China is buying gold and dumping dollars. The U.S. fiscal deficit and debt levels are unsustainable. Inflation is devaluing the dollar. We are getting closer and closer to a world where the dollar is no longer the global reserve currency. Sounds scary, right? Thankfully, the headlines don’t quite match reality. Will the dollar lose its status as the world’s reserve currency? Before we answer that question, some context might help.
With all the talk of the dollar’s status as the global reserve currency, it’s fair to ask: what exactly is a reserve currency, and what purpose does it serve?
Reserve currencies are used in international transactions, financing, and all other aspects of the global economy. These currencies are held in significant quantities by central banks globally. Using one currency for international transactions globally makes trade easier to conduct.
The U.S. dollar has served as the global reserve currency since 1944, when it was determined at the Bretton Woods Conference that it would replace the British pound sterling. Since then, the U.S. dollar has made up the plurality of the world’s currency reserves. Today, the U.S. dollar makes up over 58% of global foreign exchange reserves, as measured by the International Monetary Fund (IMF). While this is down from a recent 2016 high of just over 65%, it is comfortably higher than its 1990 level of around 47%. The 58% figure is almost triple that of the next closest currency, the euro, which is just under 20% of global reserves. Furthermore, the U.S. dollar is used in 88% of foreign exchange transactions, and over 70% of debt raised in foreign countries is actually raised in U.S. dollars rather than in local or other currencies. Beyond usage in international transacting and financing, the U.S. dollar also serves as a safe haven asset. Investors globally flock to the dollar during times of economic uncertainty. Even when the U.S. economy was in turmoil in 2008 during the Great Financial Crisis, the U.S. dollar managed to appreciate against a basket of six other major currencies by over 26%.
As the world stands today, the U.S. dollar is the dominant global currency, with nothing else coming close to its share of reserves or transactions. Despite this, recent headlines have circulated about foreign central banks, especially in emerging market countries, dumping the dollar and building up their gold reserves. Perhaps the most notable name with headlines circulating about it is China. It is worth noting that despite building their gold reserves in recent years, as a percentage of total central bank reserves, China’s gold position is only 4.3%, according to Barron’s. While this is almost a full percentage point higher than at the beginning of 2022, it still lags the global average of 7%. One potential reason for this could be a reaction to Russia’s invasion of Ukraine. When Russia invaded Ukraine in 2022, the U.S. and the broader international community imposed strict monetary sanctions on Russia. By diversifying away from the U.S. dollar, foreign nations would blunt the impact of potential monetary sanctions imposed by the U.S. With all this being said, it is worth repeating: current central bank reserves globally are made up of over 58% U.S. dollars. This metric is only down about a half percentage point from 2020. So, while it is true that alternative reserves are increasing, the scale and pace at which it is happening is not alarming. Also, replacing the dollar as the global reserve currency would require finding a suitable replacement. This task is much easier said than done.
By definition, a currency must have three traits: serve as a medium of exchange (be widely accepted as a form of payment), serve as a store of value (lacks extreme volatility in value), and serve as a stable unit of account (easy to keep track of how much something is worth). Global reserve currency requirements go a little bit further. The Atlantic Council GeoEconomics Center, an American think tank, has identified six essential qualities of a reserve currency. Those qualities include a sizeable domestic economy, the importance of an economy in international trade, the size and openness of capital markets, the convertibility of a currency, the use of the currency as a currency peg, and a stable domestic economy and political climate. These traits of global currencies can be bolstered by qualities like an independent central bank, strong institutions, and political stability.
Some alternatives to the U.S. dollar have been discussed in the media, but all have flaws. The euro for, example, is the common currency of 20 countries in the European Union, which has an economy roughly the size of the U.S. when added together. The problem with the euro is that each country within the European Union has its own economy making the currency vulnerable to any one economy’s issues. This was seen in 2011 when the Greek and Italian economies weighed on the euro’s value. The Chinese yuan has also been floated as an alternative but has a host of problems including an economy $4 trillion smaller than the U.S., capital markets that are not deep, and a lack of central bank independence. Gold or Bitcoin have long been thought to be potential alternatives to the U.S. dollar but come with their own issues, including price volatility and a lack of widespread acceptance as a form of payment.
Another challenge in replacing the dollar is incumbency. A reserve currency is difficult to unseat in part because of how intertwined global financial markets have become. The U.S. dollar overtaking the British pound sterling in 1944 did not happen overnight. The process started in the 1890s and took over 50 years, with two world wars and a fiscal crisis in the U.K., before the transformation was complete. Today, thanks to the effects of accelerated globalization, financial markets globally are even more intertwined than they were in the 1940s, making it that much more difficult to institute a new global reserve currency.
This isn’t the first time there has been talk of the U.S. dollar being replaced as the global reserve currency. In the 1990s, when the euro was introduced, it was thought it might overtake the U.S. dollar. In the late 2000s, when the Great Financial Crisis hit and China’s economy began expanding rapidly, it was thought that the yuan might overtake the dollar. Both stories failed to play out. When it comes to replacing the dollar as the global reserve currency, there are two prongs to replacement: reserve usage and transaction usage. The dollar still dominates in both departments without a close second. While it has decreased as a percentage of global reserves, the pace at which it has decreased has slowed since coming out of Covid. While a host of factors may be leading to foreign nations building up alternative reserves, a lack of viable alternatives, entrenchment within the global financial system, and the relative political and economic stability of the U.S. should keep the dollar in place as the global reserve currency for a long time.
Written by: Brian Sawyer
