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Euro's reserve standing may be hit by Greek crisis

Source: Reuters - Thu 15th Apr 2010

The euro's growing status as a world reserve currency may be vulnerable to the flaws that Greece has exposed in the euro zone's fiscal framework.

For central banks around the globe seeking a home for hard cash reserves - now a record in excess of $8 trillion (5 trillion pounds) - the euro had gradually gained favour as one alternative to the dollar over the 11 years since its launch.

As the debate about the possible demise of dollar dominance raged through the latter part of last year - largely on fears of soaring U.S. debts and money printing - the euro seemed to many a natural beneficiary.

But this neat narrative of the U.S. ancien regime gradually handing more and more of its dominance to Europe's new currency has taken a significant twist this year as sovereign debt concerns raised questions about the long-term cohesion of the euro bloc.

The Greek government's struggle to fund its ballooning deficits reached a crescendo in March when Germany led its euro zone partners in insisting that any financial support would only be considered alongside lending from the International Monetary Fund.

This convoluted euro zone pledge and Greek promises of austerity have failed to dispel concerns about its debt servicing.

The Balkan country continues to fork out twice as much interest as Germany in raising 10-year bonds and 50 percent more than it had to stump up six months ago.

Currency speculators are still selling the euro short in record amounts, according to the U.S. Commodities Futures Trading Commission. 

Fund tracker EPFR said investors have been net sellers of Europe equity funds for eight straight weeks, with outflows from Western Europe funds totalling $4.5 billion since January 1.

Invoking an external institution like the IMF, against the express wishes of the European Central Bank, may have provided Germany with a fig leaf of domestic political cover in agreeing to bail out one of its profligate neighbours.

But it has simultaneously undermined the solidarity of the 16-nation zone - a solidarity critical to launching the euro despite widespread scepticism that monetary union could be achieved in advance of some form of fiscal federalism.

Although web polling and bookies can be noisy and unreliable, it is interesting to see one Thomson Reuters webpoll showing more than half seeing a greater risk of euro breakup after the IMF deal. And online betting firm InTrade's futures show a 10 percent chance of a country exiting the euro in 2010.


But why should reserve managers in Asia and elsewhere care?

Central banks build up hard cash buffers primarily for emergency use - traditionally to cover imports or service foreign debts in a disaster and more recently as both a tool for fixing exchange rates and a net result of those pegs.

Either way, key qualities of a reserve currency are its liquidity - the ability to buy and sell at short notice both the currency and, crucially, the underlying sovereign debt its banked in - and its performance as a long-term store of value.

Looking at quarterly IMF data, the euro's share of reserves has risen to 27.4 percent at the end of 2009 from 18 percent for its pre-euro constituents in 1999. This compares with a 62 percent share for the dollar at last count. 

What is more, nearly all respondents in a poll of 43 reserve managers taken late last year said the euro's standing as a reserve currency had been enhanced since the credit crisis. Some 65 percent said the dollar's had declined.

So much for last year.

Even though it is dangerous to read too much into quarterly reserve shifts, due to exchange rate effects, the release of the IMF's first quarter data on June 30 will be very closely watched.

One of the biggest hurdles the euro has faced as a reserve currency has been the quality and liquidity of its government bond market compared to the U.S. Treasury alternative.

To be sure, the amount of euro zone bonds of maturities of more than a year is 50 percent bigger than in United States and the benchmark German bund market may be an adequate and liquid safe haven for stashing reserves.

But bunds only account for 19.5 percent of total euro zone government debt outstanding. Italy, Portugal, Ireland, Spain and Greece together account for almost 45 percent.

Even if reserve managers do not think euro breakup is likely, the possibility of capital loss, evaporating liquidity and even IMF-recommended debt restructurings could well make them wary of holding anything but bunds.

And any such shift, by blowing the borrowing premia higher on non-German debt and sucking liquidity from the euro zone's peripheral debt markets, could be traumatic.

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