It’s clearly fashionable at the moment to espouse the inevitable end of the US dollar as the world’s reserve currency. I find some of the assertions regarding the death of the US dollar laced with so much innuendo that it is hard to believe that they are even being taken seriously. This is not to say that the US dollar could not fade in relevance over time, and even one day might lose its unique status as the king of reserve currencies. It has happened before to other reserve currencies. Although there is some debate as to exactly when the UK pound lost its status as the world’s leading reserve currency, the US dollar had certainly ascended to the throne by 1944 when the greenback was linked to gold (at $35/ounce) and a series of related fixed cross-currency exchange rates were put into place under Bretton Woods. For the US dollar to lose its crown though would require there to be a viable alternative, also the subject of much hyperbole.
There are a variety of currencies that are reserve currencies today, even though the undisputed king is easily the US dollar for reasons I will discuss in this article. One point of specific irritation for me is the association by some pundits of overly accommodative monetary policy by the Federal Reserve with a loss of the US dollar’s reserve currency status. I find this ridiculous since most of the world’s central banks are embarking on the exact same policies as the Federal Reserve. Perhaps this is a race to the bottom, but the reality is that foreign exchange is a relative game. Furthermore, the two most recent recessions (i.e. the Great Recession and the pandemic recession) have been global, so the policies of central banks of the world’s largest economies more or less moved in the same direction. Uncoupling the global reserve currencies might seem theoretically possible but large economies are so linked today it is highly unlikely in the foreseeable future.
What is a reserve currency?
A reserve currency refers to a foreign currency, or bonds denominated in a foreign currency, that are held by countries’ central banks. These reserves are accumulated over time generally through foreign trade. A reserve currency has the following attributes. It is:
Fully convertible with no capital controls or regulations that restrict the exchange of the currency or restrict the foreign ownership of government bonds denominated in that currency
Used broadly as fiat / a medium of exchange, both domestically and internationally
Widely available and liquid, applicable to both the currency and to government (and other) bonds denominated in that currency, e.g. US Treasuries, UK Gilts or JGBs
Issued by a central bank that is independent (from its government) and trusted
Issued from a country that is politically stable
Recognised as a store of value over time (subject to baseline “accepted” inflation of circa 2%/annum.
When currencies have these attributes, both the public sector (i.e. governments) and private investors are comfortable holding these currencies, or assets denominated in these currencies, in their reserves or private portfolios.
What are the major global reserve currencies?
The table below from the IMF illustrates the foreign exchange holdings of 149 countries in total that are members of the IMF which report either total foreign exchange reserves without a breakdown by currency (listed as “unallocated reserves” in the table) or provide a more granular breakdown that includes foreign exchange reserves by currency. The data below is as of the end of 3Q 2021.
As you can see in the table above, the 149 countries that report their allocated foreign reserves to the IMF hold around 59.2% of their reserves in US dollars and 20.5% in euros. Collectively, these two currencies account for nearly 80% of the world’s foreign exchange reserves. Trend wise, the US dollar has decreased as a percent of total reserves slowly since 2000. The graphic below is from the Federal Reserve in an article they published in October 2021 entitled “The International Role of the U.S. Dollar”. It shows how reserve currencies have changed on a relative basis since the turn of the century.
Foreign reserves can be held in cash but are most often held as (foreign) government securities.
Which countries have the largest foreign currency reserves?
Given that foreign currency reserves generally originate from international trade, you probably will not be surprised to learn that it is the largest net exporting countries in the world that have the most foreign currency reserves, whilst countries like the US that are net importers (and run large negative trade balances) have the smallest. China is by far the largest holder of foreign reserves globally, as you can see in the table below from Wikipedia. The US is ranked 13th as far as its foreign exchange reserves, even though it is the world’s largest economy.
As far as the composition of reserves in the table above that are denominated specifically in US Treasuries, Japan is the largest holder ($1.3 trillion), followed by mainland China ($1.0 trillion), the UK ($567 billion), Luxembourg ($312 billion) and Ireland ($309 billion) (source Statista).
How important is the US dollar in international trade?
The US dollar’s global reserve status is cemented by the greenback’s significant use as a medium of exchange for international trade, as you can see in the table below from BIS.
As the table illustrates, the US dollar was on one side or the other of 88% of every foreign trade transaction that was done globally in 2019, more than three times as often at the next most used-currency, the euro. As you move down the list, you will see that the Chinese yuan is used for only 4% of international trade transactions in spite of China being the 2nd largest economy in the world, whilst the Russian ruble was scarcely used at all even well before its invasion of Ukraine.
Which other countries / territories use or link their currencies to the US dollar?
Another indicator of confidence in the US dollar is represented by countries that either use the US dollar as legal tender (all relatively small territories / countries) or that link their currencies to the US dollar. By using or linking their currencies to the US dollar, these countries are captive to US monetary policy and the actions of the Federal Reserve. It is perhaps a small price to pay for countries / territories like those on the list below to ensure that there is confidence in the integrity of their financial system.
