The dollar’s reputation for stability could be harmed by easy monetary policy and growing government budget deficits, but its position as the main reserve currency appears to be secure.
Frequently, people ask us if the US dollar will stop serving as the world’s reserve currency. Investors worry that the loose monetary policy of the Federal Reserve, coupled with expanding fiscal deficits, will erode investor confidence in the dollar. These worries have grown as a result of the recent decline in the dollar during the past year. Even though we concur that the current policy mix may have unintended implications, we think the dollar’s position as the dominant global currency is secure.
What are reserve currencies?
The majority of the time, large, industrialized nations with a track record of financial stability issue reserve currencies. The usual requirements for a currency to be maintained in reserve by a foreign central bank are:
• be freely convertible (not pegged by the government);
• have a large and liquid debt market that foreign investors can access;
• have an independent central bank;
• and be widely used in trade and global transactions.
The euro, British pound, Swiss franc, Australian dollar, and Chinese yuan are all held in reserve in addition to the U.S. dollar. Nevertheless, according to IMF figures for 2020, the dollar remains by far the most extensively used currency, with a 60% market share.
Foreign exchange holdings as a percentage of total allocated in U.S. dollars
Source: Bloomberg. Foreign Exchange Holdings as a Percentage of Total Allocated in U.S. Dollars, Euro, Yen, Renminbi, and Other Reserve Currencies.
Currencies represented in “Others”: Swiss Franc, Canadian Dollar, Australian Dollar, Great British Pound, and unclassified others (CCFRUSD% Index, CCFREUR% Index, CCFRJPY% Index, CCFRCNYP Index, CCFROTR% Index, CCFRCHF% Index, CCFRCADP Index, CCFRAUDP Index, CCFRGBP% Index). Quarterly data as of 12/30/2020.
Nearly 80% of all international cross-border transactions use the U.S. dollar, as do around 40% of trade transactions worldwide. A few examples of commodities that are exchanged in US dollars include oil, copper, and agricultural products. Dollars must be held by investors in order to transact in goods and services, and they must be able to invest them in a sizable, liquid bond market.
Source: Bank of International Settlements (BIS). The BIS Triennial OTC Derivatives Statistics: FX Turnover by currency. Triennial data as of 12/31/2019.
What about alternatives?
Over time, the role of the renminbi has increased slightly while that of the Japanese yen has remained basically unchanged. The utilization of the euro in international transactions has increased. The dollar is not expected to be replaced by any of these currencies any time soon, though.
The euro would be the most likely contender because it accounts for a sizable portion of the global gross domestic product. However, compared to American bond markets, they are less liquid and dispersed over numerous nations. Treasury bond market, which would put a cap on how much money a foreign investor may retain in euros.
China is said to want to elevate its yuan to the status of the leading reserve currency, but it still has a ways to go. The major drawback is that the value of its currency is controlled. Investors can’t be certain that capital controls won’t be utilized to restrict access to their holdings because it isn’t freely convertible into other currencies. It has only been used in a very small number of international transactions up to this point, making up just 3% of them compared to over 80% for the dollar.
Reserve currencies rise and fall in value
Although we think the dollar will continue to function as the world’s reserve currency for the foreseeable future, its value will fluctuate in response to changes in the underlying economic conditions. The value of the dollar has decreased by around 11% since its peak in March 2020. The Federal Reserve’s broad monetary policy when the COVID-19 crisis struck is reflected in the drop. To help improve financial conditions during the crisis, the Fed decreased short-term interest rates and raised the amount of dollars accessible to foreign central banks. However, we don’t observe a deliberate effort on the part of the central bank to reduce the value of the dollar. In fact, because it makes it easier for borrowers to obtain funding, particularly in emerging-market nations, a weaker dollar is typically viewed as a good for global economy.
The U.S. dollar has dropped from its highs
Source: Bloomberg. Bloomberg Dollar Spot Index (BBDXY Index). Daily data as of 3/8/2021.
Past performance is no guarantee of future results.
And lastly, the dollar continues to be a haven asset. The dollar typically increases during times of global stress as investors look for a big, liquid, and trustworthy place to invest their money. Due to worldwide demand, the dollar rose to its greatest level in decades when the pandemic broke out in early 2020 compared to a wide variety of other currencies.
The U.S. benefits from having the reserve currency of the globe. This indicates that there is persistent demand for American bonds from foreign central banks and other significant investors searching for a secure market to invest in. As a result, the United States can borrow money at rates that are lower than otherwise feasible. Many years ago, Valéry Giscard d’Estaing, a former president of France, referred to the advantages that the United States received from holding the position as world reserve currency as a “exorbitant privilege.” It still holds true today.
YOUTUBE VIDEO: Why The U.S. Dollar May Be In Danger
By: Miss Cherry May Timbol – Independent Reporter
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