A reserve currency is one held by central banks to pay their international debts with or to use as a way of influencing the exchange rate of their country’s currency.
Reserve currencies can also be used to pay for certain key commodities with in international trade, like gold and oil for example.
In order of importance, the major currencies currently held in reserve by central banks include the U.S. Dollar, the Euro, the Pound Sterling, the Japanese Yen and the Swiss Franc.
Prior to their replacement with the Euro in 1999, the German Deutsche Mark and the French Franc were also held as reserve currencies.
The U.S. Dollar as the Primary Global Reserve Currency
The main global reserve currency since the early part of the last century has been the U.S. Dollar, which was pegged to the value of gold for much of that time as it adhered to the so-called Gold Standard.
This key role for the Dollar was further supported during the Bretton Woods period of pegged exchange rates that extended from after the end of World War II to the early 1970’s when then President Richard Nixon unilaterally took the U.S. Dollar off of the gold standard.
That tumultuous event ushered in the present era of floating exchange rates for what are now virtually exclusively paper fiat currencies that cannot be converted freely into gold.
Despite the U.S. Dollar’s fall from the grace of being a stable, gold-linked currency, it has nevertheless retained its status as a reserve currency, accounting for 61.5% of global official reserves in 2009.
Benefits of Being a Reserve Currency
As a result of their importance in international trade, the demand for currencies kept in reserve by central banks tends to support their value artificially.
Furthermore, a number of observers have pointed out that the demand for its currency produced by the U.S. Dollar’s status as the world’s primary reserve currency gives the U.S. government the chance to borrow at lower interest rates.
In addition, this status helps fund the U.S. government’s spending deficits because central banks holding U.S. Dollars in reserve will tend to invest them in Dollar-denominated instruments that bear interest, driving rates even lower.
These factors generally provide the United States with a considerable advantage over other economies due to its status as the primary reserve currency.
The Dollar’s Supremacy as a Reserve Currency Threatened
Concerns over the continued excessive level of U.S. public spending, the country’s costly overseas wars, and the stubborn U.S. trade deficit, have led a number of central banks to start turn to the Euro as the next best reserve currency for their purposes.
As an alternative, China has recently proposed the use of a basket of currencies for reserve purposes. Specifically, they suggested the Special Drawing Rights used by the International Monetary Fund or IMF for international payments that consist of a basket of the U.S. Dollar, Euro, Yen and Pound Sterling currencies.
The Euro’s Rise as a Reserve Currency
Although the recent sovereign debt crisis in Europe during 2009-2010 has weakened the Euro considerably, even to the point of prompting some central banks to lessen their official holdings of the currency, the Euro still has some supporters who believe the consolidated European currency may eventually become the world’s next primary reserve currency. .
As an example of the shift toward holding Euro official reserves versus Dollar official reserves, the Euro accounted for 28.1% of global currency reserves in 2009 versus 17.9% when it was first introduced in 1999. During that same time frame, U.S. Dollar official reserves dropped from 70.9% in 1999 to 61.5% in 2009.
Nevertheless, the U.S. Dollar still has the advantage of being the main currency involved in the trading of oil, gold and other key commodities. If nations producing those commodities start to sell their products in Euros, rather than Dollars, this switch would tend to benefit the Euro at the expense of the Dollar’s with respect to being a reserve currency.