Under what circumstances would the US dollar fall out of favour, jeopardising its reserve status?
The reality is that the US dollar will not lose its status as a reserve currency anytime soon, although it is clear that the rest of the world would like to be less beholden to the US dollar and the whims of the US government. The US dollar is the “go to” during times of global financial distress as investors flock to this safe haven currency, as we have seen time and time again. Also, many global commodities – perhaps the most important of which is oil – are denominated in US dollars. The US and EU are two of the three largest economic blocs in the world, and therefore, their currencies will undoubtedly continue to be used the most in international trade, probably for years to come. The Chinese yuan should theoretically continue to gain ground since China is now the world’s second largest economy, and its economy is growing much faster than the economies of the US and EU. However, China is still an emerging economy with limitations on foreign investors holding its domestic yuan-denominated bonds, and its currency is not completely convertible and is arguably managed (or some would say “manipulated”). These will prove to be ongoing impediments to the rise of the Chinese yuan as a viable reserve currency.
The US could also undermine the decline of the US dollar as a reserve currency and is probably doing just this as I write this article. The US has from time to time “weaponized” the US dollar, which is exactly the state we find ourselves in at the moment given the broad sanctions on Russia, Iran, North Korea and other countries considered to have governments that are adverse to US interests. I can’t imagine any country liking this at all, knowing that their economies could one day be brought to their knees by a similar fate should they get on the wrong side of the US government. Also, the US dollar has been a bastion of strength since the pandemic, but once the currency starts to weaken – which it most certainly will – US exports will benefit at the detriment of imports, and those countries exporting to the US will not like this, either.
Lest you think that having the leading global reserve currency is all roses, it is not. For example, strong underlying demand for the US dollar means that the exchange rate for the greenback is artificially higher than it would be otherwise, a drag on US exports. Also, strong demand for US Treasuries puts downward pressure on yields, beneficial on one hand as it allows the US to run large deficits, detrimental on the other as mis-priced US Treasuries (and lower than otherwise yields) can lead to the misallocation of capital. Such are the pleasures of having the status of the world’s reserve currency. The US might enjoy the status of the US dollar as the world’s reserve currency, but it is not all upside by any means.
What could replace the US dollar as a global reserve currency?
The US dollar could continue to lose ground to one or more of the other reserve currencies, the most touted of which is the Chinese yuan since China has the 2nd largest economy in the world and is the fastest growing. I put together the table below to give you the opportunity to compare several reserve currencies along the criteria I mentioned at the beginning of this paper.
Many pundits also discuss the return to a gold standard, or even the replacement of the US dollar and other fiat currencies with digital cryptocurrencies (country-agnostic). Naturally, I do not think either are feasible anytime soon. The table below compares gold and cryptocurrencies (as significant reserve currency alternatives) to reserve currencies, noting that gold is a small component of many countries’ reserves currently.
The gold standard has been tried, and whilst it absolutely keeps central banks from misbehaving as far as printing too much money, it also handicaps them significantly as far as the use of countercyclical monetary policy. You might be one of those that do not trust central banks, but history has shown that a gold standard is difficult to implement and too inflexible to be viable in the long run. Cryptocurrencies – especially Bitcoin – are an interesting talking point as “protection” for investors and individuals who believe that central bank policies are errant. The inclusion of a cryptocurrency as a reserve currency (equivalent) is a far-fetched hypothetical because cryptocurrencies are highly volatile, are not accepted broadly as fiat for international trade, are not endorsed by any major government, and are subject to blatant price manipulation, amongst other things. Can people really believe that cryptos are a viable reserve currency alternative anytime soon? I don’t see how.
One other idea you might want to read about is the IMF’s Special Drawing Rights, or SDRs. These are not designed to be a replacement for the US dollar, although its formulaic approach involving a basket of currencies might be perceived this way. SDRs are not new and are controversial for various reasons. Rather than writing more about SDRs, I will direct you to the IMF website to learn more about SDRs if you are interested here.
Conclusion
Hypothetically, if the US dollar were to fade as the world’s “go to” currency, it would happen over many years, probably decades, if for no other reason because there is no viable replacement this ticks the relevant boxes today. I will not dispute that the insatiable flow of US dollars courtesy of the Federal Reserve’s quantitative easing programmes – both following the Great Recession and the pandemic – should theoretically lead to a US Dollar devaluation and prove inflationary, because we are certainly getting a taste of that now. I believe that flooding the market with US Dollars to ease the stress of self-imposed lock-downs at the onset of the pandemic was a policy decision that was correct, even though it might have adverse consequences (like inflation) in the intermediate term. Even so, one of the adverse consequences will not be the US dollar fading into obscurity.
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