When the euro debuted on the world financial stage, many economic analysts touted it, over-optimistically as it turns out, as the world's next reserve currency. The prediction was reasonable enough, based on the notion the combined financial strength of virtually the whole of western Europe might be a powerful enough economic force to topple the U.S. dollar from its position as the world's reserve currency. The euro fairly quickly became the second most important currency in the world, but as of 2015, it has failed to supplant the U.S. dollar at the top of the world's monetary heap. There are several reasons for this including liquidity, financial stability of the European Union, sovereign debt problems, the financial crisis of 2008 and the rapid rise to prominence of the Chinese yuan.
What Makes a Good Reserve Currency
For a currency to serve as a primary reserve currency, it must meet a number of requirements. It must first be a currency perceived as significant and solid enough to be utilized widely in international trade and financial transactions beyond its issuing country. Secondly, it has to be supported by a large economy and a government in which international investors have confidence. Finally, the currency must be considered to have a relatively stable exchange value, to the point central banks are comfortable accumulating and holding the currency in large amounts.
The total quantity of euros in circulation is limited by the European Central Bank's (ECB) hard-money policies and by continuing resistance by some nations to ECB capital standards and financial oversight by the European Commission. In short, major European Union (EU) members such as the United Kingdom and Germany remain reluctant to surrender sovereign financial control to the ECB. As long as major member states of the EU stop short of fully embracing the euro, this hampers worldwide reliance on its currency. Add to that serious deflation in parts of the eurozone, and the simple fact is there is not a sufficient amount of euros in worldwide circulation for it to, purely from a practical point of view, be used as the world's main trading and financial transaction currency.
Stability of the European Union
Linked to the first problem described above is the second, that of the overall economic stability of the European Union. The EU's sovereign debt crisis lingers on. Deflation and very low economic growth rates contribute to steadily worsen the debt-to-GDP ratios of many EU nations. The trouble extends from the worst point, Greece, all the way to the best point, Germany, which remains the strongest EU economy but is nonetheless seeing a weakening economic growth rate. The European banking system remains under unrelenting pressure, with many banks still seriously undercapitalized.
The 2008 Financial Crisis and the EU Sovereign Debt Crisis
From its introduction in 1999 up until the 2008 financial crisis, the euro followed a steady upward trajectory in value against the U.S. dollar, with the EUR/USD exchange rate rising all the way up to just under $1.60. But the 2008 financial crisis wrecked the euro's rise versus the dollar in almost an instant. The euro has been in steady decline versus the dollar since then, losing approximately a third of its exchange value, which by 2015, had fallen all the way back down to just above $1.10. The majority of currency market analysts are projecting the euro's further decline to par value with the U.S. dollar, and some analysts are even predicting both the euro and the EU will eventually collapse and be dissolved.
The severity of the global financial crisis in effect propped up the U.S. dollar, as the importance of maintaining the dollar's value was seen as critical to avoiding a more severe worldwide financial meltdown. In short, massive economic instability and uncertainty were seen as decidedly not the proper environments for making a fundamental change in the world's established reserve currency. To stem the global financial free fall, the United States needed to be able to sell trillions of dollars worth of U.S. debt, and that could not have occurred if the U.S. dollar lost its preeminent position as the world's reserve currency.
The ill fortunes of the euro were then compounded by the European sovereign debt crisis, which some analysts refer to as the sovereign debt crisis of 2011-2012, and some characterize as ongoing. This crisis further exposed the weakness of the EU as an economy, and also increased animosity between the more prosperous EU members such as Germany and the countries such as Greece and Spain whose economies seem to be perpetual drag on the overall European economy. The euro is certainly not strengthened by growing talk within Germany of abandoning the EU and returning to the deutsche mark.
The Rise of China and the Yuan
The meteoric 21st-century rise of the Chinese economy, which has overtaken the U.S. as the world's largest economy, has had a negative effect on the euro attaining any more substantial presence as a reserve currency. China's increased prominence in the world's economy is being accompanied by a push for its currency to be the one that replaces the U.S. dollar as the world's major reserve currency. The yuan is increasingly used in international trade and sought in international investment. China is pressuring the International Monetary Fund (IMF) to grant it the Special Drawing Rights (SDR) status accorded to recognized reserve currencies.
China has established more than a dozen yuan-clearing banks worldwide. Connections between the Shanghai and Hong Kong stock markets have been fostered to stimulate further capital market development in China. China has signed currency-swap agreements with numerous central banks of its primary trading partners, including the Bank of England and the Bank of Canada, thereby undercutting both the euro and the U.S. dollar as reserve currencies. The yuan is the second most-used currency in trade financing, ahead of the euro.
And China's cause is bolstered by the fact that it, along with Japan, is one of the world's largest holders of foreign exchange reserves, and therefore, its currency preferences have a major impact on what currencies can legitimately be considered reserve currencies. For the time being and presumably the foreseeable future, China's preference is for its own currency over the euro or the U.S. dollar.