Mike Dolan
If military and diplomatic alliances help determine where countries bank hard currency reserves, the fraying of transatlantic ties raises big questions about the future balance between global dollar and euro holdings.
Perennial doubts about the dollar’s long-dominant world reserve status are back in the spotlight as President Donald Trump’s administration sets about rewiring America’s trade and military ties.
While the discussion about geopolitics and reserve holdings has usually centered on major developing countries, such as China, little consideration has typically been given to the accounts of traditional U.S. allies, especially Europe.
The countless studies about the dollar’s role as the world’s reserve currency almost always conclude that the greenback–which still commands 57% of known global central bank reserves–is unlikely to be unseated any time soon.
The reasoning is usually that dollar alternatives lack markets with the same size, transparency and liquidity as the U.S. And the pervasive presence of the dollar in global offshore centers and in world trade invoicing further entrench its use.
But a 2022 paper from Federal Reserve Board economist Colin Weiss–examining the impact on dollar holdings of the decision to freeze Russia’s assets after it invaded Ukraine–homed in on the fact that roughly three-quarters of foreign official holdings of U.S. assets are with countries that have military ties to Washington.
“While U.S. dollar reserves are no longer exclusively held by political allies reliant on U.S. military support, as they were from the 1960s through the 1980s, these countries are still the most important set of reserve holders.”
Mr. Weiss broke down the countries between those with formal military alliances with the U.S., those with informal ones involving arms agreements or joint exercises with the U.S. military, and those with specific economic and financial ties such as dollar currency pegs.
He suggests that in scenarios involving highly fractious geopolitics, the risk of dollar reserve divestment represents about $800 billion–or just over 6% of the dollar’s share of total reserve holdings.
“Even a geopolitically-motivated move away from the U.S. dollar in trade invoicing would only diminish the dollar’s role as a reserve currency and not destroy it,” he concludes.
Reserves and coercion
But this study was done long before this year’s dramatic splintering of transatlantic relations over the Russia-Ukraine conflict, which has prompted a significant rethink of Europe’s defence relationship with Washington and led to a re-armament push across the entire continent.
Germany’s gigantic defense and fiscal reboot this month is well-documented, and increases in defense spending across the European Union both at a national and central EU level are under way–even if replacing the U.S. will likely take years.
The Financial Times reported last week that Europe’s big military powers are drawing up plans to take over responsibility for the continent’s defence from the U.S. through a managed transfer spanning five to 10 years.
That shifting landscape raises questions about how European allies will view their dollar reserve holdings going forward–or indeed their exposure to the dollar payment systems more generally in light of U.S. retrenchment.
And if Europe’s combined military clout eventually assumes some of the characteristics of the U.S.’ current military power, might that not affect where reserve holdings around the world are located too?
Pointedly last week, European Central Bank chief economist Philip Lane said Europe’s dependence on American payment providers left it open to “economic pressure and coercion,” outlining risks in deteriorating transatlantic relations.
“We are witnessing a global shift towards a more multipolar monetary system, with payments systems and currencies increasingly wielded as instruments of geopolitical influence,” he said, adding that the development of a “digital euro” was one promising option.
The euro’s 20% share of world reserves remains the second-largest, by some distance, and the percentage has remained fairly constant at this level for the past 10 years, even as the dollar’s share has fallen by seven percentage points over the decade.
While there has been much debate about the potential rise of the Chinese yuan’s tiny 2% share of world reserves, the prospect of greater euro use has often been dismissed–in part due to concerns about the fragmented underlying debt markets and incomplete aspects of the euro currency and banking unions.
But the expected expansion of European public debt and likely boost to joint EU borrowing may help meet some of the demand for top-rated “safe” assets from regional and overseas reserve managers.
In a world where Washington’s international relations are increasingly unpredictable and its trade and economic policies more inward-looking, the second-largest reserve asset may well find itself gaining ground on the longtime frontrunner.
(The author is a columnist for Reuters)
Published – March 24, 2025 02:32 pm IST
