Reserve currency

A reserve currency (or anchor currency) is a foreign currency that is held in significant quantities by central banks or other monetary authorities as part of their foreign exchange reserves. The reserve currency can be used in international transactions, international investments and all aspects of the global economy. It is often considered a hard currency or safe-haven currency.

The United Kingdom's pound sterling was the primary reserve currency of much of the world in the 19th century and first half of the 20th century.[1] However, by the end of the 20th century, the United States dollar had become the world's dominant reserve currency.[2] The world's need for dollars has allowed the United States government to borrow at lower costs, giving the United States an advantage in excess of $100 billion per year.[3][4][5]

Currency symbols of the four most widely held reserve currencies

History
John Maynard Keynes (right) and Harry Dexter White helped to draft the provisions of the post-war financial system. Here, they meet at the inaugural meeting of the International Monetary Fund, 1946.

Reserve currencies have come and gone. International currencies in the past have included the Greek drachma, coined in the fifth century B.C., the Roman denari, the Byzantine solidus and Arab dinar of the middle-ages, the Venetian ducato and the Florentine florin of the Renaissance, the 17th century Dutch guilder and the French franc.

The Dutch guilder emerged as a de facto world currency in the 18th century due to unprecedented domination of trade by the Dutch East India Company.[6] However, the development of the modern concept of a reserve currency took place in the mid 19th century, with the introduction of national central banks and treasuries and an increasingly integrated global economy. By the 1860s, most industrialised countries had followed the lead of the United Kingdom and put their currency on to the gold standard. At that point, the UK was the primary exporter of manufactured goods and services and over 60% of world trade was invoiced in pounds sterling. British banks were also expanding overseas; London was the world centre for insurance and commodity markets and British capital was the leading source of foreign investment around the world; sterling soon became the standard currency used for international commercial transactions.[7]

Attempts were made in the interwar period to restore the gold standard. The British Gold Standard Act reintroduced the gold bullion standard in 1925,[8] followed by many other countries. This led to relative stability, followed by deflation, but because the onset of the Great Depression and other factors, global trade greatly declined and the gold standard fell. Speculative attacks on the pound forced Britain entirely off the gold standard in 1931.[9][10]

After World War II, the international financial system was governed by a formal agreement, the Bretton Woods System. Under this system, the United States dollar (USD) was placed deliberately as the anchor of the system, with the US government guaranteeing other central banks that they could sell their US dollar reserves at a fixed rate for gold.[11]

In the late 1960s and early 1970s, the system suffered setbacks ostensibly due to problems pointed out by the Triffin dilemma—the conflict of economic interests that arises between short-term domestic objectives and long-term international objectives when a national currency also serves as a world reserve currency.

Additionally, in 1971 Nixon suspended the convertibility of the USD to gold, thus creating a fully fiat global reserve currency system.

Following the 2020 economic recession, the IMF opined about the emergence of "A New Bretton Woods Moment" which could imply the need for a new global reserve currency system. (see below: § Calls for an alternative reserve currency)[12]

Global currency reserves

The IMF regularly publishes the aggregated Currency Composition of Foreign Exchange Reserves (COFER).[13] The reserves of the individual reporting countries and institutions are confidential.[14] Thus the following table is a limited view about the global currency reserves that only deals with allocated reserves:

