1. Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency? MENZIE CHINN, University of Wisconsin JEFFREY FRANKEL, Harvard University For NBER conference on G7 Current Account Imbalances: Sustainability and Adjustment Newport, RI, June 1-2, 2005 Richard Clarida, Organizer

2. Reserve Currency Holdings 1977-2002 data, updated IMF Internal data

3. Figure 7: Reserves held by central banks as shares of total – major currencies (revised IMF data spliced into old data after 1979) 5/2/05

4. Figure 8: US Dollar – Reserves held by central banks as shares of total – smaller currencies revised IMF data spliced into old data after 1979)

5. Dollar-dissing is cyclical Historically, whenever the $ depreciates, commentators predict its demise as leading international currency. E.g., 1978-79; 1994-95. So the current episode was predictable: ”Sometime soon, newspaper stories will begin reporting that central banks in Asia and elsewhere are diversifying out of dollars into euros, and that the dollar is in danger of eventually losing its status as premier international currency.” -- Frankel (2004). Similar speculation in the past has been pre-mature. E.g., the true stats showed a temporary upward trend for the $ in the 1990s – Frankel (1995).

6. But this time may be different What makes this time different? –U.S. macro policy may undermine faith in the $ twin deficits net international debt monetary ease (2001-04) parallels with late 1960s –Plausible rival exists, since 1999: the euro Eichengreen & Frankel (1996): “It is unlikely that some other currency will supplant the dollar as the world’s premier currency...There is no plausible alternative for the number one position” But we also acknowledged “the possibility of a single currency coming into use throughout Europe, which would indeed pose a challenge to the supremacy of the dollar.” A very few authors had faith in the euro all along: Bergsten (1997), Portes & Rey (1998).

7. Birth of euro implies a potential rival for $ Shares of currencies in reserve holdings, %

8. Roles of Int’l Currency

9. Shares of Major Int’l Currencies in Reserve Holdings revised IMF data spliced into old data after 1979

10. Why should we care? 4 ADVANTAGES TO A COUNTRY OF HAVING ITS CURRENCY PLAY A LARGE ROLE IN THE WORLD. (1) Convenience for its residents. (2) Business for its banks & other financial institutions. (3) Seignorage –narrowly defined as willingness to hold $ as high- powered money (esp. fx reserves held by central banks) or –more broadly as willingness of private investors to hold $-denominated assets: America’s “exorbitant privilege” (4) Political power and prestige.

11. Historical precedent: £ ‘s loss of premier international currency status in 20 th century By 1919, US had passed UK in 1.output (1872) 2.trade (1914) 3.net international creditor position (1914-19) Subsequently, $ passed £ as #1 reserve currency (1940-45)

12. US overtakes UK, by trade, 1900-1957 Data sources: UK Export Data: Department of Trade and Industry, UK; UK exchange rate (1946-1970): Global Financial Data; US Export Data: Historical Statistics of the United States, Colonial Times To 1970; Published by the U.S. Census Bureau

13. Cautionary tale, cont. UK loss of international currency paralleled loss of its economic pre-eminence, military hegemony, colonies & other trappings of international power. –Suez crisis of 1956 is often recalled as occasion on which Britain was forced under US pressure to abandon imperial designs. –Often forgotten: Run on the £ was the mechanism. Paul Kennedy’s (1989) suggestion -- that imperial overreach hypothesis might apply to US hegemony -- may have been essentially correct –but 15 years premature, –much like those in early 1990s who warned prematurely over $’s imminent demise (Kindleberger, 1995; The Economist, 1995...)

14. EU GDP > US GDP 2003 2004 US $11.0 trillion $11.5 trillion Euro-zone (12 countries) 8.8 tr.9.0 tr. EU pre-5/1/04 (15 countries) 11.3 tr.11.5 tr. EU post-5/1/4 (25 countries) 11.8 tr.12.1 tr.

15. Figure 1: Currency share vs. GDP (mkt. rates). Is the relationship linear or (e.g.) ogive?

16. Explaining reserve currency shares, pre-euro (1973-98) Bold figs. sig. at 10% level [2][4][6] GDP ratio (y) 0.123 [0.049] 0.115 [0.049] 0.085 [0.047] Inflation diff (π) -0.107 [0.060] -0.143 [0.063] Depreciation (Δs) -0.094 [0.074] Exrate var (σ) -0.057 [0.032] -0.055 [0.032] -0.030 [0.030] Fxturnover (to) 0.019 [0.016] 0.023 [0.016] 0.016 [0.017] GDP leader (leader) 0.026 [0.014] 0.023 [0.014] lagshare (sh t-1 ) 0.944 [0.020] 0.904 [.029] 0.923 [.027]

17. Explaining currency logit transformed shares, pre-euro [2][4][7] GDPratio2.7683.691.04 (y)(y)[0.643][0.923][0.288] Inflationdiff-2.639-2.86 (π)(π)[1.156][1.164] Depreciation -1.095 ( Δs) [0.594] Exratevar-0.981-1.395-1.251 (σ)(σ)[0.573][0.644][0.341] Fxturnoverratio0.4460.5760.427 (to)[0.289][0.303][0.145] GDPleader -0.217 (leader) [0.156] laglogit0.8510.8460.957 log(sh t-1 /1- sh t-1 )[0.031] [0.014]

18. Explaining two-currency system of logit shares, pre-euro GDPratio 0.7621.0150.974 a/ (y) [0.247][0.773][0.688] Inflationdiff -0.554-0.844 (π) [1.247][1.259] Depreciation -4.524 a/ ( Δs) [3.337] Exratevar -2.375-2.381 (σ) [1.213][1.121] Turnover 0.4890.652 a/ (to) [0.487][0.454] Laglogit 0.8290.7750.795 log(sh t-1 / 1- sh t-1 ) [0.043][0.085][0.076]

19. Figure 9: Out-of-sample prediction of USD & Euro using logit w/o leader variable

20. Figure 10: Out-of-sample prediction of GBP, JPY and SFR using logit w/o leader variable

21. Figure 11: Case 2, Scenario B Simulation of “No UK, Swe, Den”, and no further change in the level of the exchange rate after 2004.

22. Figure 13: Case 2, Scenario D Simulation of “No UK, Swe., Den.” And continued depreciation of $ at 2001-04 rate.

23. Figure 14: Case 4, Scenario D Simulation of “UK entry” and continued depreciation of $ at 2001-04 rate.