A reserve currency is a national currency held by many other governments around the world as part of their foreign exchange reserves. The status of a reserve currency indicates a powerful economy as other governments depend on the reserve currency’s stability to manage their own monetary policies. It allows that country to ‘export inflation’; because when it prints money it circulates it outside its own economy as well, keeping the local money supply much more stable than non-reserve currencies that print money. Traders prefer working in a reserve currency because it minimizes costly exchanges when buying or selling and it gives them what they need most: efficiency and maximization of economic power of the nation to which the reserve currency belongs.
US Dollar as the largest reserve currency
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 gold reserves, other countries accumulated reserves of U.S. dollars. Needing a place to store their dollars, countries began buying U.S. Treasury securities, which they considered to be a safe store of money. U.S dollars have been a powerful reserve currency because of the depth and liquidity of the United States’ financial and forex markets, which remained robust, even during the financial crisis. The U.S. economy has maintained a track record of macroeconomic stability, which boosts confidence in the dollar’s long term purchasing power.
Why the US Dollar is at risk of losing its power as the largest reserve currency?
The primary reasons for the dollar’s continued dominance are inertia and the lack of viable alternatives, neither of which U.S. policymakers should find comforting for the longer term. The US dollar’s role as a global reserve currency declines when central banks other than the Fed shed their dollar-denominated holdings and replace it with assets denominated in other currencies. IMF data reveal the dollar share of foreign reserves fell from a high of 73% in 2001 to 62% at the end of last year. The most obvious U.S. policy contributions to a diminished role for the dollar are from economic sanctions and protectionist trade initiatives. Protectionist policies divert trade away from the U.S. and may induce new trade partners to settle in currencies other than the dollars. For instance, Moscow shifted $100 billion of its reserves into Chinese Yuan, Japanese yen and Euros to diversify away from the U.S. dollar. Russian President Vladimir Putin said that it wasn’t Russia that wanted to move away from the dollar, but that the dollar was moving away from Russia, in relation to U.S.-imposed sanctions.
Can other currencies replace the US Dollar as the reserve currency?
Some say it will be the euro; others, perhaps the Japanese yen or China’s Renminbi that will replace the US Dollar as the reserve currency. Some call for a new world reserve currency, possibly based on the IMF’s Special Drawing Right or SDR, a reserve asset. None of these candidates, however, is without flaws.
China is deliberating upon the use of the Chinese Renminbi as the next global currency. In 2016, The International Monetary Fund added Renminbi to the Special Drawing Rights basket. But, the current scenario says the Renminbi can’t overpower the U.S. dollar unless the Central banks around the world choose to keep a total of at least $700 billion worth of the Renminbi in foreign exchange reserves. China’s financial markets need to acquire the U.S. dollar’s reputation for transparency and stability, which is backed by the enormity and liquidity of the U.S. Treasury. Another candidate we have is Bitcoins but even they won’t make a good reserve currency because of its volatile nature and lack of a central regulating body to manage it. Its value has been fluctuating in thousands of dollars from the past few years. Moreover, it has seen increased involvement in illegal trading done on the dark web. The most favored candidate for the reserve currency at this time is the International Monetary Fund’s Special Drawing Rights. It is basically a basket of various currencies such as U.S. dollars, Japanese Yen, Chinese Renminbi, British Pounds and Euro. United Nations Conference on Trade and Development issued a report suggesting the establishment of a new Global Reserve Bank which manages a new global reserve currency based on SDRs. The reports from the IMF say that SDRs could help stabilize the global financial system.
At the moment, the global financial system is centered on the United States but that will not always be the case. The idea should be 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. These things will not happen overnight, but it is important to note that these changes are picking up steam. Although the change is not certain, under the right conditions, a shift in momentum can become a landslide or an avalanche for the U.S. Economy in particular and a drastic change to deal with for the global economy at large.