Reserve Currency

Reserve Currency (RC) is typically a foreign currency that central banks or other financial organizations hold in abundance as part of a country’s foreign exchange reserves. It is utilized for global trade and investment. Currently, the US dollar is the predominant reserve currency across the world and is expected to retain its status in the near future. 

To qualify as an reserve currency, the currency must be from a country of considerable economic size with open and liquid financial markets. The country also must enjoy a significant position in the global market, encouraging trade in its currency. Besides, the currency must be stable and easily convertible into domestic currencies.

• Reserve currency (RC) is a strong foreign currency possessed by central financial authorities in a massive amount to use for international dealings.
• The US dollar is currently the most dominant RC globally.
• The main feature of an reserve currency is that it is easily convertible and has a stable value.
• Factors determining the usage of a currency as an RC are the size of the underlying domestic economy, openness and depth of its financial markets, the importance of the economy in global trade, and its domestic macroeconomic policies.
• An RC helps pay off the outstanding international debt and control the value of the nation’s currency, balancing its domestic exchange rate.

Reserve Currency is a globally-recognized foreign currency held in reserve by a country’s central bank for global transactions. Every country’s central bank has reserves usually made up of gold and a specific foreign currency held in substantial numbers. This foreign currency is deployed in international monetary dealings to make investments and settle debt liabilities.

Besides making payments for imports and servicing foreign debts, nations also hold reserves to overcome economic crises and control the value of their national currency. For instance, if the national currency value falls during a recession, the central bank can use its foreign reserves to maintain the currency value.

Also, it helps reduce exchange rate risks during international dealings as nations needn’t use their own currency for transactions. Therefore, countries persistently monitor the major reserve currency to ensure their assets remain profitable.

The key characteristic of reserve currency is that it can be deftly swapped for other currencies and has the required liquidity and depth for streamlined international transactions. This is because it is issued by developed and stable economies with strong, open financial markets. Thus, the underlying economy’s supremacy and substantiality play a key role in its currency attaining the RC stature.

Over the past seven decades, the global standing and financial strength of the US has contributed to the US dollar serving as the world’s premier RC. Out of the total of $12,827.45 billion in the International Monetary Fund's (IMF) Q3 2021 Currency Composition of Official Foreign Exchange Reserves (COFER), US dollars had the highest claim ($7081.39 billion). 

RC enormously influences economic and monetary policies. At the same time, economic policies have a crucial effect on foreign currency reserves. Therefore, any major development in the policy may generate considerable depreciation or boost in the reserves. 

As per a recent Reuters report, the US economy has created 467,000 jobs in January 2022, a huge milestone after the economic upheaval caused by COVID-19. As a result, the Dollar Index, reporting the value of the US dollar assessed against six other major reserve currencies, registered a growth of 0.1%. 

The US dollar has been designated as the world's foreign RC for over 70 years. Thence, nations observe the financial regulations of the US to shield against inflation or stagflation and guarantee the security of their reserves. 

The relatively less-accepted currencies are transformed into US dollars to partake in foreign commercial activities. Being the world’s reserve currency, it can easily resist a financial crisis compared to other currencies. 

The IMF consistently publishes the COFER. Over the years, it has also selected other reserve currencies including:

1. Euro
2. Chinese Renminbi
3. Japanese Yen
4. Pounds Sterling
5. Australian Dollars
6. Canadian Dollars
7. Swiss Francs

The speculations are rife that the Chinese Renminbi will displace the US dollars as the world’s RC in the coming years. The reports came out after witnessing a downturn in the economy of the US while China experienced a major economic boost. It is also predicted that the US dollar will soon share its influence with other currencies. 

However, it still stays the most dominant currency throughout the globe. During the last one year (Q3 2020-Q3 2021), US dollars have registered a growth of US $154.16 billion in the total foreign exchange reserves.  

The emergence of a stable US economy after the second world-war revolutionized the landscape of RC. With the transformation of the US as the global economic superpower, the US dollar began increasing its share of international trade and gross domestic product.

Consequently, at the Bretton Woods conference in 1944, the US dollar was pegged to gold while most other currencies were pegged to dollars. Eventually, the US dollar displaced the British pounds sterling as the major foreign RC in the mid-20th century.

Thus, the US dollar became the primary unit for central banks to hold reserves, indulge in trading, and extend loans. However, in 1973, the new economic policy by US President Richard Nixon dissolved the arrangement of fixed exchange rates, disjointed the US dollar from gold, and replaced it with a floating exchange rate system.

Since then, the US dollar has dominated the global market. However, the successive advent of thriving economies produced other international RCs. The Deutschmark was the major RC among the euro legacy currencies. Following the US dollar, it accounted for the largest share of reserves. 

Over time, the nations’ share of reserves declined or surged as their power in the global economic marketplace. Though new currencies were added to the IMF’s list of RCs, the US dollar managed to sustain its top position. 

This has been a guide to Reserve Currency (RC) and its meaning. Here we explain the history of reserve currencies of the world (dollar) and those selected by IMF. You may learn more about financing from the following articles –

• Eurocurrency
• Currency Crisis
• Currency Market