Amidst the din of Brexit, the UK may lose sight of a potentially historic shift in one of the major bulwarks of United States’ soft power – the function of the US dollar as the heart of global finance. The EU is being forced to consider a real challenge to the functions of the dollar due to the vigour of President Trump’s use of the dollar `weapon’ – against both Iran and Russia – ignoring the wishes of the EU. The rights and wrongs of the policies are a separate topic, but what matters is that the EU has decided to try and do something about it.
In his final State of the European Union (SOTEU) speech in September, Commission President Juncker called for the euro to emerge as a genuine international currency – explicitly responding to US sanctions on Iran that started recently. Clearly, an international payments system cannot be set up in that time but it may turn out that President Trump will have forced the EU to counter the long-standing use of the US dollar’s role in international payments as a powerful instrument of US foreign policy.
Juncker laid out the geopolitical - rather than pure financial or economic - issues in emotive terms: “It is absurd that Europe pays for 80 percent of its energy import bill – worth 300 billion euros a year – in U.S. dollars when only roughly 2 percent of our energy imports come from the United States …. It is absurd that European companies buy European planes in dollars instead of euro ….The euro must become the face and the instrument of a new, more sovereign Europe,”
However, the core of the US power is deeply technical: the Real Time Gross Settlement (RTGS) payment system for dollars is run by the New York Federal Reserve Bank via Fedwire. Banks (US and non-US) may net customer dollar payments internally but the moment they wish to make a dollar payment to another bank, then it goes through Fedwire – on US soil and therefore subject to the full panoply of US laws. In recent years, many non-US banks have found out - via stunning fines – the `extra-territorial’ reach of US rules.
But this is only for dollar payments. The US reach goes far wider throughout the foreign exchange market to the extent that many cross-currency transactions that do not notionally involve the dollar are actually executed as back-to-back transactions via the dollar. Around half of all forex trades are settled via Continuous Linked Settlement (CLS) Bank. It is regulated by the New York Fed so it applies US rules. As CLS accepts 18 currencies so US soft power runs far wider than just dollar payments.
The ECB has long been monitoring the international role of the euro and it latest report provides much data. Perhaps the most striking is the `global payments currency’ function where the euro is now at 36% - just behind the dollar at 40%. However, the proportion of foreign exchange trading is 44% in dollars but only 16% in euro. Moreover, the major metrics for the “store of value” function all strongly favour the dollar versus the euro: international debt (62:23); international loans (56:23); and foreign exchange reserves (63:20). This latter function could be changed by a successful banking union in the EU, complemented by a proper capital markets union.
However, perhaps the easiest first step would be to encourage EU foreign trade to be settled in euros. As the EU represents 17% of world trade (excluding intra-EU trade) in goods and services versus only 14% for the US, any shift in the currency of invoicing - and then settlement - could move the dial significantly towards the euro. This could be facilitated by the creation of a European equivalent of CLS - especially if it settled foreign exchange deals relating to the EU’s external trade. But that shift could have happened anyway years ago. So why does the inertia continue to favour the dollar – or are there still issues about the credibility of the euro?
That credibility now seems far more assured than at the peak of the crisis in 2012. The crisis precipitated a reduction in the euro’s share of foreign exchange reserves from around 23% (at constant exchange rates) to 20% now – hardly a collapse given the bad publicity at the time. The EU has now taken many steps to rectify the problems and deepen monetary union. But it is still a work in progress – perhaps most visibly in the deadlock on EDIS (European Deposit Insurance Scheme). Foreign holders of the euro will surely want to be certain about the stability of the banks where they hold deposits.
Clearly, some pieces are still missing in the “international role” jigsaw. An effective capital markets union may even be the vital piece as the euro lags way behind the dollar in the `store of value’ function. But Europe suffers from a basic structural difficulty in matching the capital markets of the US. Mortgage–related bonds are nearly 50% of US GDP – representing 23% of the total US bond market and about 2/3 the size of the US Treasury market. Foreign central banks are now starting to rebuild their holdings of US mortgage-backed bonds. But they cannot do that in Europe as the vast majority of mortgages are held on-balance sheet by the banks.
Moreover, the most basic `parking place’ for foreigners’ dollar holdings is the Treasury bill market – at €2.2 trillion in size. This dwarfs any of the European equivalents as there is not a single European bill market of that type. This lacuna may be the biggest single problem for the euro in any quest to boost its international role – and its resolution would also help the deepening of banking union by providing a safe asset for banks. This author has proposed a Temporary Eurobill Fund (TEF) to fill the gap and it could readily challenge the size of the US Treasury bill market. Providing such a competitive store of value could be the single quickest way of enabling growth in the international role of the euro.