What is Reserve Currency?

Foreign governments hold reserve currency in their central banks to help reduce the risk of exchange rate fluctuations. A reserve currency is also used to price commodities that all economies need, like oil, gold, silver and natural gas.

The U.S. dollar is the primary reserve currency in the world and has been for nearly 80 years. However, other currencies, like the euro and Japanese yen, are also held for reserve purposes.

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Understanding Reserve Currency

A reserve currency typically maintains a stable value that countries can rely on even when inflation rises or there are other economic uncertainties, like war and pandemics. Foreign governments hold large amounts of the reserve currency to shield themselves from changes in their currency’s exchange rates.

Reserve currencies can be a source of investment and also help facilitate trade. Major commodities like oil and natural gas are priced according to the world’s reserve currency, which is the U.S. dollar.

If commodity prices go up or down, governments can still purchase them at fair amounts using their reserve currency. This feature can be advantageous to foreign governments that experience severe foreign exchange shocks.

Multiple reserve currencies are held around the world, including the Japanese yen, euro, Chinese yuan and British pound. Most governments have varying amounts of each, which gives them greater flexibility when trading. 

Characteristics of a reserve currency include:

• Easy exchange to and from other currencies
• High liquidity that allows for streamlined transactions
• Held by multiple governments, banks and other institutions in large amounts

A country’s economy is vital to a reserve currency's success or failure. Governments perceived as unstable and unpredictable are less likely to be classified as reserve currency.

Severe exchange rate fluctuations of a currency are also unattractive to foreign governments, which will choose more stable options rather than investing heavily in a currency they can’t fully trust to maintain its value.

Political stability is also a factor influencing reserve currencies. Unstable governments susceptible to war, civil unrest and economic disruptions are unattractive reserve currency options since a significant disruption can upset the currency’s value.

By contrast, countries and governments perceived as trustworthy and reliable by their foreign government peers are more likely to see higher interest levels in their currency reserves.

Each government is responsible for its own monetary policy. The central banks and head governmental administrators typically meet several times a year to evaluate their current foreign exchange reserves. If adjustments are needed, they may buy more reserve currency or sell it to protect their exchange rates from severe fluctuations.

How Reserve Currency Works

Many varieties of currency reserves exist, including traditional banknotes like the dollar bill and other items of monetary value, such as bonds and treasury bills. Governments typically hold a variety of each type of reserve, much like an investor maintains a varied stock portfolio.

If the government decides to sell or purchase currency reserves, it will do so to protect against currency devaluation or insolvency. Most governments hold currency reserves from various countries, including the U.S., U.K., China, Japan and the European Union.

Having an assortment of foreign currency reserves on hand helps protect governments from internal and external market shocks that can quickly escalate and lead to significant problems.

The Process of How the U.S. Dollar Became the World’s Reserve Currency

World War II had a significant impact on global affairs. One of its outcomes was the selection of the U.S. dollar as the world’s reserve currency, which occurred during the Bretton Woods Agreement in 1944.

At that time, the Second World War was still in full swing, and delegates from 44 nations met at the United Nations Monetary and Financial Conference in Bretton Woods, New Hampshire, to decide on a reserve currency to protect them from market swings.

The U.S. dollar was the premiere choice because it was the most stable of all the countries participating in the conference. The U.S. was also the holder of the largest gold reserves, which it initially used to back its currency.

Relationship Between Gold and the Dollar

Foreign governments purchased large amounts of U.S. banknotes rather than gold, which they held in their central banks. Many also decided to tie their exchange rates to the U.S. dollar, giving it more stability than it might otherwise have had. 

Once World War II ended, non-Axis powers agreed to adopt the U.S. dollar as their primary currency reserve.

Gold continued to back the U.S. dollar until 1971. Foreign governments saw the United States printing large amounts of paper money to fund the Vietnam War and social programs like the Great Society. They grew concerned, and many started to redeem their paper money for gold.

President Nixon ended the gold standard to halt the run and stopped backing U.S. banknotes with the precious metal. The decoupling of the dollar from its gold backing sent the value of the U.S. dollar into decline.  

However, the dollar remains the world’s top currency because of U.S. economic dominance and the size of its financial markets. 

Types of Reserve Currency

While the U.S. dollar remains the top reserve currency in the world, several others are widely held among foreign governments. Having multiple currencies at once provides greater protection from foreign exchange risk. It also helps preserve trading relationships among partners.

The five main reserve currencies are:

The Future of Reserve Currencies

While some governments have shifted their reserve policies to include less of the U.S. dollar and more of other reserve currencies like the yen and the renminbi, the dollar remains predominant. Although the U.S.’s economic output has dropped over the past several decades, it remains one of the most stable countries in the world.

The International Monetary Fund states that the shift away from the U.S. dollar may be to balance portfolios better. Currencies that have seen increased reserve holdings include Canadian and Australian dollars, the Swedish krona and the South Korean won. 

None of those four currencies are traditional reserves, and they may appeal to foreign governments that have trading relationships with those countries and want to protect against shifts in their value.

A rise in financial technologies like automated liquidity management systems has made purchasing currencies from smaller economies much easier than it once was.

The U.S. Dollar Remains the Dominant Currency Reserve

While there have been big changes in global monetary policy over the past century, the U.S. dollar remains a stable currency that governments trust.

That’s unlikely to change anytime soon. The United States remains a vital contributor to the global economy, and foreign governments are unwilling to risk massive shifts in their monetary policies that could impact their exchange rates and ability to trade on the open markets.

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