Will the Euro Replace the Dollar?

Perhaps. The authors of this research "argue that the euro's rise to major international currency status may no longer be as implausible as many believe":

The Impact of the Euro and Prospects for the Dollar, by Matt Nesvisky, NBER Digest: Will the euro replace the dollar as the leading international currency? With two-thirds of all international reserves still held in U.S. currency, the challenge of the euro appears remote. Indeed, this was the widely held view when the euro was introduced less than a decade ago. But in Optimal Currency Shares in International Reserves: The Impact of the Euro and the Prospects for the Dollar (NBER Working Paper No. 12333), authors Elias Papaioannou, Richard Portes, and Gregorios Siourounis argue that the euro's rise to major international currency status may no longer be as implausible as many believe.

The euro's growing appeal comes from several factors: the euro zone is comparable to the U.S. economy in term[s] of GDP and trade openness; the European Central Bank has kept inflation in check; the EU experiences nothing like America's current account deficit and external debt, which apply considerable pressures on the dollar. In a 2005 survey of central banks, most respondents said they intended further diversification away from the dollar, and several have recently made public announcements along these lines.

Papaioannou and his colleagues study the composition of central banks' foreign exchange reserves... Reserve growth in recent years has been dramatic, with emerging markets and developing countries tripling their reserves since 1998. In addition, rising prices for oil and other commodities have increased foreign reserves in fuel-exporting countries. These reserves come primarily from U.S. current account deficits. Even a limited shift out of dollar assets, the researchers say, could result in significant exchange rate movements - in particular, sizable dollar depreciation.

The analysts assess the impact of the euro on international reserve holdings... The results show an increase in the shares of both the dollar and the euro in recent years at the expense of other currencies, with the euro gradually becoming more important, especially in the developing world.

Among their findings, Papaioannou, Portes, and Siourounis report the following: ...the optimal euro share is actually lower than what they observe. This suggests an increasing international role for the euro... So far, however, this increased internationalization comes primarily at the expense of the yen, Britain's pound sterling, and the Swiss franc rather than against the dollar.

In addition, in recent years the spreads on transactions in the euro have fallen sharply and have narrowed significantly for other industrial countries' currencies as well, thus making diversification away from the dollar more attractive. The researchers ... perform some simulations for four emerging market countries (Brazil, Russia, India, and China) that have recently accumulated large foreign reserve assets and find larger weights for the euro than the aggregate estimate for the "representative central bank." This indicates that the euro's challenge to the dollar might occur sooner than imagined.

Finally, the authors find that the reference currency, or the choice of risk-free asset, is the chief determinant in the optimal composition of reserves... But in practice, where there is a managed exchange rate regime, the reference currency is naturally the currency or currencies to which a country's own currency is pegged. This suggests a major challenge to the dollar if more countries move away from managing their exchange rates with respect to the dollar and adopt euro-based anchors or baskets in which the euro figures strongly. ...