Reframing the euro vs. dollar debate through the perceptions of financial elites in key dollar-holding countries

ABSTRACT

This paper proposes a theoretically-informed and empirically-grounded cognitive approach to analyse how financial elites from China, the Gulf Cooperation Council states and Brazil interpret the euro vs. dollar debate. At the theoretical level, we argue that the debate should be reframed in order to capture not only the material, but also the ideational footprint of the euro, as well as to better conceptualise change in the International Monetary System (IMS). Our empirical work shows that the euro is perceived by financial elites as a useful diversification tool to avoid over-exposure to dollar weaknesses. However, despite its appeal as a valuable investment alternative, the European currency has a series of structural flaws that prevent it from substituting the dollar as the main international currency. Therefore, in purely material terms, the euro-sceptical literature is correct. However, we also find that the hitherto material inroads of the euro, while limited, have been sufficient to ideationally convince these elites that a multicurrency IMS is possible and might be more stable (and therefore preferable) to current dollar unipolarity. Therefore, the euro-optimist literature is far from wrong when it argues that the creation of the euro represents a challenge to the greenback, for it could be a stepping stone towards the formation of a multipolar IMS.

KEYWORDS:

• Currency
• dollar
• euro
• power
• geopolitics
• foreign
• reserves

ACKNOWLEDGEMENTS

We would like to thank Andrew Walter, Magnus Ryner, Mattias Vermeiren, Lara Lázaro and three anonymous referees of this journal for their useful comments and suggestions.

Notes

Currency geopolitics analyses inter-state rivalry and conflict in the international monetary arena. The collapse of the Bretton Woods system, the 1970s oil shocks, the deterritorialization of money and the globalization of finance increased currency competition in the international monetary system. This generated a large academic literature, which focuses on how states preferences and strategies shape currency rivalry (Strange, 1971; Kirshner, 1995, 2003; Helleiner, 2008; Helleiner and Kirshner, 2009; Cohen, 1998, 2010).

It is impossible to make reference to all the literature that has covered the dollar vs. euro debate along the years. Just to highlight a few examples, see Mundell and Clesse (2000); the special issue on the topic in Journal of Policy Modelling, 24, 2002; the edited books by the Peterson Institute for International Economics, Euro at Five (2005) and Euro at ten (2009), the latter with Bruegel; Roy and Gomis-Porqueras (2007); the special issue in Review of International Political Economy, 15 (3) 2008; and Cohen (2010).

The foreign reserve figures for China were taken from the People's Bank of China (2011) webpage, those for Brazil from the Brazilian Central Bank (2011) webpage and those for the GCC from Momani (2008) and Setser and Ziemba (2009).

These interviews were conducted in London, Rio de Janeiro, São Paolo, Brasilia, Beijing, Dubai, Abu Dhabi, Riyadh and Jeddah between 2008 and 2010. Participants were officials at the ministries of finance, central banks and related agencies and sovereign wealth funds; senior executives at state-owned or private commercial banks and other private financial institutions; and experts from think-tanks, universities and specialised financial and economic press. Some of the latter group were chosen as primary sources because of their policy advisory role, others were just interviewed as secondary sources to enhance the background knowledge. Anonymous interviews are shown as coded. Please see the appendix for the list of institutions that have collaborated with this research.

Methodologically this study is inspired in Odell's (1982: 58) work on how key policy-makers and their advisers interpret and shape the reality of the IMS. As he explains, ‘behaviour depends not on reality but on how reality is perceived and interpreted … Substantive ideas held by top policy makers and advisers [are] decisive or necessary elements of explanation. The core claim of this cognitive approach is that changes in reigning ideas help produce changes in policy content’. We do also agree with Blyth (2002) when he states that at moments of systemic institutional transformations ideas take a preponderant role. In our opinion the ongoing Global Financial Crisis represents such a moment of so called ‘Knightian Uncertainty’.

Strange's (1971) seminal work on the taxonomy of international currencies identifies four types of international currencies: (1) Top Currency; (2) Master Currency; (3) Neutral Currency; and (4) Negotiated Currency. We will elaborate on these categories below.

As Schultz and Weingast (2003) show, historically, states with representative governments have been particularly successful in the internationalization of their currencies because they tend to default less often than authoritarian governments. That, in turn, increases investor's confidence and gives these countries more capacity to finance their military endeavors.

These advantages include flexibility in designing its macroeconomic policy due to lower external financing costs, increased revenues from seigniorage, and greater political influence on the international arena (Portes and Rey, 1998).

A more precise definition is given by McNamara (2008: 441), who defines ‘key currency broadly, as the currency that dominates across a variety of functions: namely, the national money held most widely outside its own borders by both private actors and public authorities, used in the majority of cross border transactions around the world, and most frequently purchased in the form of various financial instruments such as bonds. The key currency is also the one money that other states most often anchor or peg their own currencies to’.

