Think of the world in 2015. Interest rates were close to 0% in major economies. The UK was a member of the European Union while Donald Trump and Vladimir Zelenskyy were merely national TV stars. Clearly a lot has changed since then. But one constant has been the euro’s share in global foreign exchange reserves – hovering around 20% for the past 10 years.
With US policy-making now undermining the dollar and Europe potentially getting its act together, the euro may finally gain some modest ground as an international reserve currency.
Germany’s gamechanger
Germany’s large fiscal stimulus on defence and infrastructure, due to be passed in the Bundestag on 18 March, could be the catalyst for renewed optimism in Europe. Speaking at an OMFIF seminar, organised with the Centre for Central Banking at the Frankfurt School of Finance and Management, a senior representative from a European central bank said ‘the debt brake reform is a gamechanger’. This topic was also a major theme of the annual ‘ECB and Its Watchers’ conference run by the Institute for Monetary and Financial Stability.
The general view among seminar participants was that Germany’s growth prospects are improving, though questions remain on the speed, scale and efficiency of its fiscal plans. Most of the economic gains from higher infrastructure and defence spending will start to filter through in 2026 and 2027. In the meantime, threats from US tariffs still loom large.
Moreover, one central bank representative pointed out that many other structural reforms are needed to boost potential growth in Germany. That includes increasing the supply of labour, energy reform, reducing red tape and improving digitalisation. So, while it’s too soon to herald a new era of German growth, the country’s economic outlook has undoubtedly improved in the light of the recent debt brake reform.
The need for common funding
The subsequent uptick in Bund yields highlights that investors are pricing in higher debt issuance from Germany to finance its defence and infrastructure plans. Some seminar participants expressed concerns if others in Europe follow Germany’s playbook of debt-financed public spending as there is less fiscal space elsewhere across the continent.
Joint EU financing would help Germany and other countries to ramp up public spending on defence. The European Commission announced plans for €150bn of loans for defence investment while additional common EU borrowing would be needed to support higher expenditure on security. However, a unified borrowing vehicle is lacking for this purpose. One speaker mentioned the ‘need to consolidate all borrowing into one issuer with a deeper pool’ to entice investors, rather than rely separately on funding from Next Generation EU, the European Stability Mechanism or perhaps a standalone defence fund.
This fragmentation in funding links to the broader issue of Europe’s lack of a capital markets union. One speaker signalled hurdles including mobilising domestic savings into European investments, ensuring accessible financing for small and medium-sized enterprises and a limited framework for digital or sustainable assets. Another participant said ‘the current challenges are an opportunity to move closer together in Europe’, suggesting there may be renewed political will to overcome the barriers to common European financing and capital markets.
ECB review: tweaks at the margins
In the meantime, the European Central Bank can play a role in supporting higher European defence and infrastructure spending by sticking to its price stability mandate – which would keep a lid on borrowing costs. One speaker suggested this should be the primary focus of the ECB, rather than issues outside of a central bank’s influence such as the green transition.
Speakers generally agreed the ECB’s monetary policy framework, which is under review, has largely been effective. This is despite the inflation shock of recent years, which was driven by supply-side factors beyond the central bank’s direct control. Applying wholesale changes to the framework off the back of this experience would ‘throw the baby out with the bathwater,’ argued one participant.
That said, it was suggested that tweaks to the framework are needed to allow the ECB to better operate in an increasingly uncertain world. That includes incorporating more scenario analysis into the ECB’s forecasts and improving the communication of risks.
Time to inch above 20%?
Ensuring the adoption of an agile but prudent monetary framework would cement the ECB’s reputation among market participants. This could, in turn, support the international reserve currency status of the euro. One seminar participant suggested the ECB’s pursuit of a digital euro as a wholesale central bank digital currency would also support this goal by facilitating the growth of digital finance in Europe.
With Trump’s policies potentially eroding trust in the dollar, there is an opportunity for the euro to gain in prominence as a liquid, stable and safe global currency. But this is not to say that the euro will overtake the dollar anytime soon. Its fragmented markets remain a key barrier and there have been many false dawns for the euro in the past. There are also other currencies are waiting in the wings to benefit from the dollar’s potential demise.
That said, against a backdrop of improving growth prospects, attractive yields, prudent monetary policy and relatively stable political institutions, euro-based assets may rise moderately above 20% of global reserves in the coming years. This will be a key focus of OMFIF’s Global Public Investor 2025 – our annual survey of reserve managers, publishing 24 June.
Nikhil Sanghani is Managing Director, Economic and Monetary Policy Institute, OMFIF.
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