Updated: Nov 19, 2021
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Held by central banks and states alike, foreign exchange reserves consist of hard currency and gold stocks. Comparable to a large savings account, these reserves play an essential role: safeguarding the economy of a country through currency stability and import growth management.
Today, over 60% of all assets stocked up are US dollars, in other words, making up for 2/3 of all global foreign exchange reserves. It begs the question: of all the available tradable currencies, why is the US dollar the default reserve currency?
The US Dollar: an international currency
The national currency of the United States of America, the Dollar is also international. Most worldwide financial transactions and commercial exchanges are either completed in dollars or using the American Dollar as a reference.
It is, therefore, no surprise that national central banks around the globe build up foreign exchange reserves predominantly composed of it.
The Bretton Woods system: a new monetary order
The status of the US Dollar came to be following the 1944 Bretton Woods economic treaty. With the system that ensued, the convertibility of the dollar into gold was set at a fixed parity of 35 USDs in exchange for an ounce of gold.
Not only did this agreement underline the economic dominion of the United States over the post-war world but it moreover reflected the trust that could be put in the stability of the currency itself. From then on, the systematic procurement of dollars from central banks to set up foreign exchange reserves would unequivocally attest to the sustainability of the American currency.
Despite the Bretton Woods system coming to an end in the early 70s, the American Dollar went on to become an international standard.
The first economic power in the world
Whenever trade deficits widen, a country is faced with three possible courses of action to reduce indebtedness: either by borrowing funds, selling domestic assets, or drawing on its reserves.
The astonishing power of their currency aside, what sets the United States apart is how easily it can issue bills, a process commonly called seigniorage. American financial assets are attractive, as we have already seen. And printing money allows Americans to avoid creating foreign exchange reserves with currencies other than their own, thus making it easier for the country to pay down the debt independently.
3 reasons why the US Dollar is preponderant
As a whole, a prerequisite for any currency to weigh internationally is to prove stable and secure, most notably in times of financial turmoil. The US Dollar ticks all the right boxes, in that regard.
The economic power of America alone is nothing short of a reassuring demonstration of the rightful influence of the country's currency.
In light of what we already know of the country's seigniorage benefits, reimbursement of the US public debt does not frighten creditors.
In times of destabilizing foreign exchange market fluctuations, having dollars at the ready helps dampen a country's currency depreciation.
Is the US Dollar crisis-proof?
The 2007-2008 financial crisis, for example, has only further reinforced the US dollar as a safe-haven currency, confirmed, in particular, by the fact that emerging nations have binge-bought it to fill in their foreign exchange reserves in the event of yet another economic collapse.
Is the US Dollar on the decline?
Yet, in response to America's budget deficit accumulating and concomitant restrictions imposed on US dollar use in certain countries, many central banks have responded in opting for diversification in their foreign exchange reserves, making way for new competitive currencies.
The Euro is what comes to mind first, ranking 2nd most prevalent forex currency reserve globally. However, although saved up by central banks, the impossibility for the Euro to overtake the US Dollar is far more political than technical. The currency is far too unstable and underperforming to be anything more than regional, for the time being.
Can China tailgate the Dollar with the Yuan?
We saw how unlikely it would be for the Euro to surpass the US dollar. But what about the seriousness of a contender like the Chinese Yuan?
Back in 2018, the central bank of Germany integrated the Yuan into its foreign exchange reserve. In an attempt to anticipate speculation surges, the bank diversified its assets, at the time following the lead of other forward-thinking monetary institutes.
As of now, the Yuan march forward towards the leading position is but speculations. Some, however, seriously see the Yuan supplant the Japanese Yen and British Pound by the year 2030, making it to the 3rd position by then.
The American Dollar to reign supreme for another decade
To become a monetary power is not necessarily automatically synonymous with neither economic nor commercial influence. The two main predictors have consistently been instilling trust and the possibility for assets to be denominated in the same currency.
Undisputed until now, only the United States has met these conditions, exemplified by the fact that even China has continuously been adding US dollars to its foreign exchange reserve.
Bitcoin: new reserve currency on the horizon?
Zhou Xioachuan, now retired governor of the People's Bank of China, when asked on the matter, stated:
"The desired objective of an international monetary system reform must be to create a reserve currency independent of any individual nation and apt to remain stable in the long run [...]."
One of the latest trends to have seized international currency markets is the growing suggestion that the US dollar could be replaced and subsequently lose its foreign exchange reserve supremacy, should Bitcoin and its derivatives gain a real foothold. While it is clear that crypto-currency aficionados hope for this shift to take hold, some central banks have even gone as far as studying the real possibility of transitioning toward a cashless world. To be continued.
While the future of the global economy remains uncertain, whenever central banks manipulate currencies, exchange rates fluctuate, more often than not for the worse. We, at Funding Routes, can help you circumnavigate unfavorable rates with our up-to-date list of international wire transfer alternatives. Contact us to know more!