Getting started with reserve currencies

For nearly a century, the U.S. dollar has been the world’s premier reserve currency, winning the crown once worn by the pound sterling. The future of the US dollar as the most popular reserve currency is uncertain. The reserve currency is the foreign currency held by the central bank. When a country acquires reserves, it does not put currency in general circulation. Instead, it deposits reserves in the central bank. Reserves are obtained through trade, and the acquiring country sells goods in exchange for currency.

Therefore, reserve currencies lubricate the wheels of international commerce by helping countries and companies use the same currency for transactions, which is much simpler than resolving transactions involving different currencies. Their popularity is obvious: between 1995 and 2011, the number of reserve currencies increased by more than 730%, from approximately US$1.4 trillion to US$10.2 trillion.

Key points

  • The reserve currency is a globally recognized national currency, often used in international trade and global finance.
  • For example, the British pound was once the de facto reserve currency in the world, but today the U.S. dollar and the euro are regarded as reserve currencies.
  • Having the status of a reserve currency has both advantages (for example, lower exchange rate risk and greater purchasing power), but also disadvantages (for example, artificially low interest rates can stimulate asset bubbles).

Reserve currency issuer

Reserve currencies are usually issued by developed and stable countries. The most commonly held currency as foreign exchange reserves is the U.S. dollar. According to the International Monetary Fund (IMF), as of the end of 2012, the U.S. dollar accounted for nearly 62% of allocated reserves. Other reserve currencies include the euro, yen, Swiss franc and pound sterling. Although the US dollar is still the most widely held reserve currency, competition from the euro has become increasingly fierce. The euro has grown from a slightly less than 18% share of reserves when it was introduced into the financial market in 1999 to 24% at the end of 2011.

The International Monetary Fund reports allocated reserves, which means that a country has determined the currency in its reserves and the total amount of foreign exchange holdings. Over the years, the overall percentage of total holdings of allocated reserves has steadily declined, from 74% in 1995 to 55% in 2011. This shift can be largely explained by changes in foreign exchange holdings in emerging and developing countries. In 1995, foreign exchange reserves held by advanced economies accounted for approximately 67% of total foreign exchange reserves, of which 82% were allocated reserves. By 2011, the situation had changed drastically: emerging and developing countries accounted for 67% of total reserves, and the allocation was less than 39%. Emerging countries now hold approximately US$6.8 trillion in reserve currencies.

How does currency gain reserve status?

Countries do not need to fill out an application to change their national currency into a reserve currency, and no international organization has granted this status. To gain a place on the adult table, it helps to become a developed country with a large economy with relatively free capital flows, a banking system that can handle creditor status, and export influence. These requirements make the reserve currency status a wealthy world club, which annoys many developing countries. The currencies of China (the world’s second largest economy), Brazil (sixth), Russia (ninth) and India (tenth)-the BRIC countries-are not considered reserves, which is why these countries are more strongly Support the establishment of a reserve country that is not attached to any country.

When the U.S. dollar is relatively weak, calls for global currencies are getting louder, because the weak U.S. dollar makes U.S. exports cheaper and may erode the trade surplus of other export-oriented economies. Critics of the dollar-dominated currency market point out that as the United States’ weight in the global economy declines, it may become increasingly difficult for the United States to keep up with world dollar demand. Instead of using the U.S. dollar, the central bank considered using a basket of currencies called special drawing rights. The agreement will effectively reduce the influence of any country and, on the surface, will force more prudent economic policies.

Benefits of reserve currency status

Why all the hustle and bustle surrounding the status of reserve currencies? The country that issues reserve currencies reduces transaction costs because both parties involved in the transaction involve the same currency, and one is yours. Countries that issue reserve currencies will not face the same level of exchange rate risk, especially when it comes to commodities that are usually quoted and settled in U.S. dollars.

Because other countries want to hold a currency as a reserve and use it for trading, higher demand means lowering the cost of borrowing by lowering bond yields (most reserves are government bonds). The issuing country can also borrow in its own currency and is less worried about supporting its own currency to avoid default.

Disadvantages of reserve currency status

The status of a reserve currency is not without its shortcomings. The problems faced by issuing countries highlight why mature economies are often countries that issue widely held currencies. The low borrowing costs brought about by the issuance of reserve currencies may spur the relaxation of public and private sector expenditures, which may lead to asset bubbles and inflation of government debt. For example, US stimulus spending has caused Chinese leaders to worry about the weakness of the U.S. dollar because it will weaken the value of the country’s dollar-denominated debt.

Others might argue that part of the reason why the United States can spend so freely is that China’s excess savings must be stored somewhere, and somewhere in U.S. dollars. This situation is nothing new. Robert Triffin (known for the Triffin dilemma) discovered this shortcoming while the gold standard still existed. Failure to control currency outflows also puts fragile financial institutions at risk, and Hollywood (and real life) shows how criminals like the dollar.

What about the renminbi?

What about the renminbi? China is the second largest economy in the world and is developing rapidly. The prestige of a country with a reserve currency is likely to make Chinese leaders salivate. Apart from China’s newcomer to economic liberalization, perhaps the biggest obstacle is the strict control of the renminbi. “Exchange rate manipulation” is a common term used during the recent US elections, because many companies believe that the renminbi has been artificially lowered to protect Chinese exports. In addition, China limits the number of bonds that foreigners can hold, and reserve currencies are often held in the form of government bonds rather than hard currency. Some experts believe that continued liberalization may cause the yuan to join the reserve currency club as early as 2020.

Bottom line

In such a global economy, where countries are transporting goods and goods at such crazy speeds, it is unlikely that concerns about market stagnation due to currency restrictions will diminish in the next few years. The recent financial crisis has increased the pressure on the U.S. dollar, especially considering the public debt outlook and political fringe policies. Countries without reserve currency status worry that their fate is related to macroeconomic and political decisions beyond their control. Pushing to reduce the dollar-dominated world market is nothing new, but just as investors seek to hold a basket of investments rather than individual stocks, so does the central bank in managing reserves.

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