Currency composition of official foreign exchange reserves (1965–2019)
2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1995 1990 1985 1980 1975 1970 1965
US dollar 60.89% 61.74% 62.72% 65.36% 65.73% 65.14% 61.24% 61.47% 62.59% 62.14% 62.05% 63.77% 63.87% 65.04% 66.51% 65.51% 65.45% 66.50% 71.51% 71.13% 58.96% 47.14% 56.66% 57.88% 84.61% 84.85% 72.93%
Euro (until 1999 - ECU) 20.54% 20.67% 20.16% 19.13% 19.14% 21.20% 24.20% 24.05% 24.40% 25.71% 27.66% 26.21% 26.14% 24.99% 23.89% 24.68% 25.03% 23.65% 19.18% 18.29% 8.53% 11.64% 14.00% 17.46%
Deutsche mark 15.75% 19.83% 13.74% 12.92% 6.62% 1.94% 0.17%
Japanese yen 5.70% 5.20% 4.89% 3.95% 3.75% 3.54% 3.82% 4.09% 3.61% 3.66% 2.90% 3.47% 3.18% 3.46% 3.96% 4.28% 4.42% 4.94% 5.04% 6.06% 6.77% 9.40% 8.69% 3.93% 0.61%
Pound sterling 4.62% 4.42% 4.54% 4.34% 4.71% 3.70% 3.98% 4.04% 3.83% 3.94% 4.25% 4.22% 4.82% 4.52% 3.75% 3.49% 2.86% 2.92% 2.70% 2.75% 2.11% 2.39% 2.03% 2.40% 3.42% 11.36% 25.76%
French franc 2.35% 2.71% 0.58% 0.97% 1.16% 0.73% 1.11%
Chinese renminbi 1.96% 1.89% 1.23% 1.07%
Canadian dollar 1.88% 1.84% 2.02% 1.94% 1.77% 1.75% 1.83% 1.42%
Australian dollar 1.69% 1.62% 1.80% 1.69% 1.77% 1.59% 1.82% 1.46%
Swiss franc 0.15% 0.14% 0.18% 0.16% 0.27% 0.24% 0.27% 0.21% 0.08% 0.13% 0.12% 0.14% 0.16% 0.17% 0.15% 0.17% 0.23% 0.41% 0.25% 0.27% 0.33% 0.84% 1.40% 2.25% 1.34% 0.61%
Dutch guilder 0.32% 1.15% 0.78% 0.89% 0.66% 0.08%
Other currencies 2.56% 2.47% 2.50% 2.37% 2.86% 2.83% 2.84% 3.26% 5.49% 4.43% 3.04% 2.20% 1.83% 1.81% 1.74% 1.87% 2.01% 1.58% 1.31% 1.49% 4.87% 4.89% 2.13% 1.29% 1.58% 0.43% 0.03%
Source: World Currency Composition of Official Foreign Exchange Reserves International Monetary Fund

The percental composition of currencies of official foreign exchange reserves from 1995 to 2019.[15][16][17]

  US dollar
  Euro
  German mark
  French franc
  Pound sterling
  Japanese yen
  Chinese renminbi
  Other

Theory

Economists debate whether a single reserve currency will always dominate the global economy.[18] Many have recently argued that one currency will almost always dominate due to network externalities (sometimes called "the network effect"), especially in the field of invoicing trade and denominating foreign debt securities, meaning that there are strong incentives to conform to the choice that dominates the marketplace. The argument is that, in the absence of sufficiently large shocks, a currency that dominates the marketplace will not lose much ground to challengers.

However, some economists, such as Barry Eichengreen, argue that this is not as true when it comes to the denomination of official reserves because the network externalities are not strong. As long as the currency's market is sufficiently liquid, the benefits of reserve diversification are strong, as it insures against large capital losses. The implication is that the world may well soon begin to move away from a financial system dominated uniquely by the US dollar. In the first half of the 20th century, multiple currencies did share the status as primary reserve currencies. 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. Since the Second World War, the dollar has dominated official reserves, but this is likely a reflection of the unusual domination of the American economy during this period, as well as official discouragement of reserve status from the potential rivals, Germany and Japan.

The top reserve currency is generally selected by the banking community for the strength and stability of the economy in which it is used. Thus, as a currency becomes less stable, or its economy becomes less dominant, bankers may over time abandon it for a currency issued by a larger or more stable economy. This can take a relatively long time, as recognition is important in determining a reserve currency. For example, it took many years after the United States overtook the United Kingdom as the world's largest economy before the dollar overtook the pound sterling as the dominant global reserve currency.[1] In 1944, when the US dollar was chosen as the world reference currency at Bretton Woods, it was only the second currency in global reserves.[1]

The G8 also frequently issues public statements as to exchange rates. In the past due to the Plaza Accord, its predecessor bodies could directly manipulate rates to reverse large trade deficits.

