Russians have long had a passion for greenbacks, a passion even Marxist ideology couldn't stifle. Starting well before 1991, when the Soviet Union dissolved, the Central Bank of Russia held up to 90% of its foreign exchange reserves--currently worth around $48 billion--in U.S. Treasury bills or dollar-denominated cash.
That monetary romance hasn't ended yet, but it is clearly cooling. By the end of last year, the dollar's share of Moscow's reserves had fallen below 75%. The Central Bank's new love: the euro, which has gone from under 10% of reserves to over 20%. Russia is buying euros, says bank First Deputy Chairman Oleg Vyugin, to diversify its risks, improve its returns, and reflect the fact that the euro zone is by far Russia's most important trading partner. "We reconsidered our investments at the end of last year in favor of other currencies. We are diversifying," says Vyugin. "Returns on dollar instruments are very low now. Other currency instruments pay more."
The story is the same across the globe. Money traders say that institutions as diverse as Bank of Canada, People's Bank of China, and Central Bank of Taiwan are giving more weight to the European currency. By the end of this year, they predict, the euro could account for 20% of global foreign currency reserves, which today amount to a cool $2.4 trillion. Little more than a year ago, the euro made up just 10%. "No one is saying that the euro's going to replace the dollar as the premier reserve currency," says Michael Klawitter, a currency strategist at WestLB Research in London. "But it will increase in importance for many central banks."
Indeed, the euro has, for the moment at least, stilled the complaint that it would never match the strength and stability of the Deutschemark, which in its heyday was the world's No. 2 reserve currency. In the first three years of its life, the euro never reached the 13% of global reserves made up by the Deutschemark and other former euro-zone currencies. The euro didn't jump that hurdle until early 2002, but it now makes up 15% of global reserves.
The euro is more appreciated these days because it's, well, appreciating. Central banks that didn't increase their euro holdings last year lost out because the currency gained almost 20% against the dollar. "Many central banks were underweight against the euro," says David Bloom, a currency specialist at HSBC Bank in London. "Now that it's stronger, they want more of a balance."
It's quite a turnaround for what was a Cinderella currency. After starting life in 1999 at $1.17, the euro steadily fell until it reached an abject low of 83 cents to the dollar in October, 2000. Its fortunes began improving in late 2001, when the dollar weakened, and the currency stood at a robust three-year high of $1.09 on Feb. 5. One factor: Central banks, like other financial institutions, are under pressure to make decent returns on their portfolios. And short-term euro securities and cash--central banks' favorite investments--pay more than their dollar equivalents right now. Three-month dollar money market rates were just 1.24% on Feb. 4, compared with 3.36% in the euro zone. At 2.56%, the interest on two-year German government bonds is well above the 1.72% yielded by their U.S. counterparts.
Governments that have sharply increased their euro holdings include Canada, Taiwan, Hong Kong, and all of the eastern European states that are looking to join the European Union. Even central banks that tie their currency to the dollar are building up their euro holdings. Currency traders say that People's Bank of China, which has a fixed dollar-yuan peg and total reserves of $286 billion, is increasing the weighting it gives to the euro as it adds new reserves. And Asia, in general, has become less dollar-centric. As their trade with Europe grows, countries such as China no longer want to have all of their currency eggs in one basket. "Asia has been exporting to the U.S., then buying U.S. Treasury bills, and so far, everybody has been happy," says Zhu Min, general manager of the commercial Bank of China. "But I don't think that is sustainable." A big exception to the trend is Japan, with $460 billion in reserves, which, because of its crucial export trade with the U.S., prefers to keep its hoard in dollars.
The shift to the euro has big implications for the foreign exchange markets and the U.S. and European economies. Currency specialists say the yawning U.S. current account deficit, now at 5%, is bound to drive the dollar down further, and the euro still higher, over the next two to four years. Although the greenback may stage a short-term recovery once the looming war with Iraq is over, predictions are that it will then continue its downward trend, and that central banks will play their part in the descent. "Even if central banks increase their euro holdings by just a few percent, it will have a major impact in the markets," says Klawitter. "We're talking many billions of dollars."
A strengthening euro, while a source of pride, will make it harder for euro-zone exporters to sell their goods abroad--which is the last thing the limping European economy needs. No wonder the markets are abuzz with rumors that the European Central Bank is quietly urging its counterparts elsewhere to curb their appetite for the euro. That's a sea change from the situation two years ago, when EU officials were trying to persuade Asian central banks to buoy up the single currency.
At the end of the day, in fact, there are limits to how many euros reserve managers will want to own. Central banks that peg their currency to the dollar need to keep the bulk of their holdings in the U.S. currency. Still, after a difficult debut, the euro is now getting some respect as a real money reserve. And for the once-besieged inventors of the single currency, a little respect goes a long way.
By David Fairlamb in Frankfurt, with bureau reports