A Primer On Reserve Currencies

For nearly a century, the United States dollar has served as the world’s premier reserve currencytaking the crown once worn by the pound sterling. The future of the dollar as the most popular reserve currency is less certain. Reserve currencies are foreign currencies held by central banks. When a country acquires reserves, it doesn’t place the currency in general circulation. Instead, it parks the reserves in the central bank. The reserves are acquired through trade, with the acquiring country selling goods in exchange for currency.

Reserve currencies thus grease the wheels of international commerce by helping countries and businesses conduct transactions using the same currency, a much simpler task than settling transactions involving different currencies. Their popularity is easy to see: between 1995 and 2011, the amount of currency held in reserve increased by over 730%, from around $1.4 trillion to $10.2 trillion.

Issuers of Reserve Currencies

Reserve currencies are typically issued by developed, stable countries. 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. The dollar, while still the most widely held reserve currency, has seen increased competition from the euro. The euro has grown from slightly less than an 18% share of allocated reserves, when it was introduced into the financial markets in 1999, to 24% at the end of 2011.

The IMF reports both allocated reserves, meaning that a country has identified the currencies held in reserve, and total foreign exchange holdings. The overall percentage of total holdings that are allocated reserves has fallen steadily over the years, from 74% in 1995 to 55% in 2011. Much of this shift can be explained by changing foreign exchange holdings in emerging and developing countries. In 1995, advanced economies held around 67% of total foreign exchange reserves, with 82% of these being allocated reserves. By 2011, the picture had been flipped on its head: emerging and developing countries held 67% of total reserves, with less than 39% allocated. Emerging countries now hold roughly $6.8 trillion in reserve currency.

How Do Currencies Gain Reserve Status?

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. The currencies of China (the world’s second largest economy), Brazil (sixth), Russia (ninth) and India (10th) – the BRIC countries – are not considered reserve, which is why these countries have been more vocal proponents of the creation of a reserve country unattached to any one country.

Cries for a global currency grow louder when the dollar is comparatively weak, since a weak dollar makes U.S. exports cheaper and can erode trade surpluses in other export-dominated economies. Critics of a dollar-dominated currency market have pointed out that it may be increasingly difficult for the U.S. to keep up with world dollar demand as its weight in the global economy shrinks. Rather than use the dollar, central banks have looked towards using a basket of currencies, called special drawing rights. This protocol would effectively reduce the influence of any one country and ostensibly would force more prudent economic policies.

Benefits of Reserve Currency Status

Why all the hubbub surrounding reserve currency status? Being the country issuing a reserve currency reduces transaction costs, since both sides of the transaction involve the same currency and one is yours. Reserve currency issuing countries are not exposed to the same level of exchange rate risk, especially when it comes to commodities, which are often quoted and settled in dollars.

Because other countries want to hold a currency in reserve and use it for transactions, the higher demand means lower borrowing costs through depressed bond yields (most reserves are of government bonds). Issuing countries are also able to borrow in their home currencies and are less worried about propping up their currencies to avoid default.

Drawbacks of Reserve Currency Status

Reserve currency status isn’t without its drawbacks, and the problems issuing countries face underscore why mature economies tend to be the ones issuing widely held currencies. Low borrowing costs stemming from issuing a reserve currency may prompt loose spending by both the public and private sectors, which may result in asset bubbles and ballooning government debt. Stimulus spending in the U.S., for example, led Chinese leaders to fear a weak dollar since that would erode the country’s value of dollar-denominated debt.

One could also argue that part of the reason the U.S. was able to spend so freely is that excess Chinese savings had to be parked somewhere, and that somewhere was in the dollar. 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.

What About the Yuan?

What of the Chinese yuan? China is the world’s second largest economy and is rapidly developing, and the national prestige associated with having a reserve currency is likely something that China’s leaders salivate over. Perhaps the greatest hurdle, other than China being an economic liberalization neophyte, is that the yuan is tightly controlled. “Currency manipulation” was a common phrase during the recent round of U.S. elections, as many businesses felt that the yuan was kept artificially low in order to protect Chinese exports. Additionally, China limits the amount of bonds that foreigners can hold, and reserve currencies tend to be held as government bonds rather than hard currency. Some experts believe that continued liberalization might lead the yuan to join the reserve currency club as soon as 2020.

The Bottom Line

In such a global economy, where countries ship commodities and goods at such a frenetic pacethe fear of markets seizing up due to monetary constraints is not likely to diminish in the coming years. The recent financial crisis has increased the pressure on the dollar, especially in light of public debt prospects and political brinksmanship. Countries without reserve currency status fear that their fates are tied to macroeconomic and political decisions that are outside of their control. The push for a world market dominated less by the dollar is nothing new, but just as investors seek to hold a basket of investments rather than a solitary stock, so do central banks when it comes to managing their reserves.