A reserve currency, or anchor currency, is a currency that is held in significant quantities by many governments and institutions as part of their foreign exchange reserves. It also tends to be the international pricing currency for products traded on a global market, and commodities such as oil, gold, etc.
This permits the issuing country to purchase the commodities at a marginally lower rate than other nations, which must exchange their currencies with each purchase and pay a transaction cost. For major currencies, this transaction cost is negligible with respect to the price of the commodity. It also permits the government issuing the currency to borrow money at a better rate, as there will always be a larger market for that currency than others.
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As emphasised by the economist Avinash Persaud, reserve currencies come and go. "International currencies in the past have included the Chinese Liang and Greek drachma, coined in the fifth century B.C., the silver punch-marked coins of fourth century India, the Roman denari, the Byzantine solidus and Islamic dinar of the middle-ages, the Venetian ducato of the Renaissance, the seventeenth century Dutch guilder and of course, more recently, sterling and the dollar.”[1]
Before 1944, the world reference currency was the Pound Sterling. After World War II, the international financial system was governed by a formal agreement, the Bretton Woods System. Under this system the United States dollar was placed deliberately as the anchor of the system, with the US government guaranteeing other central banks that they could sell their US dollar reserves at a fixed rate for gold. European countries and Japan deliberately devalued their currencies against the dollar in order to boost exports and development.[2]
In the late 1960s and early 1970s the system suffered setbacks due to problems pointed out by the Triffin dilemma, a general problem with any fiat currency under a fixed exchange regimen, as the dollar was in the Bretton Woods system.
A 2011 study about the current dominant reserve currency in central banks shows that dollar may not be the obvious dominant currency, because of the major part of Unallocated Reserves increasingly reported by central banks since 2001.[3] Thus the following table is only a limited view about the global currency reserves because it only deals with Allocated Reserves:
| '95 | '96 | '97 | '98 | '99 | '00 | '01 | '02 | '03 | '04 | '05 | '06 | '07 | '08 | '09 | '10 | Latest Data '11 Quarter III |
|
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| US dollar | 59.0% | 62.1% | 65.2% | 69.3% | 71.0% | 70.5% | 70.7% | 66.5% | 65.8% | 66.0% | 66.4% | 65.7% | 64.1% | 64.1% | 62.1% | 61.7% | 61.7% |
| Euro | 17.9% | 18.8% | 19.8% | 24.2% | 25.3% | 24.9% | 24.3% | 25.2% | 26.3% | 26.4% | 27.6% | 26.0% | 25.7% | ||||
| German mark | 15.8% | 14.7% | 14.5% | 13.8% | |||||||||||||
| French franc | 2.4% | 1.8% | 1.4% | 1.6% | |||||||||||||
| Pound sterling | 2.1% | 2.7% | 2.6% | 2.7% | 2.9% | 2.8% | 2.7% | 2.9% | 2.6% | 3.2% | 3.6% | 4.2% | 4.7% | 4.0% | 4.3% | 4.0% | 3.9% |
| Japanese yen | 6.8% | 6.7% | 5.8% | 6.2% | 6.4% | 6.3% | 5.2% | 4.5% | 4.1% | 3.8% | 3.7% | 3.2% | 2.9% | 3.1% | 2.9% | 3.7% | 3.8% |
| Swiss franc | 0.3% | 0.2% | 0.4% | 0.3% | 0.2% | 0.3% | 0.3% | 0.4% | 0.2% | 0.2% | 0.1% | 0.2% | 0.2% | 0.1% | 0.1% | 0.1% | 0.1% |
| Other | 13.6% | 11.7% | 10.2% | 6.1% | 1.6% | 1.4% | 1.2% | 1.4% | 1.9% | 1.9% | 1.9% | 1.5% | 1.8% | 2.2% | 3.1% | 4.5% | 4.8% |
| Sources: 1995-1999, 2006-2010 IMF: Currency Composition of Official Foreign Exchange Reserves Sources: 1999-2005 ECB: The Accumulation of Foreign Reserves |
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Economists debate whether a single reserve currency will always dominate the global economy.[4] Many have recently argued that one currency will almost always dominate due to network externalities, especially in the field of invoicing trade and denominating foreign debt securities, meaning that there are strong incentives to conform to the choice that dominates the marketplace. The argument is that, in the absence of sufficiently large shocks, a currency that dominates the marketplace will not lose much ground to challengers.
