COVID-19 Crisis Exposes Eurozone Weaknesses and Cements the Fed’s Role as Global Lender of Last Resort

COVID-19 Crisis Exposes Eurozone Weaknesses and Cements the Fed’s Role as Global Lender of Last Resort

Published: May 30th, 2020

The economic upheaval wrought by the coronavirus crisis has battered hopes that the euro might one day replace the dollar as the planet’s leading currency. Disagreement within the eurozone on how to support damaged economies has exposed the currency’s frailties and cemented the Fed's role as the world’s lender of last resort.

The past three months have demonstrated and even entrenched the dollar's dominant influence over global investment, borrowing, and commerce. The defining issue has been the differing American and European responses to the crisis.

Proposals unveiled this week for an EU recovery fund financed by a new, jointly-issued debt instrument could strengthen the euro's international standing -- if it leads to more coordinated action inside the bloc.

But forex analysts say that even if the proposal survives the EU meeting scheduled for the end of May, North-South in-fighting over the moral hazards of bailouts and the issuance of ‘coronabonds’ to aid weaker euro economies, has ignited old fears that the eurozone could be on the brink of a break-up.

Bond management giant Pimco said in a statement that the current crisis has once again shown that the euro may not be around forever, and the dollar continues to reign supreme as the world's reserve currency.

The euro's share of global finance in recent years had already shrunk. Data from the International Monetary Fund shows average euro allocations in central bank reserves sitting at ca. 20 per cent – down from more than 25 per cent in 2011.

Negative ECB interest rates are partly to blame for the reserve re-balancing. But even knowing that context, it’s an inescapable fact that the dollar has a 61 per cent share.

The euro has also been losing ground in forex trading and FX derivatives, while also falling behind the dollar in international borrowing. Recent data from SWIFT has the euro being used for about 30 per cent of global payments, a fall from over 40 per cent in 2013. The greenback’s share of payments has risen to 45 per cent from 30 per cent in the same period.

An ECB index of the euro's role in global finance has also dropped sharply from over 26 per cent in the early 2000s to less than 23 per cent in 2017 (the most recent year the metric was updated).

Euro’s troubles are the dollar's gain

Rising dollar dependence was highlighted amid March’s market panic, when businesses made a beeline for dollar liquidity in order to redeem debt, pay their bills, or pad out their buffers.

It seemed to underscore how important access to dollars is when a crisis lands, meaning central banks will likely now anticipate that they need to hold dollars in substantial quantities in preparation for more bad times that may lie ahead.

The March run pushed the dollar up by 8 per cent in 10 days, and appreciation only eased off when the Federal Reserve activated hundreds of billions in swap lines to designated central banks to ensure that dollars could keep flowing.

Other central banks also sought to arrange swap lines of their own. To countries which needed emergency dollars – and had Treasury bonds to use as collateral – the Fed offered repo loans.

Analysts have contrasted the Fed's decisive, fast, and comprehensive actions with the ECB’s belated and comparatively timid response to the crisis within the eurozone.

Economists at the Institute of International Finance told Reuters this week that comparing its actions now to its actions during the 2008/2009 recession, shows that the Fed quickly accepted its role as the world’s lender of last resort.

The ECB has only been able to agree swap lines with Croatia and Bulgaria since lockdown measures began to shutter European economies.

Is there space for a second major reserve currency?

From the euro's earliest days, its supporters have campaigned to put an end to the greenback’s post-World War Two dominance. Those calls resumed after President Trump began wielding the dollar as a weapon in his aggressive trade and diplomatic dealings, using it for leverage in the simmering trade war with China and while re-imposing sanctions on Iran.

During the coronavirus crisis, however, the dollar managed to cement its role as the ultimate safe-haven currency, an advantage that hasn’t been blunted by widespread condemnation of the Trump administration’s response to the crisis inside the US.

The pandemic’s economic fallout could inflict even more damage on the euro's international position if the US policy response drives it toward a faster recovery than Europe.

But it also reveals an opportunity to tackle one of the euro's key disadvantages for reserve managers: the lack of an extensive holding of 'safe' assets equivalent to American treasury bonds.

Central banks typically keep reserves in bonds which are denominated in their preferred currency. With some $17 trillion worth of triple-A-rated paper in circulation, US government bonds are as close as you’ll get to a risk-free asset.

The combined bond markets of France, Italy, and Germany add up to less than half that number, and of the three only Germany has an AAA score. Even borrowing to fund coronavirus recovery programmes wouldn’t bring Germany's debt pool to anywhere near what the Fed can offer.

It remains to be seen if backing for the eurozone’s proposed recovery fund plan could become the basis for joint euro bonds. Agreement on those might eventually give reserve managers a viable safe-haven alternative to US Treasuries.

Points of leverage for the euro as a dollar replacement might also be found in the renewed US-China trade dispute, which could see China move the majority of its reserves out of dollars.

If so, Beijing would be following Russia’s lead, where the central bank has already started to diversify. Moscow slimmed down its US Treasury holdings in 2014 after it was hit with US sanctions. Russian oil giant Rosneft, meanwhile, is already denominating its export contracts in euros.

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