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What Is a Reserve Currency? U S. Dollar’s Role and History

what is the reserve currency

This share has declined from 71 percent of reserves in 2000, but still far surpassed all other currencies including the euro (21 percent), Japanese yen (6 percent), British pound (5 percent), and the Chinese renminbi (2 percent). Moreover, the decline in the U.S. dollar share has been taken up by a wide range of other currencies, rather than by a single other currency. Thus, while countries have diversified their reserve holdings somewhat over the past two decades, the dollar remains by far the dominant reserve currency. The currency most commonly held as a foreign exchange reserve is the U.S. dollar, which, according to the International Monetary Fund (IMF), comprised nearly 62% of allocated reserves as of late 2012. Other currencies held in reserve include the euro, Japanese yen, Swiss franc and pound sterling.

Yields fall alongside dollar’s reserves dominance

what is the reserve currency

The more likely path for de-dollarization in reserves is through redirecting the flows of newly created reserves. The greenback is now about 58 percent of global reserves compared to nearly 73 percent in 2001. Critically, the reallocation came through changes in new investment flows, not by selling the stock of existing positions. As shown in Figure 4, the value of U.S. dollar banknotes held abroad has increased over the past two decades, both on an absolute basis and as a fraction of banknotes outstanding.

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The IMF would also need to be empowered to control the supply of SDR, which, given the United States’ de facto veto power within the organization’s voting structure, would be a tall order. 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 denarii, the Byzantine solidus and Islamic dinar of the middle-ages and the French franc. In the U.S., almost all banks are part of the Federal Reserve System and it is required that a certain percentage of their assets be deposited with their regional Federal Reserve Bank. By 1931, Britain was forced off the gold standard entirely following speculative attacks on the pound. However, during the Great Depression in the 1930s, trade shrank considerably and the gold standard fell.

Global currency reserves

The first U.S. dollars were printed in 1914, a year after the Federal Reserve Act was established. Treasury Secretary Janet Yellen, say that the aggressive use of sanctions could threaten the dollar’s hegemony. “Sanctions are an effective tool, but we have to be careful,” CFR’s Benn Steil told NPR. Meanwhile, the Chinese renminbi has become the most-traded currency in Russia. Foreign exchange reserves are not only used to back liabilities but also influence monetary policy.

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. Issuance of foreign currency debt—debt issued by firms in a currency other than that of their home country — is also dominated by the U.S. dollar. The percentage of foreign currency debt denominated in U.S. dollars has remained around 60 percent since 2010, as seen in Figure 8. By the 1860s, the majority of the industrialized nations followed the lead of the British and put their domestic currencies onto the gold standard.

In the past due to the Plaza Accord, its predecessor bodies could directly manipulate rates to reverse large trade deficits. Amid this geoeconomic bickering, Jeremy Allaire, the CEO of cryptocurrency firm Circle, sees a third way. “There’s been this dollar hegemony, but that’s very much under threat right now,” particularly from China, he said on our latest Leadership Next podcast, out this week. But according to Allaire, the future isn’t so much with the physical greenback or yuan. “The competition over money is becoming a technological competition,” he said.

During the Renaissance period – 14th to 17th century – the Florentine florin and Venetian ducato served as reserve currencies. During the 14th and 15th centuries, Portugal and Spain’s currencies – both called ‘real’ – dominated the world. In the seventeenth century, they gave way to the French franc and Dutch guilder. These were followed by the British pound, the United States dollar, and the euro. The Federal Reserve Act of 1913 created the Federal Reserve Bank to respond to the unreliability and instability of a currency system that was previously based on banknotes issued by individual banks. The U.S. economy surpassed that of the United Kingdom, though world commerce still centered around the U.K., with transactions taking place in British pounds.

Over time, U.S. trade swung into a sustained deficit, supported in part by global demand for dollar reserves. The euro, introduced in 1999, is the second most commonly held reserve currency in the world. According to the International Monetary Fund (IMF), which is charged with promoting global growth and trade, central banks hold more than $6.7 trillion in dollar reserves versus 2.2 trillion in euros as of Q4 2019. In the beginning, the world benefited from a strong and stable dollar, and the United States prospered from the favorable exchange rate on its currency. The foreign governments did not fully realize that although gold reserves backed their currency reserves, the United States could continue to print dollars that were backed by its debt held as U.S. As the United States printed more money to finance its spending, the gold backing behind the dollars diminished.

Following failed efforts to save the system, President Richard Nixon suspended the dollar’s convertibility to gold in August 1971, marking the beginning of the end of the Bretton Woods exchange rate system. The Smithsonian Agreement, struck a few months later by ten leading developed countries, attempted to salvage the system by devaluing the dollar and allowing exchange rates to fluctuate more, but it was short-lived. By 1973, the current system of mostly floating exchange rates was in place.

When a country acquires reserves, it doesn’t place the currency in general circulation. The reserves are acquired through trade, with the acquiring country selling goods in exchange for currency. 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.

This occurrence is nothing new; Robert Triffin (of Triffin Dilemma fame) identified this shortcoming while the gold standard was still alive and kicking. Not controlling the outflow of currency also puts weak financial institutions at risk, and Hollywood (and real life) shows just how much criminals love dollars. The entire Euro Area, as designated by the World Bank, is made up of 19 countries. This Congressional Research Service report [PDF] examines the debate over exchange rates and currency manipulation.

