Strength, stability, universal acceptability, and a lack of a viable alternative to the dollar makes it the global reserve currency.
Global trade and businesses function best when there is a currency that is widely accepted. This doesn’t imply a common currency, instead, it refers to the usage of a widely acceptable currency for international transactions. Such a currency reduces the transaction costs of converting one currency to another and enables easy invoicing of traded goods and services. This common currency is referred to as the reserve currency.
The brief history of reserve currencies:
Historically, a reserve currency implied a currency that was in wide circulation even outside the issuing state’s borders. Currently, the US dollar is the world’s reserve currency but this hasn’t been the case forever. The silver Drachma issued by the ancient Athens was probably the first reserve currency. The Roman Aureus and Denarious coins, the Byzantine Solidius coins, the Arabian Dinar, the Florence Fiorino, and the Dutch Gulden have at various points had the status of being the world’s reserve currency.
In 1717, Britain adopted the gold standard – a system where central banks had to back each paper currency note they printed with an equal or proportional amount of gold — and simultaneously built a vast empire. At the height of its power, more than 60% of world trade was invoiced in pounds and this led to the pound sterling becoming the world’s reserve currency. At around the end of the 19th century, America’s economic significance rose and this resulted in the US dollar toppling the pound as the most sought-after currency. Today, more than two-thirds of foreign exchange reserves held by central banks around the world are in US dollars (see figure).
Why do central banks maintain reserves?
Two important reasons for holding reserves are as follows:
First, safety. Reserves act as savings, and central banks can benefit from this in hours of need. When a country faces a balance of payments crisis or some other form of financial crisis, the central bank can use its reserves to alleviate the situation. Typically, central banks manage enough reserves to cover for three months’ worth of imports to maintain continuity of trade in times of crises. Reserves also act as positive assurance to debtors.
Second, reserves are maintained to manage a country’s exchange rate policy (the previous post explored this aspect). Whenever a country’s currency appreciates or depreciates, and moves away from the target exchange rate set, the central bank steps in and uses its reserves to maintain exchange rate stability. The Reserve Bank of India has done this on numerous occasions when the rupee has appreciated or depreciated.
Why is the US dollar the reserve currency?
Since the United States boasts of the world’s largest economy (around $18 trillion) and has a stable political environment, most international trade is invoiced in dollars and about 50-60% of US dollars circulate outside US borders. Since there has been no default or major devaluation of the dollar in the past few decades, the USD and the US government’s treasury bonds are thought of as the safest assets in the world; this inherent stability and risk-free nature of the dollar is attractive to investors and has therefore ensured that the US dollar is the world’s reserve currency.
According to economist Ewe-Ghee Lim, there are five factors that facilitate international currency’s status: a large economic size, the existence of a well-developed financial system, confidence in the currency’s value, political stability, and network externalities. Additional features for currencies that assume reserve status are large-scale current account and financial account convertibility, an independent central bank, a high degree of capital mobility, surveillance of economic policies, and cooperation of monetary policymaking at regional and multilateral levels. The dollar checks almost all of these boxes.
The rise of China since the 80s has made the Chinese Yuan an important world currency, but since the Yuan has been deliberately undervalued to aid exports, the real exchange rate of Yuan is unknown. Japan and Britain are waning economic powers, the emerging markets are too volatile, the Euro has many internal problems, and gold is too static a commodity to be held as the reserve currency. This leaves the dollar as the only viable option for the time being, and probably for some more time to come.
Anupam Manur is a Policy Analyst at Takshashila Institution and tweets @anupammanur
Varun Ramachandra is a Policy Analyst at Takshashila Institution and tweets @_quale