For any country of the world, having a strong currency is a matter of national importance. When the currency starts to strengthen against others, it is always favorable for their economy.
However, most countries also hold large quantities of another country’s currency in their central bank, known as the reserve currency.
Holding reserve currency is as vital for any country as it is to keep their currency strong. Moreover, it is also crucial for maintaining trade relations and conducting foreign transactions smoothly.
This article covers everything you need to know about the reserve currency and its importance for a country on the world stage.
Basics of Reserve Currency
A reserve currency refers to an international or foreign currency that is bought and stored in large amounts. Usually, it is held by the government, central bank, or a financial institution, and countries can use it to conduct international transactions.
Therefore, having a reserve currency helps the country gain a strong foothold in the global market and trade easily.
Countries that have a reserve currency usually have large quantities to be easily exchanged with other currencies. Moreover, the reserve currency is generally held by a government authority or national financial institutions.
Earlier, countries used to hold gold and silver reserves, but this changed during the middle of the 20th century when most countries left the gold standard.
For any foreign currency to be used as a reserve currency, it should have a strong presence in the global market. Moreover, you can also classify deposits, securities, or loans as a reserve currency.
Due to its strong performance and foothold, the U.S. Dollar was chosen as the international reserve currency. Since then, many other foreign currencies have worked hard to bring their currencies to the same level.
How is the Reserve Currency Chosen?
A couple of factors are involved in the choice of a reserve currency from the hundreds of foreign currencies out there. The first factor is the economic size of the country to which the particular currency belongs.
Additionally, the economy’s performance on the international stage is also crucial, as well as the health of its financial markets.
Another factor that comes into play regarding the selection of the reserve currency is its convertibility, which refers to the ease with which you can convert it to other currencies.
Other factors may include a regional or international country peg, as well as the domestic policies that strengthen or weaken the currency.
How does the Reserve Currency Work?
There are several reasons why a country might choose to hold reserve currency, one of which is to repay their foreign debt and thus use it to improve the health of their national currency.
A reserve currency is one of the best ways to conduct business with other countries and perform international transactions without worrying about foreign exchange rates. This is why entities conduct a majority of foreign transactions with the reserve currency.
Reserve currency is also essential for the trade and monetary policies implemented by countries all over the world. It also impacts the foreign currency reserves, and high-performing economies also use their reserve currency to increase the value of their own currency.
Basically, it uses foreign currency reserves to buy its national currency, which boosts the currency value.
Plus, other countries implement schemes in which they fix the exchange rate, and they use the supply and demand to increase or decrease the value of their national currency. Additionally, countries monitor reserve currencies to ensure that their currency isn’t devalued.
How did the U.S. Dollar Become the Global Reserve Currency?
The U.S. Dollar was first printed in 1914 when the Federal Reserve Bank was established. During the Second World War, the United States had the largest gold reserves of any nation globally, mainly because they got it in return for helping the Allies.
After the war, many countries made the dollar their reserve currency, but it was still pegged to the gold standard. Later on, the U.S. government dropped the gold standard and switched to fiat currency, which continues today.
Today, the U.S. Dollar makes up for around 60% of the foreign bank reserves and 40% of the world’s debt. Soon after the U.S. Dollar was made the global reserve currency, the United States became the top lender in the world.
Following this, Britain also stopped using its gold standard, which helped propel the U.S. Dollar to the world’s leading reserve currency.
In 1944, the Bretton Woods Agreement between the International Monetary Fund (IMF) and the World Bank made the U.S. Dollar the international reserve currency.
Following this agreement, countries started doing away with their dependence on gold reserves and started accumulating U.S. Dollars.
In 1973, the New Economic Policy that President Nixon rolled out ended the Bretton Woods Agreement and allowed other currencies to join it as the reserve currencies.
What Other Reserve Currencies Are There?
In today’s world, the U.S. Dollar isn’t the sole reserve currency used for international and foreign transactions.
Instead, the IMF chose a couple of other currencies and gave them this status, mainly due to the size of their economy. Some of the major reserve currencies include the U.S. Dollar, Euro, Japanese Yen, British Pound Sterling, and the Chinese Renminbi.
The United States Dollar is the most common reserve currency in the world, and it consists of more than 60% of international foreign currency reserves. This has helped the US to put off the economic impact of trade deficits for a longer time.
The amount of U.S. Dollar reserves held by the Federal Reserve Bank is much lower than that held by private holders and investors. Therefore, if these investors choose to trade their holdings to those available in other currencies, it may weaken the US economy.
The euro makes for 21% of the international foreign currency reserves in the world. After the Second World War, the Deutsche Mark made the second-largest reserves, and when the euro was introduced in 1999, it replaced the Mark and numerous other European currencies.
Thus, it replaced the Mark in second place in the foreign currency reserves list.
The Dutch Guilder is another defunct European currency that was replaced with the euro in 1999.
Before the U.S. Dollar was officially declared as the reserve currency in 1944, the biggest reserve currency was the United Kingdom’s Pound Sterling.
However, the nation destroyed its economy during the first two World Wars. Even though 55% of the global currency reserves were in Pound Sterling in the 1950s, the share dropped significantly in the next two decades.
The Japanese Yen is a part of the special drawing rights valuation by the IMF. Its currency value is determined daily according to the exchange rates of currencies that constitute the basket.
The yen has approximately $624.97 billion in foreign currency reserves, and its valuation basket is re-adjusted after five years.
Several central banks have also accumulated Canadian Dollars as their reserve currency. The Canadian Dollar empowers the economies of the British, French, and Dutch regions. Moreover, central banks in Central, South, and Latin America hold it.
It ranks fifth among the foreign currency reserves in the world.
The Swiss Franc is also becoming popular among the world’s foreign currency reserves, and countries often use it to denominate foreign loans.
Since the total share of the foreign exchange reserves in Swiss Francs translates only amounts to 0.5%, which means that you benefit every time you settle or sell your reserves.
Will the U.S. Dollar Stay the Global Reserve Currency?
There are various speculations regarding the performance of the U.S. Dollar as the global currency reserve option, and the IMF predicts that it will go further down with time.
Due to the COVID-19 pandemic, people are always looking to minimize risk and look towards assets in other currencies.
During this time, gold is one such option that reduces the risk of devaluation.
Therefore, the U.S. Dollar’s share of foreign currency reserves is slowly reducing, which is another reason why central banks of various countries are moving away from the dollar and looking for alternate currencies.
The weaker position of the dollar also contributed to the economic decline that was experienced in 2020.
This would also give rise to other currencies and bring them up gradually. Due to the shift from U.S. Dollar dominated assets, there was an increase in euro-dominated holdings, and the Japanese Yen also saw a significant growth of up to 6%.
Apart from these, gold reserves have also been climbing gradually, and there is no telling how further it will go.
As you can see, reserve currencies are important in the global market landscape. Having a reserve currency not only allows for a regulated and central method for foreign transactions but also helps strengthen the national currency.