The Dollar: The Worlds Reserve Currency Council on Foreign Relations

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The Dollar: The Worlds Reserve Currency Council on Foreign Relations

what is the reserve currency

A reserve currency, also called an anchor currency, is the foreign currency that a government, central bank and other major financial institutions hold as part of the their reserves. The popularity of reserve currencies is a function of their stability and reputation. For example, the Chinese yuan hasn’t taken off as a major reserve currency due to concerns over a sudden devaluation that could send their value lower. The same is true for the euro following the sovereign debt crisis in 2009 and the immigration crisis in 2016 and 2017. These issues have led to concerns over currency volatility, which has kept the U.S. dollar as the most popular reserve currency through the early twenty-first century. Many of them are specifically designated as reserve currencies by the International Monetary Fund (IMF).

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But it remains the world’s reserve currency, and the most redeemable currency for global commerce and transactions, based largely on the size and strength of the U.S. economy and the dominance of the U.S. financial markets. Countries also keep an eye on major reserve currencies to ensure that their holdings aren’t adversely affected. For instance, strong inflation in the U.S. could cause a devaluation of the U.S. dollar.

  1. As of February 2022, Russia’s foreign exchange reserves totaled some $630 billion.
  2. Nine years later, in 1785, the U.S. officially adopted the dollar sign, using the symbol for the Spanish-American peso as a guide.
  3. We wish them luck in deciding between rate cuts and hikes if oil prices fall, hurting Russia while causing potential booms in India and China.
  4. Having funds in a reserve currency helps minimize exchange rate risk – the purchasing country, if it holds some reserve currency, will not have to exchange its domestic currency for the current reserve currency to make purchases.

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Countries without reserve currency status fear that their fates are tied to macroeconomic and political decisions that are outside of their control. The push for a world market dominated less by the dollar is nothing new, but just as investors seek to hold a basket of investments rather than a solitary stock, so do central banks when it comes to managing their reserves. The euro is the second most used reserve currency, accounting for roughly 20 percent of global foreign exchange reserves.

Understanding Currency Reserves

Some commentators posit a more radical shift in currency positioning, where dollar reserves are dumped on the open market. It’s hard to see how tanking the economy of their biggest customer would benefit them. The resulting global turmoil would almost certainly destabilize their own economies more than the U.S. dollar and create a self-inflicted domestic political crisis. Countries like Japan and China—which have the largest trade surpluses—also have the most currency reserves because they receive U.S. dollars and other foreign currencies when they provide exports.

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Over time, U.S. trade swung into a sustained deficit, supported in part by global demand for dollar reserves. The euro, introduced in 1999, is the second most commonly held reserve currency in the world. According to the International Monetary Fund (IMF), which is charged with promoting global growth and trade, central banks hold more than $6.7 trillion in dollar reserves versus 2.2 trillion in euros as of Q4 2019. In the beginning, the world benefited from a strong and stable dollar, and the United States prospered from the favorable exchange rate on its currency. The foreign governments did not fully realize that although gold reserves backed their currency reserves, the United States could continue to print dollars that were backed by its debt held as U.S. As the United States printed more money to finance its spending, the gold backing behind the dollars diminished.

Proponents—including El Salvadoran President Nayib Bukele, who has made Bitcoin legal tender—argue that such a system would free countries from the whims of other nations’ monetary policies. But critics say adopting cryptocurrency as legal tender constrains a government’s policy options during a crisis, and that the volatility of cryptocurrency reduces its viability as a means of exchange. However, some countries are experimenting with using blockchain technology to create digital versions of their existing traditional currencies.

That made the dollar more stable than other currencies and put a system of fixed exchange rates in place. As a result, the depth and liquidity of U.S. financial markets is unmatched, and there is a large supply of extremely safe dollar-denominated assets. That said, this dominance should not be taken for granted and the note ends with a discussion of possible challenges to the dollar’s status.

When World War I broke out in 1914, many countries suspended the gold standard to pay their military expenses with paper money, which devalued their currencies. Britain held to the gold standard to maintain its position as the world’s leading currency and found itself borrowing money for the first time during the third year of the war. The dollar was first printed in 1914, a year after the establishment of the Federal Reserve as the U.S. central bank with the passing of the Federal Reserve Act. Three decades later, the dollar officially became the world’s reserve currency. Being the country issuing a reserve currency reduces transaction costs, since both sides of the transaction involve the same currency and one is yours.

The world’s largest current foreign exchange reserve holder is China, a country holding more than $3 trillion of its assets in a foreign currency. One of the reasons for this is that it makes international trade easier to execute since most of the trading takes place using the U.S. dollar. In 1999, 71% of the official foreign exchange reserves across the world were in dollars, while 17.9% were in euro, 2.9% in pound sterling, and 6.4% in Japanese yen. China has positioned its currency as next in line to the U.S. dollar; it has been the largest contributor to world growth since 2008’s global financial crisis.

