Same as it ever was.
Dollar allocation in foreign reserves unchallenged, underpinned by central bank swaps.
No doughnuts today. Instead, a critique of a recent paper1 from the IMF whose conclusion was unambiguous; the dollar was losing its status as the dominant reserve currency. ‘The share of reserves held in U.S. dollars by central banks dropped by 12 percentage points since the turn of the century, from 71 percent in 1999 to 59 percent in 2021.’ That sounds serious, especially as the authors included the most respected commentator on dollar dominance, Barry Eichengreen. Respected or not, there are problems with the study. Firstly, the dates used misleadingly suggest a decline in dollar dominance which is countered by a longer-term history. Rather, the last twenty years of reserve allocation is largely a history of rise and fall in confidence of the euro as an alternative reserve currency. Secondly, the study under-estimates the impact of central bank swap lines following the Global Financial Crisis of 2007/8 and again during the COVID-19 pandemic.
A history of euro failure, and dollar resilience
The Eichengreen study start date of 1999 coincides with the introduction of the euro through Economic and Monetary Union (EMU). Yet, a longer history shows that reserve allocation to the dollar was previously lower and the high allocation to the dollar in 1999 may have been due to the uncertainties surrounding the beginning of EMU. Latest IMF data for 2021 show the allocation to the dollar at 59%, exactly unchanged from the figure in 1995. The history of the last twenty years is the rise and fall of the euro as a challenge to the dollar.
Source: COFER, IMF
The euro was created explicitly to challenge the dollar’s supposed ‘exorbitant privilege’ so long resented by Europeans. Yet, after a promising start, acceptance of the euro as reserve currency faltered in the aftermath of the European Sovereign Crisis. The promise of ECB president Draghi in July 2012 to ‘do whatever it takes’ to save the Euro may have averted a breakup of the currency, but it reminded reserve managers of its inherent fragility. When the ECB’s Deposit Rate fell below zero in June 2014 the euro’s reputation was badly damaged. There followed a rapid switch from euro back to the dollar by reserve managers. Allocation to the euro peaked in 2009 at 29% and fell to just 19% in 2015 and the euros share of reserves has barely recovered since, with allocation in 2021 standing at 21%.
The importance of dollar swap lines
Although the Eichengreen paper acknowledges the introduction of dollar swap lines, it fails to see their significance. Swap lines are not new. The Federal Reserve had active currency swap lines in place with several central banks since the early 1960s. European central bankers saw swap lines as artificially supporting the dollar2. There were indeed deep-seated problems with the position of the dollar in Bretton Woods. The recent history of swap lines has emphasised that dominance.
During the Global Financial Crisis in 2007/8 offshore demand for dollars soared as the domestic dollar banking system excluded foreign borrowers. To alleviate the contagion and stabilise domestic monetary conditions, the Federal Reserve introduced dollar swap lines with central banks starting with Europe and Japan. As the crisis continued dollar swap lines were extended to Mexico, Brazil, South Korea and elsewhere. The crisis emphasised the centrality of dollars in the global banking system. The provision of swap lines showed which currencies could be relied upon in a crisis.
Source: BIS
Swap lines encourage diversification
Once the provision of dollars was assured, diversification of reserves became more attractive. The COVID-19 pandemic prompted the Fed again to renew swap lines not only the traditional reserve currencies of Euro, Yen, Pound and Swiss Francs but once again to Australia, Brasil, the South Korea, México, Singapore, Sweden, Denmark, Norway, and New Zealand. As a result since end-2007 it became clear that access to dollars in an emergency would be assured. Allocation to the currencies of central banks with swap lines comprise 74% of the reserve shift away from traditional reserve currencies detailed in the Eichengreen paper. Swap lines acted to emphasise (rather than diminish) dollar dominance by showing how important dollar funding remains to the global economy.
Yes, there has been an increased allocation to Chinese renminbi. But the allocation to renminbi is barely a rounding error in total allocation, driven more by attempts to cultivate goodwill with China than considerations of reserve management. The current allocation of 2.79% of total reserves to renminbi as at end-2021 serves more to highlight irrelevance than acceptance.
No threat in sight
The dollar remains safely enshrined as the reserve currency. Claims that the suspension of foreign reserves at the Central Bank of Russia undermines the sanctity of the dollar fails to recognise that it is the centrality of the dollar which permits such sanctions to be effective. Diversification may continue but is dependent on access to dollars ‘in extremis’ and is contingent on the availability of continued swap lines at the Federal Reserve.
https://www.imf.org/en/Publications/WP/Issues/2022/03/24/The-Stealth-Erosion-of-Dollar-Dominance-Active-Diversifiers-and-the-Rise-of-Nontraditional-515150
https://www.bis.org/publ/work851.pdf