This week, the EU heads of state and government are gathering in Brussels. A central topic of discussion will be the European Union's rearmament efforts, aiming for Europe to be fully defense-capable, i.e. militarily independent from the United States by 2030. But why would this matter in a newsletter about the foreign exchange market, Commerzbank's Head of FX and Commodity Research Thu Lan Nguyen notes.

EU discusses the potential use of frozen Russian assets

"The connection lies in the fact that the dominance of the US dollar in the global monetary system is not solely due to economic factors, that is, the high share of US currency in global foreign exchange reserves cannot be entirely explained by macroeconomic models. The so called "missing mass" is often attributed to network effects. However, there are other factors, such as geostrategic considerations, which could play significant roles."

"In a study conducted by Eichengreen, Mehl, and Chitu, they revealed that many nations peg their currencies to the US dollar as a matter of security. Countries with strong security ties to the US tend to maintain higher proportions of their reserves in dollars compared to countries that are militarily more independent. This is seen as one reason why the euro would be unable to replace the dollar as the global reserve currency. IMF data (for 2022) shows that 38 countries had currencies pegged in some form to the dollar, compared to 25 linked to the euro. A determining factor certainly is that nearly all economically strong Gulf states tie their currencies to the US dollar."

"Before euro bulls become too excited, beware, that there is another critical point being discussed at the EU meeting that might influence the euro's future: the potential use of frozen Russian assets within Europe to provide loans to Ukraine. This move, which has gained increasing support, is controversial and legally risky. If executed, it could set a dangerous precedent for foreign investors, particularly those from nations with differing foreign policy agendas, and lead them to reconsider investing in Europe or even withdraw existing investments. In summary, this EU meeting has the potential to spark some life in EUR exchange rates again, which have been rather lethargic lately."