserve managers will want to diversify a little bit out of dollars. This reflects the fact that the U.S. is the biggest economy, but not that much bigger,” Kirkegaard says. U.S. gross domestic product stands at $17.7 trillion, compared with $13.2 trillion for the euro zone.

It will be difficult for the euro to exceed a 30 percent share in central bank reserves, Kirkegaard says, because of the dollar’s overwhelming primacy. “There’s inertia built into this,” he says. “So many of the world’s commodities are priced in dollars. It’s the currency of choice for project investment around the world. It’s really the anchor currency.”

Douglas Elliott, an economic studies fellow at Washington’s Brookings Institution, says the euro’s future attractiveness as a reserve currency probably depends most on the relative attractiveness of the dollar and the Chinese renminbi. “The dollar will likely slowly lose share, and the renminbi will gain it, but we don’t know the pace at which either will occur,” he says. In a study, HSBC predicts that the renminbi will make up 2.9 percent of central bank reserves by year-end.

The dollar should slide in importance because the U.S. share of the global economy falls virtually every year, as emerging markets rise, Elliott says. And the renminbi should rise in importance, because even with China’s GDP growth slowing to 7 percent, its share of world output and trade continues to climb.

So, whatever reserves that leave the dollar and don’t go into the renminbi can go into the euro.

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