How Does a Dominant Currency Replace Another? Evidence from European Trade

Dominant currencies in international trade invoicing are extraordinarily stable, yet after the euro’s launch many economies in the euro area’s neighborhood shifted markedly from US dollar to euro invoicing. 

We develop a semi-structural empirical framework to estimate how much two key forces emphasized in recent theory – trade patterns and exchange-rate risk – contributed to this switch in dominant-currency use. In our structural model, firms choose the prices and currency denomination of their exports before exchange rates are realized, and invoicing decisions are interdependent across countries through input-output linkages and strategic interactions in destination markets. 

To account for non-stationary dynamics, we approximate the equilibrium conditions around the previous period’s equilibrium, which results in a dynamic, conditionally linear and high-dimensional state space model that links latent prices, quantities and currency shares across trade flows. Using observed trade, export price indices and invoicing currency shares across countries, the framework enables us to decompose the observed rise in euro invoicing into contributions from trade integration, reduced exchange-rate risk, and their propagation through the regional trade network. 

Results based on a previous specification suggest that trade integration explains almost 40% of the rise in euro invoicing from 1999 to 2019, whereas the impact of greater exchange rate stability against the euro is insignificant.