These transactions used the U.S. dollar as a reserve currency, which was accepted internationally, rather than the local currencies of the countries involved. Starting in the mid-20th century, the U.S. dollar was set as the international reserve currency. Since then, strong economies in many countries have led to the rise of other international reserve currencies. The United States is also harmed by currency manipulation—when another country holds down the value of its currency to maintain a large trade surplus.

While we think this view is wrong—or at least so premature as to be indistinguishable from being wrong—we think equally damning is that the predicted dramatic falls in U.S. asset prices are likely pure hyperbole. A shifting pepperstone review payments landscape could also pose a challenge to the U.S. dollar’s dominance. For example, the rapid growth of digital currencies, both private sector and official, could reduce reliance on the U.S. dollar.

A world currency is any money that can freely be used or exchanged for another currency inside or outside the borders of the country that issues it. The first U.S. dollar (USD) is the official currency of the United States and several other countries. A reserve currency is a currency held in large quantities by governments and institutions.

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

Reserve currencies can also be foreign currency securities, deposits, and loans. Many experts agree that the dollar will not be overtaken as the world’s leading reserve currency anytime soon. More likely, they say, is a future in which it slowly comes to share influence with other currencies, though this trend could be accelerated by the aggressive use of U.S. sanctions and growing U.S. financial instability.

In 1925, the British Gold Standard Act reintroduced the gold bullion standard – and many countries did the same. Up until the Great Depression, there was a period of economic stability. In the 18th century, when the Dutch East India Company dominated international trade, the Dutch guilder was the de facto world currency.

The euro, Chinese renminbi, Japanese yen, and British pound sterling are all popular as reserve currencies, due to the sizes of their economies. China has been trying to boost the global role of the renminbi, also known as the yuan, since the late 2000s. It currently accounts for 3 percent of global reserves, but China has increasingly pushed to use the renminbi in bilateral trade, especially in the wake of the Ukraine war. However, Chinese policymakers are wary of the lessons from previous currencies [PDF] that rapidly internationalized, and they have imposed strict controls on the flow of money that have hamstrung the renminbi’s growth. “China does not have the intention or the capacity to dethrone the dollar,” says CFR’s Zongyuan Zoe Liu.

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. Currency reserves are held by central banks and foreign institutions for several reasons, but primarily to provide stability and to purchase key imports during periods of domestic or global economic crisis. For decades, the U.S. dollar has been the currency of choice for reserves—to the tune of roughly $7 trillion. Known as the Bretton Woods Agreement, it established the authority of central banks, which would maintain fixed exchange rates between currencies and the dollar.

  1. Most of these reserves are held in the U.S. dollar since it is the most traded currency in the world.
  2. It is the most commonly held reserve currency and the most widely used currency for international trade and other transactions around the world.
  3. Saudi Arabia also holds considerable foreign exchange reserves, as the country relies mainly on the export of its vast oil reserves.
  4. As a country’s currency weakens, its goods exports should become cheaper and thus more competitive.

Britain abandoned the gold standard in 1931, which decimated the bank accounts of international merchants who traded in pounds. 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.

John Maynard Keynes proposed the bancor, a supranational currency to be used as unit of account in international trade, as reserve currency under the Bretton Woods Conference of 1945. These reserve requirements are established by the Fed’s Board of Governors. Reserves also keep the banks secure by reducing the risk that they will default by ensuring that they maintain a minimum amount of physical funds in their reserves. De-dollarization is the shrinking of the influence that the U.S. dollar has on the economies of other countries. Even as countries aim to reduce dependency, the dollar was the most widely held reserve currency in 2022.

They also can defend a national currency and even determine sovereign credit ratings. 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.

Many economists say that since Donald Trump pulled his country out of the Trans-Pacific Partnership, China will get there much faster. Outside the United States, the US dollar is the most extensively used reserve currency. Since the turn of the century, the euro has been increasingly widely used. The U.S. dollar became the official reserve currency in 1944, delegated by 44 allied countries called the Bretton Woods Agreement. The history of paper currency in the United States dates back to colonial times when banknotes were used to fund military operations.

The world’s largest current foreign exchange reserve holder is China, a country holding more than $3 trillion of its assets in a foreign currency. One of the reasons for this is that it makes international trade easier to execute since most of the trading takes place using the U.S. dollar. In 1999, 71% of the official foreign exchange reserves across the world were in dollars, while 17.9% were in euro, 2.9% in pound sterling, and 6.4% in Japanese yen. China has positioned its currency as next in line to the U.S. dollar; it has been the largest contributor to world growth since 2008’s global financial crisis.

These reserves are rounded up to the nearest billion; they include gold, U.S. dollars, and other reserve currencies. A highly valued dollar makes U.S. imports cheaper and exports more expensive, which can hurt domestic industries that sell their goods abroad and lead to job losses. This imbalance can worsen during times of financial turmoil, when investors seek the stability inherent to the dollar. Some analysts argue that the cost of the dollar’s dominance for manufacturing-heavy U.S. regions such as the Rust Belt are too high, and that the United States should voluntarily abdicate. Other economists disagree, arguing that there will always be winners and losers with a strong dollar. 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.

For instance, increased demand due to a relatively strong economy would lead to a higher value for a country’s currency. Another source of challenges to the U.S. dollar’s dominance could be the continued rapid growth of China. GDP on a purchasing power parity basis (IMF World Economic Outlook, July 2021) and is projected to exceed U.S. GDP in nominal terms in the 2030s.10 It is also by far the world’s largest exporter, though it lags the United States by value of imports (IMF Direction of Trade Statistics, 2021-Q2).