It is interesting to note that the current situation resembles that of the late 1960s, when American monetary hegemony began to decline. Back then, the US dollar was able to maintain its status, mainly because there were no alternatives to the greenback and because the US maintained its military hegemony in the context of the Cold War. The current scenario is different both because the euro (and possibly the renminbi in the future) is a credible alternative to the dollar and because some of the emerging countries that are now questioning American monetary hegemony are not US military allies (Kirshner, 2009).

The euro could be regarded as a top international currency in its regional sphere of influence which covers the rest of Europe (including Russia) and the African countries that are pegged to the euro. It is important to emphasize here that Strange's currency typology is not static. ‘Any international currency can assume different roles simultaneously in different contexts’ (Helleiner, 2008: 360).

The EZ has also gained more autonomy in the IMS by avoiding disruptive exchange rate volatility, a conspicuous feature of Europe in previous crises (Wyplosz, 2009). This volatility has now moved to the sovereign debt markets. By discussing mechanisms such as ‘Eurobonds’, the EZ tries to enhance its autonomy also on this front. We will discuss this further in the empirical sections.

De Cecco (2009) is one of the few euro-optimists in the IPE field. As we will see below, the main doubts about the euro came precisely from the political economy analysis, not from economics.

As of January 2011, and according to data from Thomson Reuters Datastream, the US debt market amounts to $9055 trillion while the sum of the euro zone sovereign debt markets is $ 8226 trillion (6139 trillion euros). However, since there is no single pan European debt instrument, European markets have less depth and liquidity than their American counterparts.

For a critical discussion of the reforms undertaken since the outbreak of the EZ's sovereign debt crisis see De Grauwe (2011).

The latest IMF COFER data, which correspond to the first quarter of 2011, show a steady decline of the share of the dollar from 70.7 per cent in 2001 to 60.7 per cent in 2011. The euro's share, on the other hand, went during the same period from 19.8 to 26.6 per cent. This is not the first time the dollar experiences a steady decline in its share levels. In 1990, after a decade of similar weaknesses, the dollar represented only 50.6 per cent of overall share. However, even then the challenge of the competing currencies was not comparable. The Deutschmark represented 16.8 per cent of total shares, while the Japanese yen only eight per cent.

Please note that we use double quotation marks when the interview has been recorded and single quotation marks when the interview has not been recorded and we are paraphrasing the interviewee.

For the IMF COFER data see note 16. The qualitative evidence that we have collected in the three case study regions suggests that the diversification benchmark for the euro in foreign investment portfolios hovers around 25 per cent to 30 per cent both in the GCC and China (the portfolio of the Norwegian sovereign wealth fund is here often cited as a role model) but it is still considerably lower for Brazil. In its latest report on the currency share of its foreign reserves for 2009 the Brazilian Central Bank states that only seven per cent of its reserves are in euros versus 81.9 per cent in dollars (BCB, 2010).

It needs to be mentioned here that some of the share-gains of the euro need to be attributed to nominal exchange rate variations.

The lack of growth is certainly a topic that came up in a number of interviews. But opinions would vary widely. Some interviewees would see growth prospects stronger for the US and others would highlight that the economic fundamentals are stronger in the EZ than in the US. The lack of an integrated euro-debt market is on the other hand a widely used argument to explain the euro's underperformance in its challenge to the dollar.

In 2010 and early 2011, the three main Chinese leaders: President Hu Jintao, Premier Wen Jiabao, and Deputy Premier, and prospective Premier, Li Keqiang visited different European countries and signed numerous multi-billion-euro trade and investment agreements with European firms and states.

For a good up-to-date summary on how Europe is becoming more attractive than the US for Chinese businesses, see the special briefing on the topic in the Economist, 2–8 July 2011, print edition.

Posen (2009) is one of the few exceptions in this field.

The influence of military aspects in the use of a specific international currency affects China and Brazil indirectly through regional externalities. Similarly to the GCC, in East Asia Japan and South Korea depend on the US for their security. In South America, this is also true for countries such as Colombia and Paraguay. This is one of the reasons why the dollar is still dominant in both regions.

Spiro (1999) has shown that after the 1970s oil shocks the US secretly persuaded Saudi Arabia to buy large quantities of US assets outside formal markets to help finance its current account deficit. Therefore, the negotiated or political status of the dollar in this region has a long history.

Essayyad and Algahtani (2005: 77) quote officials from the Energy Directorate of the European Commission saying that they ‘could see the euro replacing the dollar as the main currency for oil pricing’. If these statements are true, it seems that this possibility is seriously considered in Brussels.

It is to note that according to 2011 IMF COFER data, the share of the euro in central bank foreign reserves has increased and not decreased since the eruption of the EZ debt crisis in 2010.

These four factors of why China is keen to support the euro are our own speculation. There are not based on our empirical work. Unfortunately, when we undertook the interviews this topic was not on the agenda. From our research, geopolitically, we have the sense that China is eager to support the euro because its main aim is to erode US hegemony and establish a multipolar world order. A stronger and more independent Europe is generally seen as a first step to multipolarity. For this reason (and this was stated by a number of participants) China is also reluctant to embrace the G-2 framework. China is more comfortable whit the Europeans and other emerging markets around the table.