However, some economists, such as Barry Eichengreen argue that this is not as true when it comes to the denomination of official reserves because the network externalities are not strong. As long as the currency's market is sufficiently liquid, the benefits of reserve diversification are strong, as it insures against large capital losses. The implication is that the world may well soon begin to move away from a financial system dominated uniquely by the US dollar. In the first half of the 20th century multiple currencies did share the status as primary reserve currencies. Although the British Sterling was the largest currency, both the French franc and the German mark shared large portions of the market until the First World War, after which the mark was replaced by the dollar. Since the Second World War, the dollar has dominated official reserves, but this is likely a reflection of the unusual domination of the American economy during this period, as well as official discouragement of reserve status from the potential rivals, Germany and Japan.
The top reserve currency is generally selected by the banking community for the strength and stability of the economy in which it is used. Thus, as a currency becomes less stable, or its economy becomes less dominant, bankers may over time abandon it for a currency issued by a larger or more stable economy. This can take a relatively long time, as recognition is important in determining a reserve currency. For example, it took many years after the United States overtook the United Kingdom as the world's largest economy before the dollar overtook Sterling as the dominant global reserve currency.[5] Schenk has shown in her 2009 study that in 1944 (Bretton Woods) the US dollar was chosen as the world reference currency whereas it was only the second currency in global reserves.[5]
The G8 also frequently issues public statements as to exchange rates. In the past due to the Plaza Accord, its predecessor bodies could directly manipulate rates to reverse large trade deficits.
The United States dollar is the most widely held currency in the Allocated Reserves today. Throughout the last decade, an average of two thirds of the total Allocated foreign exchange reserves of countries have been in US dollars. For this reason, the US dollar is said to have "reserve-currency status", making it somewhat easier for the United States to run higher trade deficits with greatly postponed economic impact or even postponing a currency crisis. Central bank reserves held in dollar-denominated debt, however, are small compared to private holdings of such debt. In the event that non-United States holders of dollar-denominated assets decided to shift holdings to assets denominated in other currencies, there could be serious consequences for the US economy. Changes of this kind are rare, and typically change takes place gradually over time; the markets involved adjust accordingly.[5]
However, the dollar remains until recently the favorite reserve currency because it has stability along with assets such as United States Treasury security that have both scale and liquidity.[6]
US dollar dominant position in global reserves is very much challenged currently, because of the growing share of Unallocated Reserves, and because of the doubt regarding dollar stability in the long term.[7][8][9][10][11]
The euro is currently the second most commonly held reserve currency, comprising approximately a quarter of allocated holdings. After World War II and the rebuilding of the German economy, the German Deutsche Mark gained the status of the second most important reserve currency after the US dollar. When the euro was launched on 1 January 1999, replacing the Mark, French Franc and ten other European currencies, it inherited the status of a major reserve currency from the Mark. Since then, its contribution to official reserves has risen continually as banks seek to diversify their reserves and trade in the eurozone continues to expand.[12]
Former U.S. Federal Reserve Chairman Alan Greenspan said in September 2007 that the euro could replace the U.S. dollar as the world's primary reserve currency. It is "absolutely conceivable that the euro will replace the US dollar as reserve currency, or will be traded as an equally important reserve currency."[13] Econometric analysis by Jeffery Frankel and Menzie Chinn in 2006 suggests the euro may replace the U.S. dollar as the major reserve currency by 2020 if (1) the remaining EU members, including the UK and Denmark, adopt the euro by 2020 or (2) the recent depreciation trend of the dollar persists into the future.[14][15] In recent years, the euro's increase in the share of the worldwide currency reserve basket has continued to increase—albeit at a slower rate than prior to the beginning of the worldwide credit crunch related recession and sovereign debt crisis[16]
The United Kingdom's pound sterling was the primary reserve currency of much of the world in the 19th century.[5] U.S. and German economic dominance from the second half of the 20th century onward, the emergence of the USA as an economic superpower (and, importantly, the establishment of the U.S. Federal Reserve System in 1913) as well as economic weakness in the UK at various intervals during the second half of the 20th century resulted in Sterling losing its status as the world's most reserved currency.[5]
Since mid-2006 it is the third most widely held reserve currency, having seen a resurgence in popularity in recent years, but growing from about 2.5% to just around 4% of all currency reserves.[17] Analysts say this resurgence is caused by carry-trade investors considering the pound as a stable high-yield proxy to the euro, as well as the position of London in world financial affairs.[18]
Japan's yen is part of the International Monetary Fund's (IMF) Special Drawing Rights (SDR) valuation. The SDR currency value is determined daily by the IMF, based on the exchange rates of the currencies making up the basket, as quoted at noon at the London market. The valuation basket is reviewed and adjusted every five years.
