The United States has enjoyed the benefits of the dollar as the world’s reserve currency for decades, but several events have led some economists and market watchers to wonder if that might change. Now that Saudi Arabia is threatening to switch from the dollar to the yuan for its oil sales to China, concerns about the dollar could come back to the fore.
What are reserve currencies?
Reserve currencies are those used to store money in many countries. Each country’s central bank holds different amounts of foreign currency, and the US dollar is often the most popular currency in which central banks hold their money.
When a country’s central bank acquires reserves, it holds them as cash on a balance sheet rather than putting them into circulation. Reserves are acquired through trade, and reserve currencies support international trade by allowing various countries to transact with each other using the same currency.
Reserve currencies are usually issued by developed countries with stable economies. According to the Council on Foreign Relations, the IMF recognizes eight primary reserve currencies: the US dollar, Australian dollar, British pound, Canadian dollar, euro, Chinese renminbi, Swiss franc and Japanese yen.
Data from the International Monetary Fund indicates that around 59% of global reserves were held in dollars in the third quarter of 2021, the most recent quarter for which data is available. The percentage fell to 59% in the fourth quarter of 2020, and the IMF said at the time that it was the lowest level in 25 years.
Analysts suggested the decline was partly due to the dollar’s declining role in the global economy as it competes with other currencies used by central banks for international transactions. However, there are other signs of dollar dominance. The Federal Reserve estimates that around 40% of global trade transactions use the greenback, while 80% of global cross-border transactions use it.
How did the US dollar become the world’s reserve currency?
Before we can analyze whether the dollar will lose its status as the primary reserve currency, it is important to understand how it acquired this status in the first place. During World War I, the pound sterling was the world’s primary currency.
Many countries stopped pegging the value of their currency to gold so that they could use paper money to pay for their war efforts, which devalued their currencies. However, the UK continued to stick to the gold standard until 1931 and began borrowing money for the first time during the war.
Meanwhile, the dollar has become more important globally as nations load up on US bonds. During World War II, the United States supplied the Allies with weapons and other goods, and most of them paid in gold. As a result, the United States ended up holding most of the world’s gold by the end of the war. When the war ended, the Allied nations could not return to the gold standard because they had exhausted their reserves of the shiny metal.
In 1944, delegates from 44 Allied nations came together to develop a way of managing foreign currency that would put none of them at a disadvantage. The meeting known today as Bretton Woods, named after the New Hampshire town where they met, led to the determination that world currencies could be pegged to the US dollar instead of the standard- gold.
At that time, the dollar was pegged to gold, so participating countries chose to peg their currencies to the next best thing to gold: an extremely popular currency that was itself pegged to gold. Because of this decision, countries have accumulated dollars in their reserves instead of gold.
The Bretton Woods agreement also established central banks, whose tasks included establishing fixed exchange rates between the dollar and their currencies. In exchange, the United States would exchange dollars for gold whenever other countries needed them.
However, when the United States began flooding the world market with dollars to fund the Vietnam War and its Great Society programs, other countries began to worry about the stability of the dollar. They started converting their dollar reserves into gold, causing the demand for gold to increase so much that the United States decided to withdraw the dollar from it.
Even though the dollar is no longer pegged to gold, it remains the world’s leading reserve currency. Most countries are very confident that the United States will always be able to repay its debt, so they continue to hold US Treasuries, seeing them as the safest way to store money.
Join our Telegram group and never miss a breaking digital asset story.
Advantages and disadvantages of reserve currencies
There are pros and cons for the United States to have its dollar as the world’s primary reserve currency. On the plus side, it reduces transaction costs and currency risks, especially for commodities, which are often quoted and settled in dollars.
Higher demand also means lower borrowing costs, and the US can borrow in its own currency without worrying about having to support the dollar to avoid default. On the other hand, lawmakers took advantage of lower borrowing costs for the United States through slack spending, which contributed significantly to the country’s soaring debt levels.
Why the dollar could lose its status as the top reserve currency
Russia’s invasion of Ukraine is one reason some economists are wondering if the US dollar will lose its status as the world’s premier reserve currency. According to several news outlets, including The Hill, Washington has effectively weaponized the dollar by piling up layer upon layer of sanctions against Moscow. The United States has even cut off Russia’s access to its foreign exchange reserves, which could lead other countries to wonder if they can trust the United States not to attack them at some point. .
A key concern for dollar dominance is the nation’s mounting debt. The United States has been printing money for years, and the pandemic is the most recent reason why. It should be noted that CoinDesk reports that the franc lost its status as a reserve currency in the 1960s when the French government started printing money to deal with the Algerian revolution.
However, inflation is soaring, which is depreciating the dollar, and other countries may start to worry that the United States will not be able to repay its debts.
Find out how, with Five Minute Finance.
A weekly newsletter that covers major trends in FinTech and Decentralized Finance.
You are subscribed.
You are well on your way to being aware.
Why the dollar might not be in danger
Bloomberg contributor Robert Burgess recently backed the opposite side. He noted that it will not be easy to replace the dollar as the reserve currency of choice for the world, despite signs that reserve demand is falling. For example, Burgess noted that less than 3% of the world’s currency reserves are in the yuan despite China’s concerted efforts over the past 10 years to try to make it a viable alternative to the dollar.
He also pointed out that the benefits of holding dollar reserves are that US markets are significantly more liquid and deeper than other markets. The $23 trillion US Treasury market is more than twice the size of Japan’s government bond market, and Japan’s central bank holds the vast majority of its own bonds. In Europe, the UK, Germany, Italy and France all have government bond markets below $3 trillion.
Bloomberg also suggested that China’s threat to switch oil pricing from dollars to yuan is a political move aimed at pressuring Washington for more consideration. The outlet pointed out that the Saudi riyal is pegged to the dollar, so switching to the yuan for oil would cause a backlash on the kingdom.
Do you think the United States will lose its status as the world’s reserve currency in the years to come? Give your answer in the comments below.