Without a doubt, the most important and strategic currency traded in the forex market is the U.S. Dollar. The Dollar is a part of currency pairs that together account for over 85% of trading volume in the huge forex market.
The following sections will describe how the U.S. Dollar has achieved and maintained this position as the world’s most actively traded currency.
The Historical Rise of the U.S. Dollar
The United States was the only nation that fought in World War II which did not suffer major physical damage to its mainland and infrastructure. All the other nations involved had to rebuild considerably which left their economies in complete disarray. Some nations also paid the United States for their assistance.
Although an alternative global reserve currency known as the bancor was originally proposed, the U.S. Dollar became the currency selected at Bretton Woods, New Hampshire shortly before the end of the war in 1944, for which gold was freely convertible at $35 per ounce. All other major currencies were then pegged to the Dollar with fixed ranges of fluctuation.
After Bretton Woods, the U.S. Dollar was the most stable currency for many years, until all currencies were allowed to float freely against each other. This took place in the early 1970s after the United States unilaterally stopped the convertibility of its currency into gold.
The U.S. Dollar as a Key Reserve Currency
Reserve currencies are defined as the currency or currencies which a government or central bank holds in significant quantities.
The U.S. Dollar is by far the top reserve currency in the world in terms of the percentage of global currency reserves. The Dollar accounts for an estimated share of over 60% of the total global currency reserves.
Other popular reserve currencies and their percentage of world reserves held by governments and central banks are as follows:
- European Union Euro: 28% of world reserves
- U.K. Pound Sterling: 4.2% of world reserves
- Japanese Yen: 3.0% of world reserves.
These reserves can be use to conduct foreign exchange transactions on behalf of a central bank’s domestic currency or to purchase key commodities like oil or gold.
In addition, the governments issuing reserve currencies usually have the advantage of being able to borrow money at advantageous interest rates. This arises because there tends to be a larger market for investment in reserve currencies than for others.
How International Lending Policies Support the Dollar
The international debt of many countries that are actively trading in the global market is now in large part denominated in U.S. Dollars. This is primarily due to the establishment of institutions such as the International Monetary Fund or IMF and the World Bank that also arose out of the Bretton Woods conference.
Basically, all debt owed to the IMF is U.S. Dollar denominated. This means that if a developing nation receives a loan from the IMF, then that loan will be in U.S. Dollars and will later have to be repaid in U.S. Dollars.
As a consequence, any repayment of the USD denominated loan or attempt to stabilize the national currency would tend to necessitate the trading of U.S. Dollars on the open market.