Investing.com -- The euro lags the dollar as a reserve currency by some distance, but as Germany leads Europe into a looser fiscal policy era,Capital Economics argues the single currency now has its best shot in years at narrowing the gap-just as President Trump’s policies chip away at the greenback’s safe-haven crown.
“Recent actions by the Trump administration have raised doubts about the dollar’s safe-haven credentials, and could contribute to a further decline in its share of global FX reserves,” Capital Economics analysts said.
Market upheaval and uncertainty has usually led investors into the safe arms of the dollar. But the sharp depreciation in the greenback since the start of Trump’s second term suggests "the dollar’s appeal as a low-risk, safe-haven currency has waned," they said, as investors seemingly "seek refuge in the euro.”
Despite these tailwinds, the euro’s rise as a global reserve currency has been held back by three main factors. First, “the poor prospects for economic growth in the euro-zone” have weighed on confidence. Second, the bloc’s fragmented bond market limits liquidity and scale, making euro-denominated assets less attractive. Third, there has been a “limited supply of safe assets such as German Bunds and jointly-issued EU debt,” which are crucial for reserve currency status.
But these obstacles may soon ease. Germany’s decision to scrap its strict fiscal rules and ramp up defense as well as public spending, combined with the EU’s more relaxed budget framework, could mark a turning point.
“The supply of euro-denominated bonds issued by highly-rated sovereigns and supranational institutions is set to increase significantly over the coming years,” Capital Economics said. Germany’s expected borrowing surge, driven by increased public spending, and pointed to the EU’s common debt market, which “is set to grow to over €900bn by the end of 2026,” up from just around €60bn in 2019.
Still, the analysts caution that the dollar’s entrenched advantages including the size and depth of U..S financial markets and its institutional credibility-mean the greenback’s dominance won’t disappear overnight.
“We do not think the recent bout of market volatility will strip the dollar of its ‘global reserve currency’ status...but its share in reserves will edge down further over the coming years. And we think that there is a decent chance that the euro’s share will rise.”
While the euro may not dethrone the dollar overnight, Germany’s fiscal pivot and shifting global dynamics give the single currency its best chance in years to narrow the reserve currency gap-especially as U.S. policy uncertainty chips away at the greenback’s bonafide safe haven status that stretches back to the early 1940s.