What is a Reserve Currency

What is a Reserve Currency explained by professional forex trading experts the “ForexSQ” FX trading team.

What is a Reserve Currency?

A reserve currency is a currency held in significant quantities by many governments and institutions as a means of international payment. While this used to consist of mostly gold and silver, 1944’s Bretton Woods system expanded acceptable reserves to include the U.S. dollar and other currencies. Since 1973, no major currencies can be officially converted into gold.

Regardless, reserve currency is held in order to support the value of national currencies.

For instance, Mexico issues pesos (which are essentially IOUs) to its citizens and repurchases them with U.S. dollars, euros, or other reserve currency around the world held by its central bank. Countries can also hold gold or other precious metals in their official reserves.

In this article, we will take a look at the history and future of reserve currencies, as well as how these currencies impact monetary policies around the world.

Reserve Currency History and Future

The U.S. dollar replaced the British pound sterling as the world’s premier reserve currency circa 1945 in accordance with the Bretton Woods agreements. At the time, the U.S. dollar was the currency with the greatest purchasing power and the only currency backed by gold (although this backing was eliminated in 1973 in a controversial decision), while the U.S. had become a leading world power.

But, the U.S. dollar isn’t the only reserve currency designated by the International Monetary Fund and other global organizations.

The euro and Japanese yen have become increasingly popular as a reserve currency given the size of their respective economies. China is also well-positioned to become a major player as the largest creditor and exporter in the world. In fact, the China’s yuan was named by the International Monetary Fund as a global reserve currency in 2015.

The popularity of reserve currencies is a function of their stability and reputation. For example, the Chinese yuan hasn’t taken off as a major reserve currency due to concerns over a sudden devaluation that could send their value lower. The same is true for the euro following the sovereign debt crisis in 2009 and the immigration crisis in 2016-17. These issues have led to concerns over currency volatility, which has kept the U.S. dollar as the most popular reserve currency.

Reserve Currency & Monetary Policy

Monetary policy has a strong effect on foreign currency reserves. Most major economies with flexible or floating exchange-rate schemes clear excess supply and demand by purchasing or selling reserve currency. For instance, a country looking to boost the value of its currency can repurchase its national currency with its foreign currency reserves. The Bank of Japan has been notorious for intervening in the currency markets using its foreign reserves as ammunition.

Other countries may employ a fixed exchange rate schemes for a variety of reasons. Under this type of system, supply and demand can move the value of its national currency higher or lower. For example, increased demand for a national currency (e.g. due to a relatively strong economy) would lead to a higher value for its currency.

This was China’s preferred way to control their currency before floating the yuan in order to gain reserve status in the global financial system.

Countries also continuously monitor major reserve currencies to ensure their holdings aren’t adversely affected. For instance, significant inflation in the U.S. could cause a devaluation of the dollar and the subsequent devaluation of foreign currency reserves. Ultimately, this limits the monetary policy benefits achievable using these reserves. In other words, there’s only a margin benefit for a country’s currency being considered a ‘reserve’ currency around the world.

Countries with the Most Reserve Currency

Countries hold reserve currency for a number of different reasons. They are an important indicator of ability to repay foreign debt, to defend a national currency, and even to determine sovereign credit ratings.

In addition, countries may simply hold a large amount of currency due to a trade imbalance as is the case with China and their U.S. dollar holdings.

Here are the five countries with the most foreign reserve currency:

China – $3.5 Trillion
Japan – $1.3 Trillion
Switzerland – $661 Billion
Saudi Arabia – $581 Billion
Russia – $407 Billion

The European Central Bank, which serves the Eurozone, holds foreign currency reserves holds foreign reserve currency in the amount of $700 Billion — more than Switzerland and less than Japan.

Other countries have very little in currency reserves. For example, Venezuela has experienced hyperinflation leading up to 2017 and holds just a few billion U.S. dollars needed to repay dollar-denominated sovereign debts. Argentina also faced dwindling currency reserves after its own fight with rising inflation before Macri won the presidency from the Peronists.

Key Takeaway Points

Reserve currency is held in significant quantities by many governments and institutions as a means of international payment.
Reserve currency can be used by central banks to pay foreign debts and defend national currency, while also helping to determine sovereign ratings.
The largest holders of reserve currency are China, Japan, and Switzerland.