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The US dollar as the world’s dominant reserve currency

Rebecca M Nelson and Martin A Weiss
27 Sep 2022 00:00:00 | Update: 27 Sep 2022 00:53:09
The US dollar as the world’s dominant reserve currency

The U.S. dollar is the world’s dominant reserve currency, among other such currencies including the euro, the yen, the pound, the renminbi (RMB), the Canadian dollar, the Swiss franc, and the Australian dollar. A reserve currency is a currency held by central banks in significant quantities. It is widely used to conduct international trade and financial transactions, eliminating the costs of settling transactions involving different currencies.

The dollar has functioned as the world’s dominant reserve currency since World War II. Today, central banks hold about 60% of their foreign exchange reserves in dollars (Figure 1). About half of international trade is invoiced in dollars, and about half of all international loans and global debt securities are denominated in dollars. In foreign exchange markets, where currencies are traded, dollars are involved in nearly 90% of all transactions.

The dollar is the preferred currency for investors during major economic crises, as a “safe haven” currency. During the global financial crisis of 2008-2009, for example, and amidst the economic turmoil associated with the Coronavirus Disease 2019 pandemic in 2020, investors sought U.S. dollars, expecting the dollar to retain its value. In both crises, the U.S. Federal Reserve adopted extraordinary monetary authorities and currency swap lines with other central banks to provide liquidity and dollars.

The U.S. economy generally benefits from the dollar’s status as the world’s dominant reserve currency, once famously referred to as the United States’ “exorbitant privilege” by France’s finance minister in the 1960s. Because many central banks and financial institutions around the world want to hold U.S. dollars and dollar-backed securities like U.S. Treasury bonds, there is strong demand for U.S. dollars. That demand, in turn, allows the United States to borrow more cheaply (at lower interest rates) than it would otherwise.

Strong demand for dollars also allows the U.S. government, firms, and consumers to borrow from foreign creditors in dollars rather than foreign currencies. As a result, the value of that debt does not depend on fluctuations in exchange rates. When other governments, firms, and individuals borrow in foreign currencies, they incur the risk that swings in exchange rates will cause their real debt level (the size of the debt in the borrower’s national currency) to increase, potentially quickly and significantly. U.S. firms and consumers also benefit by saving on transaction costs.

The widespread use of the dollar entails economic risks. Low borrowing costs can lead to the accumulation of debt, and the funds borrowed may not be channeled into productive investments. Additionally, the demand for the dollar associated with its position as a reserve currency can lead to a stronger U.S. dollar. A strong U.S. dollar generally makes it harder for U.S. producers to compete in global markets and can lead to persistent trade deficits, although U.S. consumers may benefit from less expensive imports. For example, the dollar has strengthened since mid-2021 as the Fed tightened monetary policy to combat rising inflation. In addition to the impact of a rising dollar on U.S. exporters, it will create challenges for many other countries servicing their debts amidst higher interest rates and slowing global economic growth.

Historically, shifts from one dominant international currency to another occur over many years. For example, in the 20th century the U.S. dollar replaced the British pound sterling as the dominant international currency over many decades (including two World Wars and the Great Depression) after the United States overtook the United Kingdom as the world’s largest economy and exporter.

 

Eurasia Review