However, the hegemony of the dollar as a reserve currency is being questioned because of fears that the dollar may have to depreciate substantially to restore sustainability to the US balance of payments—given a current account deficit equal to 6 percent of US GDP and net foreign liabilities (at market value) in excess of 20 percent of GDP. Already, the dollar has depreciated by over 40 percent against the euro relative to its peak. Thus, the role of the euro in the reserves of developing countries may expand in the future. The paper discusses three main models that purport to explain the demand for, and the currency composition of, reserves. Each of them has its limitations. Focusing instead on a model of optimal diversification, the paper applies a simple mean-variance model to assess the attractiveness of the euro as a reserve currency on the basis of realized returns on holdings of dollar, yen, pound sterling, and euro reserves, and compares calculated values to actual holdings. Published data on reserve composition need to be adjusted to account for incomplete reporting and reallocated accordingly. If one does so, actual reserves of developing countries are 60 percent in dollars and 30 percent in euros. While the euro’s share is roughly equal to that implied by the meanvariance portfolio, the dollar’s share actual share is much higher.

# **2. The Present Role of the Euro in International Finance**

Since its introduction on January 1, 1999, the euro has assumed an important international role, but to varying extents depending on the dimensions one considers. Money can serve a number of international functions: as the currency in which exports and imports or external assets are denominated, as a vehicle currency for foreign exchange transactions, and as a component of official foreign exchange reserves, among others. In its 2005 review of the international role of the euro (ECB 2005), the European Central Bank highlighted the fact that bond issuance in euros far exceeds that in the legacy currencies (i.e., the national moneys of euro-area countries that were replaced by the euro). The explanation for this change lies in the effect the introduction of the euro has had in creating a single market for debt instruments in euro across a dozen countries. This is a notable change relative to the segmented markets that existed before, since a French investor purchasing bonds denominated in deutsche marks, for instance, took on exchange risk, which was also true for a German investor buying franc-denominated bonds. The elimination of intra-euro-area exchange risk has created a market for eurodenominated securities that rivals in size the US market for dollar securities. As a result, a potential issuer of bonds faces comparable terms, whether it issues in dollars or euros: underwriting fees are comparable (or may in fact be lower for euro issues<sup>1</sup> ), and so is market liquidity for comparably sized issues. Issuance in euro increased rapidly; already in 1999, the euro was approaching the importance of the dollar. According to Bloomberg

> 1 See “Deutsche Bank Ousts Citigroup: Demand for euro-denominated issues puts sales on a record pace for 2005,” _Bloomberg Markets_ , November 2005

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