Major reserve currencies
Distribution of global reserve currencies

United States dollar

The United States dollar is the most widely held currency in the allocated reserves, representing about 61% of international foreign currency reserves, which makes it somewhat easier for the United States to run higher trade deficits with greatly postponed economic impact or even postponing a currency crisis. Central bank US dollar reserves, however, are small compared to private holdings of such debt. In the event that non-United States holders of dollar-denominated assets decided to shift holdings to assets denominated in other currencies, there could be serious consequences for the US economy. Changes of this kind are rare, and typically change takes place gradually over time, and markets involved adjust accordingly.[1]

However, the US dollar remains the preferred reserve currency because of its stability along with assets such as United States Treasury security that have both scale and liquidity.[19]

The US dollar's position in global reserves is often questioned because of the growing share of unallocated reserves, and because of the doubt regarding dollar stability in the long term.[20][21][22][23][24] However, in the aftermath of the financial crisis, the dollar's share in the world's foreign-exchange trades rose slightly from 85% in 2010 to 87% in 2013.[25]

The dollar's role as the undisputed reserve currency of the world allows the United States to impose unilateral sanctions against actions performed between other countries, for example the American fine against BNP Paribas for violations of U.S. sanctions that were not laws of France or the other countries involved in the transactions.[26] In 2014 Beijing, New Delhi and Moscow signed a 150 billion yuan central bank liquidity swap line agreement to get around American sanctions on their behaviors.[27]

Euro
Further information: International status and usage of the euro

The euro is currently the second most commonly held reserve currency, representing about 21% of international foreign currency reserves. After World War II and the rebuilding of the German economy, the German Deutsche Mark gained the status of the second most important reserve currency after the US dollar. When the euro was introduced on 1 January 1999, replacing the Mark, French franc and ten other European currencies, it inherited the status of a major reserve currency from the Mark. Since then, its contribution to official reserves has risen continually as banks seek to diversify their reserves, and trade in the eurozone continues to expand.[28]

Former U.S. Federal Reserve Chairman Alan Greenspan said in September 2007 that the euro could replace the U.S. dollar as the world's primary reserve currency. It was "absolutely conceivable that the euro will replace the US dollar as reserve currency, or will be traded as an equally important reserve currency."[29] Econometric analysis by Jeffrey Frankel and Menzie Chinn in 2006 suggested that the euro could replace the U.S. dollar as the major reserve currency by 2020 if either the remaining EU members, including the UK and Denmark, adopted the euro by 2020, or the (then) recent depreciation trend of the dollar persisted into the future.[30][31]

Other reserve currencies

Dutch guilder

The Dutch guilder was the de facto reserve currency in Europe in 17th and 18th centuries.[6][32]

Pound sterling

The United Kingdom's pound sterling was the primary reserve currency of much of the world in the 19th century and first half of the 20th century.[1] until the UK almost bankrupted itself fighting World War I[33] and World War II[34] resulting in the Pound losing its status as the world's most important reserve currency.

In the 1950s 55% of global reserves were still held in sterling; but the share was 10% lower within 20 years.[1][35]

The economic vacuum following the World Wars allowed the emergence of the United States as an economic superpower, and the establishment of the U.S. Federal Reserve System in 1913.[36]

As of 30 September 2019, the pound sterling represented the fourth largest proportion (by USD equivalent value) of foreign currency reserves.[37]

Japanese yen

Japan's yen is part of the International Monetary Fund's (IMF) special drawing rights (SDR) valuation. The SDR currency value is determined daily by the IMF, based on the exchange rates of the currencies making up the basket, as quoted at noon at the London market. The valuation basket is reviewed and adjusted every five years.[38]

The SDR Values and yen conversion for government procurement are used by the Japan External Trade Organization for Japan's official procurement in international trade.[39]

Swiss franc

The Swiss franc, despite gaining ground among the world's foreign-currency reserves[40] and being often used in denominating foreign loans,[41] cannot be considered as a world reserve currency, since the share of all foreign exchange reserves held in Swiss francs has historically been well below 0.5%. The daily trading market turnover of the franc, however, ranked fifth, or about 3.4%, among all currencies in a 2007 survey by the Bank for International Settlements.[42]

Canadian dollar

A number of central banks (and commercial banks) keep Canadian dollars as a reserve currency. In the economy of the Americas, the Canadian dollar plays a similar role to that played by the Australian dollar (AUD) in the Asia-Pacific region. The Canadian dollar (as a regional reserve currency for banking) has been an important part of the British, French and Dutch Caribbean states' economies and finance systems since the 1950s.[43] The Canadian dollar is also held by many central banks in Central America and South America. It is held in Latin America because of remittances and international trade in the region.[43]

Because Canada's primary foreign-trade relationship is with the United States, Canadian consumers, economists, and many businesses primarily define and value the Canadian dollar in terms of the United States dollar. Thus, by observing how the Canadian dollar floats in terms of the US dollar, foreign-exchange economists can indirectly observe internal behaviours and patterns in the US economy that could not be seen by direct observation. Also, because it is considered a petrodollar, the Canadian dollar has only fully evolved into a global reserve currency since the 1970s, when it was floated against all other world currencies.