The SDR Values and yen conversion for government procurement are used by the Japan External Trade Organization for Japan's official procurement in international trade.
A number of central banks (and commercial banks) keep Canadian dollars as a reserve currency. In the economy of the Americas, the Canadian dollar plays a similar role to that played by the Australian dollar (AUD) in the Asia-Pacific region. The Canadian dollar (as a regional reserve currency for banking) has been an important part of the British, French and Dutch Caribbean states' economies and finance systems since the 1950s. The Canadian dollar is also held by many central banks in Central America and South America. The Canadian dollar is held in Latin America because of remittances and international trade in each nation.
Canadian economists primarily define and value the Canadian dollar in terms of the United States dollar, and thus by observing how the Canadian dollar floats in terms of the US dollar, foreign-exchange economists can indirectly observe internal behaviours and patterns in the US economy that could not be seen by direct observation (Canada’s primary foreign-trade relationship is with the United States). Also, considered a petrodollar, the Canadian dollar has only fully evolved into a global reserve currency since the 1970s when it was floated against all other world currencies. Some economists have attributed the rise of importance of the Canadian dollar to the long term effects of the Nixon Shock that effectively ended the Bretton Woods system of global finance.
The Canadian dollar is used as a reserve currency around the world and is currently ranked 6th in value held as reserves.
The Swiss franc is often considered a reserve currency, because of the perceived stability of the currency and the Swiss banking system. However, the share of all foreign exchange reserves held in Swiss francs has historically been well below 0.5%. The daily trading market turnover of the franc however, ranked fifth, or about 3.4%, among all currencies in a 2007 survey by the Bank for International Settlements.[19]
A report released by the United Nations in 2010, called for abandoning the U.S. dollar as the single major reserve currency. The report states that the new reserve system should not be based on a single currency or even multiple national currencies but instead permit the emission of international liquidity to create a more stable global financial system.[20][21][22]
Countries such as Russia and the People's Republic of China, central banks, and economic analysts and groups, such as the Gulf Cooperation Council, have expressed a desire to see an independent new currency replace the dollar as the reserve currency.
On 10 July 2009, Russian President Medvedev proposed a new 'world currency' at the G8 meeting in London as an alternative reserve currency to replace the dollar.[23]
According to economist Michael Hudson, China has said, "we don't want to make any more foreign exchange reserve of any paper currency, because all the paper currencies are government debt currencies." China, Russia, India, Turkey, Brazil, Venezuela and oil-producing countries have recently agreed "to transact all of their mutual trade and investment in their own currencies" effectively minimizing the need, at least in the short term, for a global reserve currency.[24] And yet oil is still priced in dollars, which has brought complaints about OPEC's policies of managing oil quotas to maintain dollar price stability.[25]
Some have proposed the use of the International Monetary Fund's (IMF) Special Drawing Rights (SDRs) as a reserve.
China has proposed using SDRs, calculated daily from a basket of U.S. dollar, euro, Japanese yen and British pound, for international payments.[26]
On 3 September 2009, the United Nations Conference on Trade and Development (UNCTAD) issued a report calling for a new reserve currency based on the SDR, managed by a new global reserve bank.[27] The IMF released a report in February 2011, stating that using SDRs could help stabilize the world economy.[28]
The Chinese yuan or renminbi (RMB) cannot be used as a reserve currency as long as the Chinese government maintains capital controls on the conversion of its currency.[29] The currency would not be attractive to central banks for holding unless China developed a strong open bond market.[30] The Bank for International Settlements estimates that in 2010 around 0.9% of all currency market transactions were carried out in renminbi.[31]
Chinese President Hu Jintao has said that it would be a long process before the yuan was accepted as a global currency.[32]