Reserve Currency Essay ⋆ Business Essay Examples ⋆ EssayEmpire

A reserve currency is one in which institutions (mostly central banks, but also financial institutions or individuals) hold their nondomestic-currency reserves. A reserve currency must meet the requirements of an international currency and there must also be sufficient supply of the currency. Over the past decade, the U.S. dollar, euro, yen, and sterling have accounted for about 98 percent of all reserves held in foreign currencies.

An international currency is one that firms use to settle trade or financial transactions with their international clients. International currencies belong to strong, stable, and internationally involved economies that provide convincing assurances that they will not impose exchange controls on the use of their currencies. In addition, users of an international currency must believe that the exchange rates of the currency will not change at the whim of the government. When an international currency belongs to a large economy that can provide sufficient supply of the currency and large financial markets exist in that currency, the currency can be used as a reserve currency.

In addition to the four currencies listed above, the Swiss franc, French franc, Deutsche mark, and Dutch guilder (last three now replaced by the euro) have been used as reserve currencies during the past century. Note that small holdings of an international currency to facilitate transactions—much like a small bank balance in a checking account to facilitate normal operations of a firm or a family—do not constitute a reserve currency.

A reserve currency is different from a reserve asset. Most common of these reserve assets have been gold and Special Drawing Rights issued by the International Monetary Fund. Although historically gold had been a very important reserve asset, its use as a reserve asset declined sharply after the United States withdrew its promise to exchange gold at a fixed dollar price in response to its balance of payments problems in the 1960s. At the end of 2007, gold accounted for less than 10 percent of global foreign reserves.

Since the establishment of the Bretton Woods system in 1944, the U.S. dollar has become the prominent reserve currency. Before World War I and during the 18th and 19th centuries, sterling was the main reserve currency. At the end of 2007, total allocated foreign currency reserves (the portion for which currencies of holdings are known) in the world added up to the equivalent of US$4.065 trillion (currencies breakdown for another $2.3 trillion of foreign currency reserves are not known), of which 63.9 percent were in U.S. dollars, 26.5 percent in euros, 4.7 percent in sterling, 2.9 percent in yen, and the remainder 2 percent in other smaller currencies.

With the introduction of the euro as a currency for all transactions in 2001, however, the prominence of the U.S. dollar may be on a decline. Two factors have led to this decline. First, industrialized as well as developing countries have reduced the share of their foreign currency reserves they hold in the form of dollars. Industrialized countries reduced the share of dollars in their foreign currency reserves slightly from 72.3 percent at the end of 2000 to 69.4 percent at the end of 2007. Developing countries reduced their dependence on the dollar much more—from 69.9 percent to 60.7 percent over the same period. Second, foreign currency reserves of developing countries have grown much faster than those of the industrialized countries. In 1995 developing countries accounted for only 52.5 percent (59.4 percent in 2000) of global foreign currency reserves. By the end of 2007, this proportion had risen to 76.5 percent. The combined effect of these two changes has been to reduce the share of foreign currency reserves held in dollars from 71.1 percent at the end of 2000 to 63.9 percent in 2007.

Why would any country allow its currency to be used by foreigners as a reserve or an international currency? If foreigners hold nontrivial amounts of a country’s currency, could they not influence the monetary policy of the country by changing the amounts they hold or destabilize the economy either by dumping the currency in the country or by influencing the currency’s foreign exchange rate? In an extreme case, use of a currency in international markets could also become a conduit for introduction of counterfeit currency because unsuspecting foreigners are less likely to be able to distinguish between real and counterfeit bills.

Seigniorage Benefits

While these objections to allowing the use of a currency as a reserve currency are valid, such a use also confers important benefits on the issuing country. First, a reserve currency country is in the privileged position of being able to pay for foreign goods (and services) not by producing goods of equal value, but by merely producing its currency. The cost of producing currency is merely the cost of printing the bills.

Governments derive “seigniorage” benefit (the difference between the face value of a bill and the cost of printing that bill) when they issue their currency in the domestic economy. Similarly, countries derive seigniorage benefit when their currency acquires the status of a reserve currency.

The U.S. economy has used this seigniorage benefit over the past few decades. For the period between World War II and about 1995, U.S. current account deficits, a measure of net import of goods and services by the U.S. economy, were financed largely by an increase in the supply of U.S. dollars to the restof-the-world dollars. During that period, players in the global economy were happy to acquire increasing volumes of dollars to carry out the increasing volume of international trade and financial transactions between themselves. During the past decade, financing of very large U.S. deficits has been made easier partly by an increase in the dollar reserves that the central banks have been willing to hold. In addition to these seigniorage benefits, use of one’s currency as a reserve currency adds to the political prestige of the country.

Bibliography:

Claudio Borio, Gabriele Galati, and Alexandra Heath, FX Reserve Management: Trends and Challenges (Bank for International Settlements, 2008);
Barry Eichengreen, Sterling’s Past, Dollar’s Future: Historical Perspectives on Reserve Currency Competition (National Bureau of Economic Research, 2005);
Barry J. Eichengreen and Marc Flandreau, The Rise and Fall of the Dollar, or When Did the Dollar Replace Sterling As the Leading International Currency? (National Bureau of Economic Research, 2008).

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