A Primer on Reserve Currencies and the Global Reserve Dollar (Part 1 of 4)

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4 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff usually doesn’t do requests but has been known to make exceptions if petitioned by the highest authority within the CO universe. Thus begins a four part series on the U.S. dollar as today's preeminent global reserve currency.

What is a reserve currency? Why does the world use one? What are its benefits and drawbacks? The COCEA will attempt to answer these questions in this series of short articles.

First, the definition: A reserve currency is a currency of choice used by governments and central banks around the world as a universal means of settling international transactions and balance of payments in bilateral or multilateral trade.

Next, what are the international benefits of using a reserve currency and the drawbacks or forgoing one?

I.  BENEFITS OF USING A SINGLE RESERVE CURRENCY

The benefit of a single or very few reserve currencies is that it makes trading among nations much simpler and less costly.

Imagine for a moment if there was no one universal currency used among nations. For our thought experiment we’ll focus on one country as an example—say, India whose currency is the rupee.

If India wants to import goods from Mexico then the Indian central bank must maintain a reserve of Mexican pesos to buy those imports since Mexican exporters want pesos and have no use for rupees. But if India wishes to import goods from China too then it must maintain a reserve of Chinese yuan. In fact the Indian central bank would have to maintain reserve balances of U.S. dollars, Canadian dollars, Japanese yen, South African rand, British pounds…. effectively every currency of every nation it conducts any sort of trade with, or over 100 currencies.

The same would be true for every other country. Every central bank in the world would have to maintain constantly changing reserve balances of over 100 different currencies.

  

(there are additional drawbacks to holding small balances of over 100 different currencies instead of one large reserve currency which we will review in Part 3 of this series)

Also, since currency exchange rates float and change on a minute-to-minute basis, calculations for Indian importers and exporters (and the Indian central bank itself) would be a huge headache—tracking constant movements in cost prices or selling prices overseas in every other currency relative to their own domestic currency, the rupee. Granted, with a single reserve currency—in today’s case mostly the U.S. dollar—Indian importers and exporters still must be acutely aware of the U.S. dollar/rupee exchange rate, but that’s much simpler than tracking the exchange rates of over a hundred currencies to the rupee.

So using a single or very few reserve currencies makes global trade between the world’s over 100 nations much less complex and less costly.

II. DRAWBACKS TO “GOING IT ALONE”

What if a single country decided it didn’t like the United States and refused to either conduct overseas trade in U.S. dollars or refused to hold U.S. dollars?

Well it turns out if would incur additional costs beyond simply tracking multiple exchange rates.

First, commercial banks do a great deal of lending in U.S. dollars since the dollar is the incumbent reserve currency for settling international balance of payments. Therefore that country would lose out on a great deal of international banking business since most overseas clients would not want to borrow money solely in that rogue nation’s currency.

Also the exporters of that country would be at a large disadvantage on the world market since their goods would be priced in their domestic currency. Since the dollar is the primary currency for large importers, most exporters price their goods in dollars to prevent confusion. But the rogue nation who refuses to deal in dollars would be selling at a price that, when adjusting for its own exchange rate, would fluctuate constantly against dollar-denominated competing goods sold by other countries.

In fact, one way to envision the complications and costs of breaking away from the current U.S. dollar international regime is to use the United States itself as an example. Today all 50 states conduct trade, buying and selling, interstate pricing, borrowing and debt issuance in U.S. dollars. This makes conducting commerce across state lines very easy, convenient, and inexpensive.

Now imagine if one rogue state, say California (a fitting choice) refused to trade with other states in dollars, broke off from the dollar system, and created its own central bank to start printing its own currency, say “calis.” The value of calis against dollars would fluctuate constantly, making California exports more difficult to price against the exports of other states. Thus the 49 remaining states would tend to buy from one another unless California exports came at a deep discount.

California banks would also find their loans (denominated in calis) rejected by borrowers from other states who still want dollars.

Banks, merchants, and consumers in the other 49 states would balk at having to maintain both dollar and cali balances, and when the time came for them to buy or borrow they would tend to ignore California and buy or borrow from the other 49 states where dealing with uniform dollar currency is much more convenient and transactions less costly.

On the flip side California’s businesses and consumers needing to borrow money would find themselves confined mostly to California banks that take cali deposits because banks in the other 49 states would either be unwilling to hold large cali balances, or if they were willing to lend in calis would charge higher interest rates to compensate for the additional cost of holding cali reserves.

Californians borrowing from non-California banks would also pay higher interest rates since those banks would have to hedge against the risk of lending in calis just to have the cali depreciate against the dollar in which case it takes more calis to convert back to a dollar (ie. the banks lose money even on repaid loans due simply to unfavorable currency exchange movements).

Now if this scenario sounds bad enough imagine all 50 states going off the dollar and onto their own fluctuating currencies. Do you have a headache yet? This was the state the European Union found itself in prior to 1999, and the experiment to transition to the euro was an attempt to derive the same benefits the states of the USA enjoy by using a unified currency: the dollar.

  

III. TODAY’S RESERVE CURRENCY FOR THE WORLD: THE U.S DOLLAR

  

The U.S. dollar has been the reserve currency of choice for the world going back to at least the signing of the 1944 Bretton-Woods international monetary agreement. As of 2018 U.S. dollars account for approximately 63% of world central bank reserve holdings with the euro enjoying about 20%, the Japanese yen 5%. British pound 4.5%, Canadian and Australian dollar 2% each, and the remainder spread out among several other currencies.

Prior to the U.S. dollar the reserve currency of choice was the British pound sterling although during the gold standard era, when currency exchange rates were fixed, the benefits of using a single reserve currency were lessened by fewer fluctuations. Instead, the British pound tended to benefit from the sheer size of the British Empire and the perceived reliability of the Bank of England to make good on its pledge to redeem sterling in gold. That reliability was in no small part maintained by Great Britain’s status as military superpower to protect the pound’s reputation.

Once Great Britain was effectively bankrupted by the cost of two world wars, the world decided to switch to the U.S. dollar. This decision was also helped by the fact that the United States held approximately 40% of the entire world’s gold reserves at the time, and the world was looking to go back to a gold-backed reserve currency.

Exception: Great Britain, represented by economist John Maynard Keynes at Bretton-Woods, wanted to place the world on a new supranational fiat reserve currency dubbed the “bancor” by Keynes himself, jerry-rigged with mechanisms to drain trade surplus countries like the United States of their bancor reserves for the benefit of deficit countries like Britain.

However, Keynes lost the political debate and the gold-backed U.S. dollar won out. In the eyes of most Bretton-Woods participant nations America’s vast gold holdings made the dollar a more trustworthy (or at minimum less untrustworthy) option than the capricious and more easily manipulated bancor.

In Part 2 we’ll discuss what benefits the issuer of the reserve currency (ie. the United States) enjoys.