Some experts say this benefit is modest, pointing to the fact that other developed countries are able to borrow at similarly low rates. Former Federal Reserve Chair Ben Bernanke has argued that the United States’ declining share of the global economy and the rise of other currencies such as the euro and yen have eroded the U.S. advantage. “The exorbitant privilege is not so exorbitant any more,” Bernanke wrote in 2016. The other fatal flaw, in our view, is that there is no viable replacement for the dollar, as has been discussed previously. The euro can absorb some redirected flows from new reserves accumulation, but the math on shifting the $7 trillion stock of dollar reserves into a German bond market with €2 trillion outstanding does not work. Not to mention that the eurozone would almost certainly look to limit inflows from countries that had just weaponized bond markets.

We explain why we believe it will be status quo for the currency despite reports to the contrary. In the fifth century B.C., it was the Greek drachma, followed by the Roman denari, the Byzantine solidus, and in the middle-ages the Arab dinar. So representatives from 44 nations gathered in the small town of Bretton Woods, New Hampshire to come up with the solution.

The IMF would also need to be empowered to control the supply of SDR, which, given the United States’ de facto veto power within the organization’s voting structure, would be a tall order. Reserve currencies have come and gone with the evolution of the world’s geopolitical order. International currencies in the past have (excluding those discussed below) included the Greek drachma, coined in the fifth century B.C.E., the Roman denarii, the Byzantine solidus and Islamic dinar of the middle-ages and the French franc. In the U.S., almost all banks are part of the Federal Reserve System and it is required that a certain percentage of their assets be deposited with their regional Federal Reserve Bank. By 1931, Britain was forced off the gold standard entirely following speculative attacks on the pound. However, during the Great Depression in the 1930s, trade shrank considerably and the gold standard fell.

Most countries want to hold their reserves in a currency with large and open financial markets, since they want to be sure that they can access their reserves in a moment of need. Central banks often hold currency in the form of government bonds, such as U.S. treasuries. The U.S. treasury market remains by far the world’s largest and most liquid—the easiest to buy into and sell out of—bond market. By buying and selling currencies on the open market, a central bank can influence the value of its country’s currency, which can provide stability and maintain investor confidence.

Reserve currencies can also be foreign currency securities, deposits, and loans. Many experts agree that the dollar will not be overtaken as the world’s leading reserve currency anytime soon. More likely, they say, is a future in which it slowly comes to share influence with other currencies, though this trend could be accelerated by the aggressive use of U.S. sanctions and growing U.S. financial instability.

Meanwhile, the dollar’s outsize role in international trade could have negative consequences for the global economy. As a country’s currency weakens, its goods exports should become cheaper and thus more competitive. But because so much trade is conducted in U.S. dollars, other countries do not always see this benefit when their currencies depreciate. “Both the United States and the world at large would benefit from a less dominant U.S. dollar,” writes Michael Pettis, a professor of finance at Peking University. By the 1960s, however, the United States did not have enough gold to cover the dollars in circulation outside the United States, leading to fears of a run that could wipe out U.S. gold reserves.

A world currency is any money that can freely be used or exchanged for another currency inside or outside the borders of the country that issues it. The first U.S. dollar (USD) is the official currency of the United States and several other countries. A reserve currency is a currency held in large quantities by governments and institutions.

During this time, more than sixty percent of world trade invoicing was done in pound sterling (British pound). Having funds in a reserve currency helps minimize exchange rate risk – the purchasing country, if it holds some reserve currency, will not have to exchange its domestic currency for the current reserve currency to make purchases. Because other countries want to hold a currency in reserve and use it for transactions, the higher demand means lower borrowing costs through depressed bond yields (most reserves are of government bonds).

Federal Reserve Board staff estimate that over $950 billion in U.S. dollar banknotes were held by foreigners at the end of the first quarter of 2021, roughly half of total U.S. dollar banknotes outstanding. The IMF (International Monetary Fund) now includes the yuan, which is also called the renminbi, in a basket of currencies that it uses to help manage countries’ economic problems. Currently, all bets are on the Chinese yuan taking over from the US dollar.

Periodically, the board of governors of a central bank meets and decides on the reserve requirements as a part of monetary policy. The amount that a bank is required to hold in reserve fluctuates depending on the state of the economy and what the governing board determines as the optimal level. Governments and their central banks across the world monitor US monetary policy closely to check whether the value of their reserves is not negatively affected by inflation.

