What is a Reserve Currency?

Fundamentals · Nov 17, 2019

All of the major countries' central banks hold a significant portion of their reserves in foreign currencies. Why do they purchase them and why the U.S. dollar is the most popular reserve currency?

Illustration

In this article, we’ll explain what the reserve currencies are, what purpose do they serve and why the world’s central banks hold them.

Table of Contents

Basics

There are 180 local currencies across the world, as recognized by the United Nations.

Almost any country has its own local money, a sovereign currency. Very few nations exist without their own currency and most of them rely on Euro as most of the countries without sovereign currencies are the members of the European Union (Spain, Germany, Portugal, Malta and other members of the Eurozone). Also, those EU members had their own currencies for ages and they started to abandon them after they joined the Eurozone, which was established on January 1st, 1999, not so long ago.

So, the overwhelming majority of the world’s natios have their own money and they also engage in various activities such as trade, money lending, etc. To execute an exchange between two different countries, there has to be a system that simplifies such international transactions.

That is why central banks came up with a system where a portion of their reserves is held not only in the local currency, but in a few other reliable currencies as well. Those currencies are called reserve currencies and the examples are: the U.S. dollar, Euro, Japanese yen, Pound sterling, and a few other currencies.

Gold and Silver

To understand the mechanics of today’s reserve currencies let’s have a quick look at the history of money in general.

Most countries used gold as the main reserve “currency” for a long time. It was accepted everywhere (at least in Europe) and everybody understood the value of this shiny precious thing. Many kings stored gold to show their personal wealth and gold could buy anything. Even local currencies and coins, which were different in many places from Persia to Spain, had one thing in common: all of those coins were made of gold.

Silver played an important role too as the second valued metal.

The reason why gold was (and still is) popular is quite complicated, but a part of it is that gold is quite hard to extract, i.e. there is a limited supply of it, ergo it has value due to its scarcity. Gold itself can be used for jewelry and some electronic components but those uses alone can’t explain such a huge demand for gold, there has to be something else.

What made gold universally recognized is the faith by many people, especially powerful and wealthy, in its value.

Also, gold is a good material for coins as it’s quite easy to melt. This way, people can divide large pieces of gold into small coins of equal value, which further eases any exchanges.

Europe witnessed first serious issues with gold when Spanish brought a large amount of it from the New World, mostly South America. After that, gold did suddenly drop in value and the “Price Revolution” begun.

Paper Money

Paper money have been in use for a long time in China in particular, but in Europe, it became popular right after the Price Revolution in the 17th century. The bankers began to issue notes with a greater value than their actual physical reserves because back than it wasn’t perfectly understood that such behavior leads to inflation. Actually, even before, the rulers (and traders, lenders, etc.) tried to cheat with the value of gold by mixing less valuable metals in coins.

If any country can issue its own money and gold is not as popular as it used to be, should we trust any note that says “100” something on it? Maybe if it’s a French note, and France is a big and relatively rich country, we can trust it (although even French occasionally “cheated”), but how can a note of a small or even a new country can be trusted? What if the issuer suddenly decides to print more notes, driving down the value of existing ones?

With this in mind, many countries used gold as the main reserve to back their paper money. So, if Germany has, say, 1 trillion Deutsche Marks in circulation, it should have the equal amount of gold in its reserves to back the value of their money. This system worked well until World War II.

Bretton Woods Agreement and Nixon Shock

In 1944, the whole system changed, as the Bretton Woods Agreement was accepted by many western countries. This agreement stated that a country can use not only gold and silver as the main reserves but also the U.S. dollar and other currencies, which back then were backed by precious metals anyway.

Richard Nixon’s New Economic Policy (Nixon shock) ended the Bretton Woods system in 1973. One of the major results of this program was that it canceled direct international convertibility of the United States dollar to gold.

This Nixon’s measure meant to fight inflation, he stated that it’s not going to be permanent, however, he couldn’t restore the old Bretton Woods system and now, de facto, the world lives with freely floating fiat currencies system.

The Lead of U.S. Dollar

After World War II, Europe was in ruins and other parts of the world suffered too and the only country that benefited economically from the war was the United States. Its mission was to help to rebuild Europe and to lead the world against its new enemy - the Soviet Union.

In 1950 the U.S. was the major economic power with more than 35% of the world’s GDP.

After the war, the world had no choice but to accept American leadership and recognize the power of the dollar.

With the collapse of the Soviet Union in 1991, the rise of Asia and China particularly and with the unification of Europe, the situation changed. Europe recovered from the war a while ago and together was a strong power, the Japanese economy was doing very well, so these new currencies started to be used as reserves for trade, money lending and as a diversification tool.

However, even today, the U.S. dollar holds the lead as its currency takes more than 60% of the global financial reserves.

