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While the US dollar currently enjoys a dominant position as the world’s reserve currency, various factors could challenge its supremacy. Emerging economies, digital currencies, geopolitical shifts, and global financial reforms all pose potential threats.
In this episode, we’ll discuss what it means to be a reserve currency, why the US dollar holds its dominant reserve currency position, and the likelihood of the US dollar losing that status along with potential implications for lower US dollar demand.
Lots to cover here, so let’s dive in!
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What is a Reserve Currency?
To understand the concept of a reserve currency, imagine you’re traveling the world. No matter where you go, there’s one language that almost everyone speaks, at least a little bit: English. It’s the lingua franca of international business, diplomacy, and tourism.
Similarly, in the world of global finance, there’s a “universal language” of money: a reserve currency.
Think about it–having a currency that is widely accepted and trusted simplifies international trade and finance. When countries engage in trade, they need a reliable medium of exchange. For instance, when a company in Japan buys oil from Saudi Arabia, the transaction is likely settled in US dollars. This eliminates the need for constant currency exchanges, which can be costly and complicated.
The other role of a reserve currency is to act as a safe haven for countries and investors during times of economic instability. This trust is not easily earned; it’s built over decades of economic stability, prudent financial policies, and strong institutions.
Why the US Dollar is the World’s Dominant Reserve Currency
Since World War II, the US dollar has been the dominant international reserve currency thanks to the Bretton Woods Agreement in 1944, in which 44 countries formally adopted the US dollar as an official reserve currency. Under this agreement, other countries pegged their exchange rates to the dollar, which was convertible to gold at the time and relatively stable. That made it easier for other countries to stabilize their currencies, so the agreement worked out for everyone in the beginning.
But over time, as the US printed more money to finance its spending, the gold backing behind the US dollar diminished, leading to a chain of events that concluded with President Nixon ending the gold standard and severing the link between the value of the US dollar to gold in 1971.
From that point on, countries have been free to link their currency value to that of another currencies, a basket of currencies, or float freely in the marketplace. And yet, the US dollar remains the dominant reserve currency for a handful reasons:
1. Economic Stability and Size
A reserve currency requires a large and stable economy to make it a reliable store of value. The United States, boasting the world’s largest economy, provides a vast and secure market for international investors. The size and robustness of the US economy instill confidence, making the dollar a safe haven in turbulent times.
2. Liquidity and Trust
Liquidity is the lifeblood of any financial system, and the US dollar is the most liquid currency on the planet. This means it can be easily exchanged for goods, services, or other currencies without causing significant price fluctuations. The sheer volume of dollar-denominated transactions conducted daily around the world underscores its unparalleled liquidity.
Trust, however, is an equally critical component. The US financial system, backed by strong institutions and the rule of law, is viewed as one of the most reliable in the world. Investors trust that their dollar-denominated assets will be honored and protected, which is not a guarantee they feel with every currency.
3. Historical Precedent
The US dollar was the world’s undisputed reserve currency for three decades before it decoupled from the price of gold. But even after that happened, the number of viable options were relatively limited for another few decades.
That made the US dollar like a colossal tree with deep roots spread far and wide into the global financial system. And because the US has enjoyed its dominant position for so long, those roots are difficult to replace or remove. Plus, many international economies have grown accustomed to the shade and shelter provided by its branches.
4. Global Financial Infrastructure
Many of the world’s major financial institutions, including the IMF and the World Bank, conduct their operations in dollars. International trade, especially in commodities like oil, is predominantly priced in dollars. This entrenched usage creates a self-reinforcing cycle: the more the dollar is used, the more it is trusted and needed.
The Rise of Competing Reserve Currencies
What is the likelihood of the US dollar losing its reserve status?
It’s a question that comes up from time to time because having the world’s leading reserve currency comes with some pretty nice perks. Most notably, it creates a continuous demand for US dollars, which helps keep US interest rates lower than they might otherwise be. That allows the US government to run larger deficits at a lower cost because the world is willing to lend money to the US at favorable terms (essentially) because they trust the dollar.
So being the world’s leading reserve currency is pretty great for our country. But that also makes the idea of losing that status seem pretty scary. Not only would a decline in the US dollar’s reserve status lead to higher inflation, higher interest rates, and reduced fiscal flexibility; it would also impact our country’s ability to influence global economic policies. Currently, the dollar’s dominance allows the US to impose sanctions effectively, regulate international financial flows, and exert significant influence over global economic policies.
So I’ll repeat the question: What is the likelihood of the US dollar losing its reserve currency status?
Well, the thing is, there isn’t just one single reserve currency. Yes, the US dollar remains the dominant reserve currency, but nations across the globe already maintain reserves in other currencies. And while the US dollar was largely uncontested for five-ish decades following Bretton Woods agreement in 1944, international operations made a noticeable shift toward the euro since its launch in the 1990s and, to a much lesser extent, other major developed-market currencies such as the Japanese yen and the British pound.
Is that a concern? Looking at data on global currency reserves and usage, I’d say it’s not.
According to data from the IMF, the US dollar makes up over 58% of the world’s exchange reserves compared to 19.98% for the euro, 5.70% for the yen, 4.84% for the pound and 2.29% for the Chinese renminbi.
Source: IMF – Currency Composition of Official Foreign Exchange Reserves
Meanwhile, a recent Vanguard study shows that the US dollar far outpaces rivals in terms of usage, with the US dollar making up 69.0%, the euro 23.1%, the pound 6.4%, the yen 7.3%, and the renminbi 3.0%.
Source: Vanguard – Why the US Dollar Remains a Reserve Currency Leader
And while US dollar reserves have continued to gradually decline over the past few decades, we haven’t seen matching increases in the shares of the other “big four” currencies–the euro, yen, and pound. Instead, there has been a rise in share for what are referred to as “nontraditional reserve currencies” such as the Australian dollar, Canadian dollar, Chinese renminbi, South Korean won, Singaporean dollar, and the Nordic currencies.
The country among those nontraditional reserve currencies that tends to get the most attention is China’s renminbi, in large part because of the market share gains it has experienced since the mid-to-late 2000s when the Chinese government began advancing a variety of policies to promote renminbi internationalization. But if you look at the currency reserve data, that trend appears to be stalling out.
So I would be skeptical if you hear people using China as a reason that the US dollar will lose it’s reserve currency status. It’s perfectly reasonable to expect China economy and currency to gain market share relative to the US over several decades, but it’s hardly worth worrying about from a long-term investing perspective.
Similarly, I suspect we will continue to see a variety of politicians, market forecasters, newsletter writers, and gold and/or cryptocurrency evangelists use the declining status of the dollar in a manner that I would associate as a scare tactic.
It is true that the US must manage its economic policies carefully to maintain this trust. Excessive debt or fiscal mismanagement could erode confidence in the dollar, leading to potential challenges in maintaining its dominant reserve currency status.
But the fact of the matter is that there isn’t a single global reserve currency. The significant globalization we’ve seen in the last few decades has certainly led to there being many reserve currencies, but the US dollar still dwarfs them all.
What Investors Need to Know About the US Dollar’s Reserve Currency Status
The US dollar’s status as the world’s reserve currency is built on a foundation of economic might, historical precedent, unmatched liquidity, and deep-seated trust. While the landscape of global finance is constantly evolving, these core strengths ensure that the dollar remains the bedrock of international trade and investment.
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Resources:
- IMF: Currency Composition of Official Foreign Exchange Reserves
- Vanguard: Why the US Dollar Remains a Reserve Currency Leader
- Dollar Dominance in the International Reserve System: An Update
The Long Term Investor audio is edited by the team at The Podcast Consultant
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