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Understanding a Global Currency: What Makes the Dollar the Reserve Currency of the World?

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USD is the world’s currency. Through its ups and downs, recessions, stagflation, bull and bear markets, wars, and turmoil, the Dollar has shown great resilience as the world’s measure of value. What is behind the great staying power of the currency? What makes a currency a candidate for being an international definition of value? And is this position threatened? We’ll discuss these subjects in this article.

Economic Power

The main cause of the dominance of a nation’s currency is of course its economic power. The greater the Gross Domestic Product, and trade volume of a nation, the greater the demand for its currency. But beyond the health of the economy itself, the nation must be a center of demand, so that its currency will be available with ease, supported by a strong consumer sector, and must not be dampened by official intervention. Such has been the case with both the British Pound, and the U.S. Dollar in this century. In the past, gold production, or accumulation were important factors as well.

Military Deterrence

It is not a coincidence that the U.S. has few enemies among the smaller or bigger nations of the world. Apart from a few ideologically driven adversaries, the U.S. has reasonably good relationships with everyone in spite of the fact that jealousy of its unchallenged dominance should be causing lots of antagonism among nations. But one kisses the hand that he cannot harm, and the strong have fewer enemies than the weak.

Military, or hard power, can be a great boost to a nation’s image among others. The British, for example, had their colonies boost the demand for their currency by restricting their import of goods from other centers of economic power. When Germany was in the ascendant before the First World War, many nations purchased German goods, boosting the demand for the German Mark, partly to improve relations, and to benefit from German protection in conflicts. America, of course, has the Gulf Cooperation Council currencies pegged to the dollar at least in part due to the credibility of its pledge, in consequence of its immense military might, to defend their independence against regional or external aggression.

Throughout history, the cases where a dominant currency is accompanied by dominant military power are more frequent than the opposit case.

Diplomatic Prestige

Nations tend to trade with others with which they have overall good relations. The power behind a dominant currency must have high prestige, and great diplomatic relations with others, so that it can project its economic dominance on others. The worst case is the one where a puny nation has bad relations with everyone, and has hardly any diplomatic prestige. The embargoed nation of Zimbabwe, the currency of which is one of the cheapest in the world, and the DPRK, the currency of which is not convertible, are two examples of the lack of diplomatic power. The Soviet Union was an interesting case where diplomatic isolation outside of its own block lead to more limited trade volumes with the rest of the world, leading to limited demand for the Soviet Ruble (apart from the fact that the currency was not tightly controlled, and not convertible). The U.S. with its many free trade agreements, and alliances all over the world is a good example of the extreme positive scenario.

Stability, and Credibility

In the period between the First and Second World Wars, Germany was one of the leading nations in the science and economic development. But the German Mark never developed dominant status. After the Second World War, even as Germany was of far smaller significance in all these areas, and no longer a dominant power, its currency was one of the favored reserve assets among world central banks.

The discrepancy is of course explained by the fact that the German Central Bank, the Reichsbank pursued hyperinflationary policies in the interwar era, evaporating the savings of those who had assets denominated in the Mark. The lack of credibility (and options) by the central bank reduced demand for the currency, even as the German economy was strong and highly visible in international trade.

By contrast, after the war, the German central banking culture focused its strength on inflation fighting, partly in consequence of the events of the interwar era. Thus, because of the credibility of the Bundesbank, not to mention the importance of German exports, the Deutsche Mark was able to attain dominant status, even as Germany was completely beholden to American power in other fields.

Is this position of the US dollar threatened?

According to numbers compiled by the International Monetary Fund on the currency composition of official foreign exchange reserves, the U.S. Dollar has fallen from a recent high of 70.9% of international reserves seen in 1999 to just 62.2% in 2009.

It seems that most of the Dollar’s loss of favor has been taken up by the Euro, which went from 17.9% in 1999 to 27.3% in 2009. Nevertheless, the Pound Sterling has also benefitted to a lesser degree, rising from 2.9% to 4.3% over the same period.

Reasons for Shifting Reserves Away From Dollars

It seems that the Dollar’s status as a reserve currency has been hurt at least partly because of such factors as:

  • The almost surreal recent level of government public spending in the United States as the country attempts to spend its way out of recession.
  • The seemingly endless and very costly overseas wars the U.S. military has been involved in recently.
  • Ever increasing U.S. trade and budget deficits that suck funds out of the country or into servicing debt.
  • The long term decline in the value of the U.S. Dollar, accompanied by an increasing lack of confidence in the country and its currency.

In essence, the U.S. Dollar no longer has the luster it once had when its value was tied to gold during the Bretton Woods system of fixed exchange rates.

China Proposes Replacing Dollar With Special Drawing Rights

In addition, China recently proposed replacing the U.S. Dollar with a basket of currencies to be used for its reserve currency keeping purposes.

The basket of currencies the Chinese suggested were the International Monetary Fund’s Special Drawing Rights or SDRs which are based on a currency basket that can change in composition.

At presently, the composition of the Special Drawing Right consists of 44% U.S. Dollars, 34% Euros, 11% Pound Sterling and 11% Japanese Yen. Maintaining reserves based on SDRs would tend to reduce reserve demand for U.S. Dollars considerably.

Conclusion

Political (diplomatic) power, and stability are probably the most important factors determining a currency’s potential as a global currency. Political power is a consequence of military might, but diplomatic prestige is perhaps even more important. Eventhough the US dollar has lost some of its position as a reserve currency in some countries, the conclusion that we can derive from the above discussion is that the USD will remain the dominant denominator of value throughout the world for at least the next twenty years, even as its dominance is challenged by rising local powers.

Further reading:

The strategic importance of the US dollar.

Why currencies trade against the dollar.


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