In 1925, the British Gold Standard Act reintroduced the gold bullion standard – and many countries did the same. Up until the Great Depression, there was a period of economic stability. In the 18th century, when the Dutch East India Company dominated international trade, the Dutch guilder was the de facto world currency.

what is the reserve currency

In 2022, global central banks held over half of their reserves in U.S. dollars. Cries for a global currency grow louder when the dollar is comparatively weak, since a weak dollar makes U.S. exports cheaper and can erode trade surpluses in other export-dominated economies. Critics of a dollar-dominated currency market have pointed out that it may be increasingly difficult for the U.S. to keep up with world dollar demand as its weight in the global economy shrinks. Rather than use the dollar, central banks have looked towards using a basket of currencies, called special drawing rights.

As a result of the Bretton Woods Agreement, the U.S dollar was officially crowned the world’s reserve currency, backed by the world’s largest gold reserves. Instead of keeping supplies of gold, other countries accumulated reserves of U.S. dollars; central banks would maintain fixed exchange rates between their currencies and the greenback. After the war ended, the restructured governments of the former Axis powers also agreed to use dollars for their currency reserves. A key function of a currency is as a store of value which can be saved and retrieved in the future without a significant loss of purchasing power. One measure of confidence in a currency as a store of value is its usage in official foreign exchange reserves. As shown in Figure 2, the dollar comprised 60 percent of globally disclosed official foreign reserves in 2021.

The increase monetary supply of dollars went beyond the backing of gold reserves, which reduced the value of the currency reserves held by foreign countries. Currency reserves are held by central banks and foreign institutions for several reasons, but primarily to provide stability and to purchase key imports during periods of domestic or global economic crisis. For decades, the U.S. dollar has been the currency of choice for reserves—to the tune of roughly $7 trillion. Known as the Bretton Woods Agreement, it established the authority of central banks, which would maintain fixed exchange rates between currencies and the dollar.

Britain abandoned the gold standard in 1931, which decimated the bank accounts of international merchants who traded in pounds. Countries don’t fill out an application to have their currencies become reserve currencies, and there is no international organization that confers this status. To get a seat at the legacy fx review grownups’ table, it helps to be a developed country with a big economy with relatively free capital flows, to have a banking system able to handle being a creditor, and to have export clout. These requirements make reserve currency status a rich world club, much to the chagrin of many developing countries.

Although the British Sterling was the largest currency, both the French franc and the German mark shared large portions of the market until the First World War, after which the mark was replaced by the dollar. Foreign exchange reserves can include banknotes, deposits, bonds, treasury bills and other government securities. These assets serve many purposes but are most significantly held to ensure that a central government agency has backup funds if their national currency rapidly devalues or becomes entirely insolvent. Foreign exchange reserves are assets held on reserve by a central bank in foreign currencies. These reserves are used to back liabilities and influence monetary policy. The US government guaranteed other central banks that they could sell their dollar reserve currency at a fixed rate for gold.

These transactions used the U.S. dollar as a reserve currency, which was accepted internationally, rather than the local currencies of the countries involved. Starting in the mid-20th century, the U.S. dollar was set as the international reserve currency. Since then, strong economies in many countries have led to the rise of other international reserve currencies. The United States is also harmed by currency manipulation—when another country holds down the value of its currency to maintain a large trade surplus.

In the past due to the Plaza Accord, its predecessor bodies could directly manipulate rates to reverse large trade deficits. Amid this geoeconomic bickering, Jeremy Allaire, the CEO of cryptocurrency firm Circle, sees a third way. “There’s been this dollar hegemony, but that’s very much under threat right now,” particularly from China, he said on our latest Leadership Next podcast, out this week. But according to Allaire, the future isn’t so much with the physical greenback or yuan. “The competition over money is becoming a technological competition,” he said.

In part because of its dominant role as a medium of exchange, the U.S. dollar is also the dominant currency in international banking. As shown in Figure 6, about 60 percent of international and foreign currency liabilities (primarily deposits) and claims (primarily loans) are denominated in U.S. dollars. This share has remained relatively stable since 2000 and is well above that for the euro (about 20 percent). Central banks also use it to influence the exchange rate of their domestic currency. The United States became the lender of choice for many countries that wanted to buy dollar-denominated U.S. bonds.

For example, in the wake of the Russian invasion of Ukraine in 2022, unprecedented U.S. sanctions cut Russia off from the dollar, freezing $300 billion in Russian central bank assets and triggering a default on the country’s sovereign debt. “There’s no doubt that if the dollar were not so widely used, the reach of sanctions would be reduced,” says Setser. In addition to accounting for the majority of global reserves, the dollar remains the currency of choice for international trade. Major commodities such as oil are primarily bought and sold using U.S. dollars, and some major economies, including Saudi Arabia, still peg their currencies to the dollar. Some have proposed the use of the International Monetary Fund’s (IMF) special drawing rights (SDRs) as a reserve.