(SINGAPORE) Central banks around the world are sitting on piles of euro-denominated foreign exchange reserves - and their positions aren't cushy.
These holdings have become a source of concern as the euro see-saws and battles doubts about its survival while Europe's sovereign debt mess unravels.
Some market observers suggest that the euro's share of reserves will slide over time. Meanwhile, the hunt for other reserve assets has intensified, with gold, the Australian dollar, the Canadian dollar and even emerging market currencies among those garnering support.
'I think central banks are worried, but I don't think any major central bank is going to make a statement that would imply a lack of confidence in the euro,' said Charles Adams, a former International Monetary Fund (IMF) official and now professor at the Lee Kuan Yew School of Public Policy. 'If they are doing this diversification, they are doing it very quietly.'
Until recently, the euro was seen as a strong contender to the US dollar as a key reserve currency. Central banks were moving away from the greenback, reflecting the United States' declining weight in the global economy, as well as worries about the country's loose monetary policy and huge fiscal deficit.
Also, central banks, especially those in emerging markets, simply needed another place to invest their ballooning forex reserves in. According to the IMF, official forex reserves grew more than five times from end-2000 to reach an estimated US$10.2 trillion at the end of the third quarter last year.
Not every country reports the currency composition of its reserves to the IMF. Of the US$5.4 trillion that the Fund has data for, some 61.7 per cent was in US dollars, followed by 25.7 per cent in euros. The euro's share has climbed almost steadily from 18.3 per cent at the end of 2000.
Eurozone woes are threatening to end that trend. Central banks have stomached swings in the value of their euro-denominated reserves as the volatility of the common currency spiked.
In the next few years, the euro area's economy could stagnate - 'which would imply continued very low interest rates and a risk of further depreciation of the euro', said Joseph Gagnon, senior fellow at the Washington-based Peterson Institute for International Economics.
More daunting is the possibility - however slim - of a complete break-up of the eurozone, which would lead to the euro's demise and leave the value of trillions of forex reserves in doubt.
'I believe central banks should be worried because the (eurozone) crisis is not really fully resolved,' said Stephen Jen, previously global head of currency research at Morgan Stanley who now runs his own hedge fund, SLJ Macro Partners.
'The EMU (European Monetary Union) is a sub-optimal arrangement, and there will likely be breakages in the future. I don't expect the euro to 'disappear', but the current membership is not sustainable.'
Despite the uncertainty, market watchers are not expecting central banks to dump euro-denominated assets. They might trim their holdings gradually, or channel new inflows elsewhere. The question is whether better substitutes for the euro exist.
Most observers BT spoke to named the Aussie as an option. Holders of the currency - a commodity play - get exposure to China's growth story without having to purchase the tightly controlled Chinese yuan, said Mizuho economist Vishnu Varathan.
Several also picked the Canadian dollar. Investors in the loonie stand to benefit from the uptick in the US economy without being long in the dollar, Mr Varathan said.
Standard Chartered Bank head of Asian FX strategy Thomas Harr believes that central banks are also looking at emerging market currencies.
At the Monetary Authority of Singapore (MAS), emerging markets are on the radar. No single currency makes up more than a third of its foreign reserves.
'Central banks and sovereign wealth funds will likely look to allocate more funds to Asian markets, both to diversify risk and to enhance returns,' said managing director Ravi Menon on Wednesday. 'Speaking for the MAS, we have always invested our official foreign reserves in a highly diversified global portfolio. As Asian markets develop in depth and sophistication, our allocation to emerging markets, especially in Asia, will grow.'
Gold is likely to maintain its appeal, especially to emerging market central banks. The World Gold Council estimates that gold made up some 11.7 per cent of total reserves across all countries at end-Q3 last year, up from 9.1 per cent at end-Q3 2008.
Few are betting on central banks raising their US dollar holdings. 'I think the US dollar and the euro as a proportion of total reserves will decrease over time,' Mr Harr said. 'This is in line with the declining weight of the contribution by the US and Europe to the global economy and financial system.'
Within their euro holdings, central banks might move away from bonds issued by peripheral European Union countries towards those from safer countries such as Germany.
But that is limited by the depth and liquidity of bond markets in the core countries. 'The German bund market is much less liquid than the US Treasury market, by a factor of 1:5,' Mr Jen said. If central banks were to hold only bunds, 'they will need to deal with one-fifth as good liquidity'.
The euro is likely to remain on central banks' books despite the problems surrounding it. Near-term weakness aside, the euro will survive, Mr Harr said. 'From a long-term perspective, it makes sense for central banks to have a sizeable share in the currency.'
And the euro could stage a comeback. If membership in the eurozone shrinks, leaving like-minded countries with the right fiscal discipline in the grouping, 'we may end up with a euro that is actually stronger', said Prof Adams.