LONDON, June 4 (Reuters) – Arguments about the euro’s reserve status often centre on whether it could replace the dollar as the dominant world currency. But such binary thinking misses a key point: even relatively small changes in relative reserve holdings can lead to enormous investment shifts.
Thursday’s European Central Bank meeting is set to agree another interest rate cut. And yet the following press briefing may be watched just as closely for President Christine Lagarde’s take on how the ECB would cope with an outsize euro surge in the event of seismic world reserve shifts.
Lagarde raised eyebrows last week by championing a “global euro” as an alternative to the dollar. The greenback’s role as a safe-haven for world savings has been rattled this year by the trade, diplomatic and institutional upheavals wrought by U.S. President Donald Trump’s new administration.
“Careful what you wish for” is the response from many economists watching the euro’s year-to-date gains of 10% on the dollar and to record highs on broader trade-weighted indexes.
Morgan Stanley’s European economists Jens Eisenschmidt and Gabriela Silova reckon that significant further appreciation of the euro from here represents a “prominent” risk to their euro growth and inflation forecasts.
Showing how an expansion of the euro’s global role could deliver an unwelcome foreign exchange surge, the Morgan Stanley team said even marginal shifts in the currency’s share of world reserves could unleash vast capital flows back into the region, even if the euro never supplants the dollar as kingpin.
If the euro’s share of the total central bank stash worldwide were just to return to where it was at its peak of 28% in late 2009 – on the eve of the euro sovereign debt crisis – then global reserve managers would have to add an additional 878 billion ($1 trillion) in euro assets.
As it stands, the euro’s share of the $12.4 trillion in global central bank coffers is just below 20%, with the dollar at 57%. Back in 2009, that was 28% and 61% respectively, so there could be a huge recovery of the euro’s relative position without it necessarily challenging for the top spot.
But that could see an epic exchange rate fallout, especially when you think the euro/dollar pair was as high as $1.50 at that reserve peak 16 years ago.
Eisenschmidt and Silova reckon that even if the euro only returns to $1.27 by the end of next year, as Morgan Stanley forecasts, that could knock another 0.2 percentage points off ECB inflation forecasts and lop 30 basis point off its euro zone growth call.
Given that headline euro zone inflation already fell back below 2% last month, an additional hit from a rapidly appreciating currency might push the ECB to cut rates by a further 50 to 75 bps in this cycle to offset the effects – bringing them close to 1% in the process.
The upside would be about 500 billion euros extra of demand for the core euro government bonds, of course, effectively funding the German and French fiscal expansions planned for the coming two years.
Would that be just getting back what left over a lost decade and a half?
Not quite. Even though euro’s share of the total has never fully recovered since the 2010-2012 sovereign debt shock, the near 50% expansion of world reserves since then means there was likely no actual offloading of euro assets by reserve managers – just a reduced proportion of the growing overall pot.
Ramping up the share now involves much larger nominal sums.
Looking at the total picture, it’s still unclear whether the “global euro” would be a blessing or a curse.
It certainly provides the “exorbitant privilege” that Lagarde has publicly extolled, but also potentially the sort of costs the Trump administration is baulking at in relation to the dollar’s long-standing overvaluation.
“While a larger share in global currency reserves has its long-term perks, it seems to come with significant pain too,” the Morgan Stanley report concluded. “With all the trade tensions around, this strength may just come at the wrong moment for Europe.”
As ever with currency matters, velocity may be the key issue to control. When Lagarde speaks on Thursday, she may seek to use language that limits the speed and scale of euro moves rather than the direction of travel.
What the ECB won’t want is to end up like the Swiss National Bank, which has seen inflation and interest rates start flirting with negative territory again, meaning it has to resort to currency intervention to battle protracted and damaging currency strength.
Lagarde will have to choose her words very carefully.
The opinions expressed here are those of the author, a columnist for Reuters
(By Mike Dolan; Editing by Jamie Freed)
