Euro Takes a Hit as Reserve Currency

Countries around the world cut back on their holdings of euros as a percentage of foreign exchange reserves last year as the sovereign debt crisis kept investors wary, the European Central Bank said on Tuesday.

International Monetary Fund data shows the decrease continued in the first quarter of this year, although the euro remains the world’s second-most important reserve currency after the dollar.

In its annual review on the international role of the euro, the ECB, the 17-country bloc’s central bank, said the currency’s share of global central bank foreign exchange reserves declined by 1.2 percentage points, to 23.9 percent.

This made 2012 the third year in a row the euro has declined in popularity as a reserve currency, putting its share at the lowest level since 2000.

The share of the euro fell also in international debt markets, to 25.5 percent in 2012 from 26.2 percent a year earlier, again due to tensions about the stability of euro zone sovereign debt.

“In 2012, the euro area sovereign debt crisis continued to weigh on the international use of the euro,” ECB President Mario Draghi said in the foreword of the report.

“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 report added, however, that some indicators pointed to improvement in the second half of last year after the ECB announced its yet-to-be-activated bond-buying programme, known as Outright Monetary Transactions (OMT).

It cited a survey of 60 central banks conducted early this year, in which 89 percent of respondents indicated that this announcement had alleviated their concerns about the euro.

The ECB was not worried about the drop, saying “the euro continued in 2012 to perform its function as the second-most important reserve currency in the world.”

There was also not much change in the popularity of the euro on foreign exchange trading.

“The use of the euro as a vehicle currency in global foreign exchange markets remained by and large the same as last year,” ECB Executive Board member Joerg Asmussen told reporters.

Turning to such non-traditional reserve currencies as the Australian and Canadian dollars, the ECB said their use is on the rise due to less willingness to take risk, but added that this might reverse.

“A lack of large, deep and liquid financial markets limits the potential of non-traditional currencies to become truly major reserve units, however,” the report said. “In addition, their growing use might be dampened if market conditions normalise.”

Chinese renminbi also lacks in domestic capital market depth, and combined with financial restrictions, capital controls and limited exchange rate flexibility hamper its use as an international currency, in particular a reserve currency.

However, the Chinese currency could gain in importance, if reforms continue, the euro zone’s monetary guardian said.

“There is potential for the renminbi to play a still more prominent international role in the medium term, provided that the Chinese authorities continue to gradually introduce financial sector reforms, liberalise China’s capital account and strengthen exchange rate flexibility,” the ECB said.