By Mike Dolan
LONDON, June 23 (Reuters) - Even if the U.S. dollar does fall from grace as the world's primary reserve currency, the euro is struggling to prove itself an obvious alternative and the performance of euro government bonds may be the main drag.
Intense speculation surrounding the dollar's reserve currency status has come to the fore again as big reserve holders such as China and Russia fret about U.S. borrowing and money printing and openly mull alternatives.
Arguments favouring the euro as an heir apparent include the sheer scale of the currency bloc as an economic and trading force; the maturity of its financial markets and -- more fundamentally -- the primacy of the rule of law and property rights.
On the face of it, the numbers speak fairly clearly.
As a single entity, the 16-nation euro zone would be the second biggest economy in the world, just behind the United States, with well over $10 trillion in annual gross domestic product. The area exported and imported more than 1.5 trillion euros worth of goods last year alone.
The total amount of outstanding euro zone government bonds with maturities of more than one year is, at some 3.5 trillion euros, almost 50 percent more than equivalent U.S. Treasuries.
So it's no great surprise the euro's share of the almost $7 trillion of central bank reserves is estimated to have risen to 26 percent compared with 18 percent at its 1999 launch.
RUN INTO SAND
Yet that remains less than half the 64 percent held in U.S. dollars and these proportions have hovered about these levels for years despite periodic scares about diversification.
What is more, recent surveys of reserve managers show the euro is not even necessarily a second choice for future prominence.
Swiss bank UBS this month polled 80 central bank reserve managers, multilateral institutions and sovereign wealth funds with some $5.5 trillion under management. Their answers on future reserve currencies were equivocal, to say the least.
Asked what the most important reserve currency would be in 25 years time, about 40 percent said the U.S. dollar would remain in pole position -- down from more than 45 percent over the past two years.
But the eye-opener was the second most popular choice: an unspecified "Asian currency" favoured by almost 20 percent of respondents.
The euro gained favour from less than 15 percent and this only marginally more than those picking gold and the International Monetary Fund's basket Special Drawing Rights.
WHO CARES AND WHY
Even though many in the ECB and in Brussels are sceptical of the euro's use as a reserve currency -- partly because it risks complicating monetary policy for a central bank still targeting money supply -- there are substantial benefits for the status.
The main boon to the United States, for example, has been that it can borrow hundreds of billions in dollar-denominated bonds at relatively cheap rates because it is assured of demand from foreign central banks needing to bank huge dollar reserves. That at least partly explains why the country could go from an annual budget surplus 10 years ago to a projected deficit of more than 10 percent of GDP and still manage to be paying almost half its 1999 interest cost for benchmark 10-year borrowings.
But this need of reserve managers to bank hard cash reserves in top-rated and liquid government bonds appears to be the euro's critical weakness as a reserve currency.
And, in some respects, the past 18 months of the credit crisis can be viewed as a "stress test" for the euro zone government bond market in the eyes of reserve managers.
Euro zone government bonds -- with the possible exception of German bunds -- have never been as easily tradable as Treasuries, where prices are made around the 24 trading clock via a diverse group of brokers and market makers.
Although improving, traders say there are few active trading quotes in euro zone debt much after 2000 GMT, a possible concern for largely Asian reserve managers who prize the instant cash-in-hand quality of Treasuries in the event of emergencies.
Over the past couple of years there have also been accusations -- hotly denied -- by brokers such as ICAP that the main pan-European trading platform Euro MTS acts as an effective monopoly and that pressure by governments on primary dealers to make quotes on MTS gives a false impression of market depth.
"Liquidity in the euro government bond markets has frequently been a bit of a mirage," said Meyrick Chapman, strategist at UBS in London.
Critically, the relatively liquid and smooth functioning AAA-rated German bund market makes up only a third of the total euro government bond market.
Italian government debt, for example, also makes up another full third. But Italy's credit rating is now only A+ and its 10-year bonds yields offer a 112 basis point premium to bunds.
And during the worst of the recent credit crisis, more peripheral euro zone government bonds markets such as those in Greece, Ireland and Portugal dried up completely.
So while the dollar may gradually be waning as a force and the prospects of a notional "Asian currency" taking over may be distant, the euro too has high hurdles to jump in order to command the dominant reserve role.
(Editing by Ruth Pitchford)