Dollar and euro slug it out for world title

Dollar and euro slug it out for world title

America is facing a financial moment of truth says Ambrose Evans-Pritchard. But will the European challenger be around in 10 years?
# Industrial gloom drags down dollar

The US dollar is losing its 70-year grip on the world financial system as an ever-more muscular euro carves out its own rival empire, according to the Bank for International Settlements.
Euro and Dollar boxing gloves

The BIS, the elite bank of central bankers, said currencies from states as far away as Australia, New Zealand, South Africa, Chile and Brazil were succumbing to the "gravitational pull" of Europe's monetary union, breaking their historic linkage to the dollar to trade in close alignment with the euro.

The eurozone's $4.7 trillion (£2.5 trillion) debt securities market has overtaken America's $4.2 trillion market, while Europeans have pulled ahead in new-fangled instruments.

"In terms of liquidity, the dollar's advantage is quickly eroding. In derivatives markets, euro securities are as liquid as, if not more liquid than, dollar securities. The turnover of euro-denominated interest rates swaps greatly exceeds that of their dollar counterparts," said the bank.

The BIS is the ultimate watchdog of the global system, ensconced in its Swiss lair of Basle. It was founded in the Great Depression to ensure that Mankind would never repeat the currency madness of the post-Versailles order, later overseeing the hand-over from sterling to the dollar in the 1940s.

The report – "The euro as a reserve currency: challenge to the pre-eminence of the US dollar?" – said the euro was steadily expanding its zone of influence, with 40 central banks using its as part of their currency peg. The Swiss, Scandinavian, Balkan, and (most) East European currencies are already satellites of a greater EMU sphere. The surprise is that sterling and a clutch of commodity currencies have switched across from the dollar to the EMU camp, tracking moves in the euro two-thirds of the time.

International deposits in London

Investors have begun to treat the pound as a high-yield "proxy" for the euro, helping to explain why the sterling share of central bank deposits across the world has rocketed from 5pc to 12pc in the last decade. Reserves have risen less, from 2pc to 4pc.

David Bloom, HSBC's currency guru, said the markets had pummelled the euro when it was first launched in 1999, but were now learning respect.

"It was a little baby that needed nurturing and love, and it didn't get much of that, but now it's a teenager getting bigger and stronger every day, chiselling away at dollar dominance. How much longer are Europeans going to buy oil from Russia in dollars?" he said.

US bears have been warning for years that the dollar is damaged below the water-line, putting at risk the subtle advantages of "seignorage" and cheap debt finance that flows to a hegemonic reserve power.
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America has been living beyond its means for a quarter of a century, switching from top creditor to top debtor with alarming speed. It is now $2.5 trillion in hock to the world, risking a vicious circle as the current account balloons this year to 7pc of GDP.

Yet the mighty greenback has so far shrugged off troubles that have invariably doomed reserve currencies in the past. It's share of world central bank holdings actually rose from a nadir of 45pc in 1990 to 70pc in 2001, in part because the China-led pack of rising economies have had a dollar bias.

This is a lagging indicator, however. Dollar reserves have slipped back to 66pc over the last five years and dollar-flight may now be gathering pace.

Sweden's Riksbank has slashed its dollar holdings from 37pc to 20pc, while Russia – now master of the world's third biggest chest of foreign money at $261bn – is cutting back from about 70pc to nearer 40pc.

Italy trimmed from 84pc to 63pc last year, and the fuel-rich sheikhdoms of Qatar and the United Arab Emirates aim to end their "hard-wire" link to the dollar – a move that could presage a broader exodus by petro-dollar powers. Mr Bloom said Asia is now the last pillar holding up dollar hegemony through a system of pegs and "dirty-floats". "If China breaks away and forms a super-currency of its own, most of Asia will go with it," he said, predicting a tripod system based on the dollar, euro, and the yuan.

China has built up colossal holdings of $987bn as it recycles its $15bn monthly trade surplus in order to cap the yuan. Her Communist bosses fear that a fast rising yuan will lead to a flood of food imports, driving bankrupt farmers into the cities – political powder-kegs already in the throw of dissident uprisings. But China will have to revalue sooner or later because the reserve build up is fuelling inflation.

That will be the moment of truth for the US, the day Americans have to start earning their keep in the world, no longer able to count on limitless flows of foreign money to plug the deficits. As for the euro, the BIS takes it as a given that Europe's stateless currency will hold together in stormy times, an assumption yet to be tested.

For all its ills, the dollar is backed by the full force of a cohesive nation, bound together by the "sacred ties of history" in the words of Abraham Lincoln. It rests on a debt union under a single treasury, with a welfare system that shifts money to depressed corners of the economy to cushion the ups and downs of the cycle.

None of this exists in EMU, where the 12 economies are drifting further apart under the twisted effects of a one-size-fits-all monetary policy. Booms are turning to bust in the Club Med bloc, while Germany is emerging lean and fit from five years of slump. German firms are conquering the markets of Italy and Spain like latter day Goths. Eventually, this is going to stretch the EMU project towards its political limits.

Come what may, the US dollar will remain a central feature of the global landscape a decade hence. But will the euro still exist?

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