The Canadian dollar, since 2013, is ranked 5th among foreign currency reserves in the world.[44]

Chinese yuan
Main article: Internationalization of the renminbi

Chinese yuan officially became a world reserve currency on 1 October 2016. It represents 10.92% of the IMF's special drawing rights currency basket.[45][46] The Chinese yuan is the third reserve currency after the US dollar and Euro within the basket of currencies in the SDR which is a fraction of the total reserve currencies in reserves today.[45]

Calls for an alternative reserve currency

A report released by the United Nations Conference on Trade and Development in 2010, called for abandoning the U.S. dollar as the single major reserve currency. The report states that the new reserve system should not be based on a single currency or even multiple national currencies but instead permit the emission of international liquidity to create a more stable global financial system.[47][48][49]

Countries such as Russia and the People's Republic of China, central banks, and economic analysts and groups, such as the Gulf Cooperation Council, have expressed a desire to see an independent new currency replace the dollar as the reserve currency.

On 10 July 2009, Russian President Medvedev proposed a new 'World currency' at the G8 meeting in London as an alternative reserve currency to replace the dollar.[50]

At the beginning of the 21st century, gold and crude oil were still priced in dollars, which helps export inflation and has brought complaints about OPEC's policies of managing oil quotas to maintain dollar price stability.[51]

Special drawing rights

Some have proposed the use of the International Monetary Fund's (IMF) special drawing rights (SDRs) as a reserve.

China has proposed using SDRs, calculated daily from a basket of U.S. dollar, euro, Japanese yen and British pounds, for international payments.[52]

On 3 September 2009, the United Nations Conference on Trade and Development (UNCTAD) issued a report calling for a new reserve currency based on the SDR, managed by a new global reserve bank.[53] The IMF released a report in February 2011, stating that using SDRs "could help stabilize the global financial system."[54]

Further reading
  • Prasad, Eswar S. (2014). The Dollar Trap: How the U.S. Dollar Tightened Its Grip on Global Finance. Princeton, NJ: Princeton University Press. ISBN 978-0-691-16112-9.

See also

References
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  2. "The Federal Reserve in the International Sphere", The Federal Reserve System: Purposes & Functions, a publication of the Board of Governors of the Federal Reserve System, 9th Edition, June 2005
  3. Rogoff, Kenneth (October 2013). "America's Endless Budget Battle". Project Syndicate.
  4. "Quantitative Easing vs. Currency Manipulation". Investopedia. Retrieved 15 January 2021.
  5. "What Is a Reserve Currency?". Investopedia. 16 September 2020. Retrieved 15 January 2021.
  6. Pisani-Ferry, Jean; Posen, Adam S. (2009). The Euro at Ten: The Next Global Currency. United States of America: Peter G. Peterson Institute for International Economies & Brueggel. ISBN 9780881325584.
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  8. Text of the Gold Standard Bill speech Archived 2 October 2009 at the Wayback Machine by Winston Churchill, House of Commons, 4 May 1925
  9. Text of speech by Chancellor of the Exchequer Archived 2 October 2009 at the Wayback Machine Philip Snowden to the House of Commons, 21 September 1931
  10. Eichengreen, Barry J. (15 September 2008). Globalizing Capital: A History of the International Monetary System. Princeton University Press. pp. 61–. ISBN 978-0-691-13937-1. Retrieved 23 November 2010.
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  16. For 1999–2005: International Relations Committee Task Force on Accumulation of Foreign Reserves (February 2006), The Accumulation of Foreign Reserves (PDF), Occasional Paper Series, Nr. 43, Frankfurt am Main: European Central Bank, ISSN 1607-1484ISSN 1725-6534 (online).
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