ECB Says Debt Crisis Weighed on Role of Euro in Global Markets

European Central Bank President Mario Draghi said unsound public finances in the euro area have curbed the single currency’s use in global financial markets.

“In 2012 the euro-area sovereign debt crisis continued to weigh on the international use of the euro, which declined moderately in some market segments,” Draghi said in the foreword of an ECB report published today on the international role of the currency. “The persistent fragmentation of the euro-area financial system is one of the main underlying causes of these developments, as it affects the depth and liquidity of euro-area capital markets.”

The 17-nation region is struggling to emerge from a sovereign debt crisis, now in its fourth year, that has led to five countries seeking bailouts and fostered speculation about a breakup of the currency bloc. Since European leaders agreed last year to set up a banking union and the ECB committed to backstop the euro with its Outright Monetary Transactions program, confidence has returned, according to the report.

The euro’s share in globally disclosed foreign-exchange reserves declined to 23.9 percent at the end of 2012 from 25.1 percent in 2011, the ECB said.

Currency Reserves

“Several survey indicators suggest that the decline in the international role of the euro might have bottomed out or even partly reversed during the second half of 2012,” Executive Board member Joerg Asmussen told reporters in Frankfurt today. “We can say that the trend goes in the right direction, but we all have to continue to work to tackle the fundamental causes of financial fragmentation in the euro area. In this respect, moving decisively towards a banking union is crucial.”

An “overwhelming majority” of foreign reserve managers credits the ECB’s yet-to-be-used bond-purchase program for alleviating concerns that the euro will collapse, Asmussen said. Prime U.S. money market funds increased their exposure to short-term debt instruments issued by financial institutions in the currency bloc in the second half of last year, he said.

In emerging and developing economies, the share of the euro as reserve currency dropped to 24.2 percent at the end of 2012 from 27.4 percent a year earlier, according to the report. The share in international debt markets slid to 25.5 percent from 26.2 percent as issuers continued to favor dollar-denominated securities.

Risk Aversion

“The U.S. dollar and the euro, as the second-most important reserve currency, continued to perform their function as a credible store of value for foreign central banks,” the ECB said.

Foreign demand for euro banknotes increased, implying that “the intensification of the euro-area sovereign debt crisis in the second half of 2011 did not have a major impact on the use of euro banknotes outside the euro area,” it said.

About a quarter of euro currency in circulation was used outside the euro area at the end of last year, particularly in Switzerland, the U.K., Russia and northern Africa, Asmussen said.

Higher risk aversion in foreign-exchange markets and perceptions of heightened credit risk for government debt in some advanced economies have boosted the use of alternative reserve currencies such as the Australian and Canadian dollars, the report shows.

Alternative Currencies

While those countries “have a track record of rapid and resilient growth, price stability and sound public finances,” the lack of “large, deep and liquid financial markets limits the potential of non-traditional currencies to become truly major reserve units,” the ECB said, adding that their use may decrease once market conditions normalize.

China’s currency increased its prominence in global trade, the report showed. Between 2010 and the end of 2012, the share of the nation’s trade in goods settled in yuan increased to nearly 10 percent from almost zero.

Still, “the lack of sufficiently deep and liquid domestic financial markets, tight financial restrictions, remaining capital controls and insufficient exchange-rate flexibility hamper the development of the international use of the renminbi, notably as a reserve currency,” the ECB said. “It is nevertheless conceivable that the renminbi could play an increasingly prominent role to the extent that the Chinese authorities continue to gradually address these challenges.”

China has allowed businesses to settle foreign trade in yuan and signed swap agreements to promote the use of the currency in international trade and investment. It has also eased rules for foreign companies to invest in the country using yuan raised offshore, as well as starting direct trading with currencies including the yen as part of efforts to make the yuan a global currency.

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