The dollar has never been so popular. So why is interest in the yuan and euro growing?

The US dollar’s share of global reserves is falling, while the euro and Chinese yuan are becoming more popular. Is the dollar’s reign coming to an end?

Not so fast.

Although the United States’ trade policies are part of the reason central banks around the globe looking to diversify their currency holdings, the dollar remains the world’s reserve currency for a reason: Everyone trades it, the American economy is strong, and it is backed by the full faith and credit of the the US Treasury.

Last year, the dollar’s share of global reserves dropped to below 62%, according to a report by the European Central Bank reviewing the international role of currencies and the euro. That’s the lowest level since the start of the Economic and Monetary Union, which was in 1992. The dollar’s share is now more than seven percentage points lower than it was before the financial crisis.

But the total amount of dollars held in the world actually went up last year.

“There have been some movements in reserves, but dollar holdings have never been larger,” because total reserves in the world have grown, said Marc Chandler, chief market strategist at Bannockburn Global Forex.

Central banks and similar institutions hold dollars, often in form of US Treasuries, as backup funds in case of a crisis event – and also to facilitate international payments.

Other currencies like the euro and, more recently, the Chinese yuan are used to diversify so not all central bank eggs are in one dollar-denominated basket. The share of yuan reserves reached almost 2% last year, nearly double compared with early 2017. The euro is the second most popular reserve with a global share just under 21%, notwithstanding today’s drop in the currency after ECB President Mario Draghi hinted at a path for more monetary stimulus in for the eurozone.

Politics are likely playing are role in these movements, with ongoing trade spats between the United States and its partners.

Losing market share

Both politics and market volatility can be blamed for the dollar’s loss of market share last year.

Some central banks actively diversified their reserves to move away from the dominant dollar because of actions by the United States.

“One example is Russia, one of the world’s largest reserve holders, which sold about $100 billion worth of US dollar-denominated reserves in the wake of new rounds of US sanctions, and purchased almost $90 billion worth of euro-denominated and renminbi [Chinese yuan]-denominated assets in the second quarter of 2018,” the ECB report said.

China also reduced its US Treasury holdings “to the tune of about $60 billion” over the course of last year amid the escalating trade war, according to the report.

But one fundamental problem for central banks is choosing an alternative to the greenback that is similar in liquidity and market depth, said Neil Mellor, chief currency strategist at BNY Mellon. That is to say, while it’s a fine concept to want to diversify from US holdings to a smaller country’s government bonds, that market might not be sophisticated or large enough to make sense for this kind of investment.

Another reason the dollar’s share got knocked last year is that emerging markets, such as Turkey and Argentina, sold a lot of their foreign reserves to stabilize their own currencies. As the Federal Reserve was raising interest rates at the time, the dollar strengthened, which caused pain for emerging markets, many of which have dollar-denominated debt.

Between March and September 2018, emerging markets central banks sold some $200 billion in foreign exchange reserves, according to the ECB report.

The dollar’s share of global reserves might well continue to decline going forward even as overall reserves increase. But so far, it doesn’t look like the dollar will lose its status as No. 1 anytime soon.

“It’s too early to tell if this is the beginning of the end of the dollar as the king reserve currency,” said Chandler, the Bannockburn market strategist. “If the dollar share is going down because people have lost confidence [in the United States] due to repeated recessions and financial crisis, that’s one thing. But if it is about straight diversification, that is not in and of itself a bad thing.”