How the U S. Dollar Became the World’s Reserve Currency

what is the reserve currency

So representatives from 44 nations gathered in the small town of Bretton Woods, New Hampshire to come up with the solution. For Foreign Affairs, Peking University’s Michael Pettis looks at the high price of dollar dominance.

  1. Even as countries aim to reduce dependency, the dollar was the most widely held reserve currency in 2022.
  2. 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.
  3. “Sanctions are an effective tool, but we have to be careful,” CFR’s Benn Steil told NPR.
  4. But for SDR to be adopted widely, economists say it would need to function more like an actual currency, accepted in private transactions with a market for SDR-denominated debt.
  5. 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.

As the United States printed more money to finance its spending, the gold backing behind the dollars diminished. 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. The dollar’s status as the leading reserve currency has been called the “exorbitant privilege” of the United States, a phrase coined by former French Finance Minister Valery Giscard d’Estaing in the 1960s. At the time, French officials believed that the world’s appetite for dollars provided cheap financing for U.S. investment abroad. Over time, U.S. trade swung into a sustained deficit, supported in part by global demand for dollar reserves. The reserve status is based on the size and strength of the U.S. economy and the dominance of the U.S. financial markets.

A reserve currency is a foreign currency that a central bank or treasury holds as part of its country’s formal foreign exchange reserves. Countries hold reserves for a number of reasons, including to weather economic shocks, pay for imports, service debts, and moderate the value of their own currencies. Currency reserves used to consist mostly of gold and silver, but the Bretton Woods agreement in 1944 set the U.S. dollar as an international reserve currency and replaced the British pound sterling. It chose the U.S. dollar because of the strength of the U.S. economy, which hadn’t been damaged by the war the way other European and Asian countries’ economies had. The U.S. dollar was also still backed by gold at the time; its value was set at $35 per ounce.

Central Bank

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. The U.S. dollar was officially crowned the world’s reserve currency and backed by the world’s largest gold reserves thanks to the Bretton Woods Agreement.

what is the reserve currency

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 denari, the Byzantine solidus and Islamic dinar of the middle-ages and the French franc. It came down to two different plans put forward by two very different men. But it was the American that won the day and put the U.S. dollar right in the middle of world trade. As World War II was ending, world leaders realized they had a problem.

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. 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. For instance, if the value of the Brazilian real starts to fall during an economic downturn, the Central Bank of Brazil can step in and use its foreign reserves to bid up its value. Conversely, countries can intervene to stop their currencies from appreciating and make their exports cheaper.

These experts contend that losses for exporters are countered by gains for importers, and that overall, the situation is a net benefit to the U.S. economy. Tech evangelists dream of a world where cryptocurrencies such as Bitcoin replace government-backed currencies. Such digital currencies are “mined” and transferred via a decentralized network of computers without any issuing authority. 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.

But some experts argue that high foreign demand for dollars comes at a cost to export-heavy U.S. states, resulting in trade deficits and lost jobs. Many emerging economies have increasingly sought ways to conduct trade in non-dollar currencies, a process known as de-dollarization, especially given the fallout from the Russian invasion of Ukraine and the repercussions of the COVID-19 pandemic. Yet, few serious contenders have emerged, making it unlikely that the greenback will be replaced as the leading reserve currency anytime soon. Another reason many countries stockpile USD is to manipulate their own currency value by buying or selling it on the open market, creating excess supply or demand. Central banks require reserve currencies to maintain liquidity for domestic companies involved in import and export activities.

What is a reserve currency?

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. Today, the U.S. dollar isn’t the only reserve currency designated by the IMF and other global organizations. The euro, Chinese renminbi, Japanese yen, and British pound sterling are all popular as reserve currencies, due to the sizes of their economies. Many of them are specifically designated as reserve currencies by the International Monetary Fund (IMF).

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. In the end, this limits the monetary policy benefits that are achievable using these reserves. It creates only a marginal benefit for a country’s currency if it is considered a reserve currency around the world.

what is the reserve currency

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 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. As of July 2023, China has by far the most reported foreign currency reserves of any country, with more than $3 trillion.

Major reserve currencies

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. Recently, a new discussion has evolved around the ability of the USD to maintain its position as the dominant global reserve currency, specifically due to increasingly expansionary US monetary policy and debt levels of the country. 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.

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As a result, countries with large reserves typically receive preferential borrowing rates. Most international debt is held in USD to maintain stability in lending costs and expected returns. As of 2022, central banks held around 59% of their reserves in U.S. dollars, according to the International Monetary Fund (IMF). In 1973, President Nixon’s New Economic Policy brought an end to the Bretton Woods system of fixed exchange rates. It also decoupled the U.S. dollar from the value of gold, which opened up the world to the rise of new reserve currencies.

How Do Currencies Gain Reserve Status?

Some have proposed the use of the International Monetary Fund’s (IMF) special drawing rights (SDRs) as a reserve. The value of SDRs are calculated from a basket determined by the IMF of key international currencies, which as of 2016 consisted of the United States dollar, euro, renminbi, yen, and pound sterling. 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.

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