Major Reserve Currencies

Here is the share of reserve currencies in 2018 according to the International Monetary Fund (IMF):

  • US dollar: 61.74%
  • Euro: 20.67%
  • Japanese yen: 5.20%
  • Pound sterling: 4.42%
  • Chinese renminbi (yuan): 1.89%
  • Canadian dollar: 1.84%
  • Australian dollar: 1.62%
  • Swiss franc: 0.14%
  • Other currencies: 2.48%

As you can see, the shares here are not proportional to the nominal GDPs. For instance, Canada with its $1.7 trillion GDP as of 2019 has almost the same share as China with $14.1 trillion economy and huge India ($2.9 T) doesn’t interest many in regards to its currency at all.

This situation is seen as unfair by some countries and its leaders, but the reason why a currency is trusted lies not only in the size of the economy (however, this is an important factor too), many other factors determine currency’s status.

How a Currency Raises its Status?

One important factor that determines what currency to use as a reserve one is the degree of involvement of a country in global financial operations. To illustrate that, recall what country has its corporations all over the world? It’s the United States' companies that operate everywhere: Apple, McDonald’s, VISA, MasterCard, Google, Facebook and thousands of other powerful global corporations.

Another important factor is the general trust in the country’s institutions. The United States may seem as a young country compared to China, Iran or Russia, but the important thing is not the total length of the country’s history in general in terms of culture or people, but the length of one stable political and economic system. And, by these standards, the U.S. is extremely old compared to many other countries.

The U.S. was established in 1776 by declaring its independence, the country is 243 years old, and during all these years America had pretty much the same political system, the same economic system (capitalism) and the same constitution (with some amendments). Modern-day China as People’s Republic exists from 1949, modern-day Russia appeared on the map in 1991 and India gained its independence in 1947. Only Europe had a stable economic and political system longer than the U.S., but Europe suffered great damage after two wars that reduced its economic power. Plus, Europe as a whole is known from 1958 and it’s still not unified completely and might not ever be.

So, the U.S. is actually one of the oldest systems in the world and that what makes it trustworthy. That is why people choose America as their immigration destination. The country had one currency for 243 years (with some changes in value due to inflation), but other countries managed to completely flip the whole ideologies twice or more during this time.

Another thing that adds value to the U.S. dollar is trade and the U.S. trades a lot.

America is the world’s leader by imports and it’s in the top 3 by total export.

Lastly, and this is arguable, but capitalism and democracy add some points to the U.S currency as well. After all, we are talking about the value of money and how secured is the wealth located in the country, therefore a country that may at some point decide to take over everything from the rich and give it to poor (socialism) may not be the one where you want to keep your money and which money you’d want to use.

These days many Americans don’t see socialism as a bad thing, which might be damaging to its currency status in the future. Also, a great status of the U.S dollar implies great responsibilities, the whole world is watching every move of the Federal Reserve and despite strong economic growth, these days the country with its current leadership doesn’t look as stable as many would like to see.

New Reserve Currencies

One obvious candidate for the leadership position as the main reserve currency provider is China, its share is already growing from 1.07% in 2017 to 1.89% in 2018. With this growth rate, China would need around 70 years to become the first reserve currency, but the assumption that this growth speed will stay the same is very uncertain. However, it’s safe to say that the current share of Chinese currency as a reserve one is inadequate. There has been a historic achievement of China’s economy in 2016 when yuan joined elite club of IMF reserve currencies, but as we already mentioned, it’s share stays relatively minor.

India might change the current low status of its currency, Brazil and South Korea could gain some points in this game too, but those countries don’t seem to have a huge potential to change the overall picture by a lot in the near future.

Who Holds the Most of Currency Reserves?

Here is the list of countries that hold the most of foreign currency reserves (in trillions of U.S. dollars) as of 2018:

  • China: $3.21
  • Japan: $1.25
  • Switzerland: $0.8
  • Saudi Arabia: $0.5
  • Russia: $0.46
  • Taiwan: $0.45
  • Hong Kong: $0.42
  • India: $0.4
  • South Korea: $0.4
  • Brazil: $0.37

The data is provided by IMF and Central Bank of the Republic of China. In this list, the reserves of mainland China and Hong Kong are separated.

Asian countries hold the most foreign currency reserves due to the active trade and positive trade balance that they have.

American Debt

It’s not a secret that the U.S. has a huge nominal debt of $22 trillion, but in a way, this debt secures the American’s dollar status of the main reserve currency. Why do countries and regular people purchase the American debt (Treasurys)? It’s because they believe that America will pay it off on time as it did for all its history while other countries declared bankruptcies.

China holds a significant portion of this debt, Japan has quite a lot and many other countries too, so this secures the status of the dollar because no debt holder would like the situation when the money he supposed to eventually get back disappear.

Conclusion and Summary

It’s important to understand that there is no one person or an organization that decides what would share of all reserve currencies in the world be, it’s a long and complicated process of many small negotiations. The world evolved to its current shape in terms of the global financial reserves, but the current state is not static, it changes every year. Who knows, maybe a cryptocurrency like Libra would become the next top reserve currency, but right now the status quo of the American dollar looks quite strong.

Banks   Capital   China   Diversification   Economics   Europe   Finance   Government   History   Japan   Macroeconomics   Money   Risk   The United States

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