By Dhara Ranasinghe

LONDON, (Reuters) – The U.S. debt ceiling wrangles as well as euro’s increasing dominance in bond issuance linked with environmental or sustainability goals could begin to reduce Treasuries’ position of the ultimate reserve asset. Europe will be able to grow its share.

Global financial stability is built on the U.S. Treasury Bond market, which has a $22 trillion value. It is considered a super-safe asset and will not be defaulted upon. This makes the US dollar the most important reserve currency in the world.

Analysts and investors agree that it is possible to avoid a default even if the situation is temporary. This could impact Treasuries’ image as a safe haven.

The Treasury continues to push back against borrowing limits. In recent years, Congress’s growing polarization has made what was supposed to be an easy vote on raising the debt limit into a series long-lasting crises.

A recent October default was avoided. However, deadlock could recur with an extended-term solution needed by December.

However, this does not mean that the dollar is going to fall off its pedestal. Over the years, the Reserve Status shifts take place and most international trade, besides the easy trading Treasuries is still in the greenback.

However, Treasuries may soon be forced to give up some of their share to other rivals, especially the euro. Investors and business alike are warning about the potential financial consequences of using the debt ceiling to support partisan causes.

This kind of behavior can cause a decline in international trust in Treasuries each time it happens. It’s impossible to say that the U.S. does not lose feathers every time it politicizes the debt ceiling issue,” stated Thomas Costerg of Pictet Wealth Management.

Graphic: IMF Q2 foreign exchange reserves – https://fingfx.thomsonreuters.com/gfx/mkt/dwpkragqgvm/IMF0810.PNG

According to the Brookings Institution, even a slight erosion in reserve status could result in significant financial costs for U.S taxpayers.

This paper estimates that Treasuries have a remarkable safety record, which reduces the cost of borrowing by on average 25 basis point compared to major sovereign issuers. This equates to interest savings of approximately $60 billion per year at current debt levels and over $700 billion in the future.

OCEANS RISE; EMPIRES FALL

International Monetary Fund data showed that dollar reserve held by central bank fell to 59% in 2020 from a peak of 25 years. This level is still very close to the historic low.

Research by Institute of International Finance (IIF), shows that investors bought Treasuries last year while simultaneously buying Japanese and German bonds.

Graphic: Foreign flows into Treasuries vs peers, 2009 and 2020 – https://fingfx.thomsonreuters.com/gfx/mkt/movanjmbqpa/IIFDATA0810.PNG

The pandemic crisis forced emerging market central bank to sell Treasuries. Robin Brooks, chief economist at IIF, however, notes that the bonds were not a safe-haven during March 2020’s market crash. This was when yields rose sharply before Federal Reserve intervention stabilized markets.

“What matters – if you are a safe haven asset that Treasuries purport to be – is that you get inflows when times are tough and risk appetite is low,” Brooks said. Brooks stated, “That didn’t happen last year. But it happened very clearly for German Bunds.”

EURO GAINER

The global euro reserves account for five percent of all currency reserves, but the absence of large-sized “safe assets” has made it difficult. The AAA-rated German bonds are worth just 1.6 trillion Euros ($1.9 Trillion), which is a small amount when compared with the huge Treasury market of $20 trillion.

However, the U.S.’s fractious politics contrast with European cohesion in the COVID crisis. The creation of an 800-billion-euro joint funds has reduced the risk of euro zone collapse and will expand the number of assets AAA-rated.

Graphic: The cost of insuring against a debt default, US vs Italy – https://fingfx.thomsonreuters.com/gfx/mkt/lgvdwlmqypo/USIT0810.png

Christian Kopf is Union Investments’ CIO for Fixed Income and FX. He said that he was impressed by demand for euro-denominated asset from Asian clients. This included South Korea. When including bonds with an AA or better rating, the total supply of such assets is 4 trillion euros.

Future selling points include euro dominance for bonds that satisfy environmental, social, and governance (ESG), criteria which allow them to finance projects that are beneficial to the climate or society.

According to Marcus Pratsch (head of sustainable bonds and finance, DZ Bank), almost half the new global green bond issuances were in euros in 2013, compared with 28% in dollars.

They are very popular and this week the European Union’s green bond, 12 billion euros, was overwhelmed with orders totalling 135 trillion euros. U.S. Treasury has yet to issue green bonds.

A 2019 survey found that central banks want more ESG exposure. Morgan Stanley (NYSE:) And the IIF Found. Japan said last week it would use its reserves to purchase ESG securities.

Pratsch predicts that the euro “will…remain most-sought in the sustainable bond marketplace, further strengthening its international position.”

Graphic: ESG bond issuance in US dollars vs euros – https://graphics.reuters.com/GLOBAL-MARKETS/mopanjmoqva/chart.png