The Dollar: The World’s Reserve Currency
The dollar’s role as the primary reserve currency for the global economy allows the United States to borrow money more easily and impose painful financial sanctions. Other countries are beginning to consider alternatives.
Since the end of World War II, the dollar has been the world’s most important means of exchange. It is the most commonly held reserve currency and the most widely used currency for international trade and other transactions around the world. The centrality of the dollar to the global economy confers some benefits to the United States, including borrowing money abroad more easily and extending the reach of U.S. financial sanctions.
But some experts argue that high foreign demand for dollars comes at a cost to export-heavy U.S. states, resulting in trade deficits and lost jobs. Meanwhile, the dollar’s dominance could be at risk. Many emerging economies have increasingly sought ways to conduct trade in non-dollar currencies, a process known as de-dollarization, especially given the fallout from the Russian invasion of Ukraine and the repercussions of the COVID-19 pandemic. Yet, few serious contenders have emerged, making it unlikely that the greenback will be replaced as the leading reserve currency anytime soon.
What is a reserve currency?
A reserve currency is a foreign currency that a central bank or treasury holds as part of its country’s formal foreign exchange reserves. Countries hold reserves for a number of reasons, including to weather economic shocks, pay for imports, service debts, and moderate the value of their own currencies. Many countries cannot borrow money or pay for foreign goods in their own currencies—since much of international trade is still done in dollars—and therefore need to hold reserves to ensure a steady supply of imports during a crisis and assure creditors that debt payments denominated in foreign currency can be made.
By buying and selling currencies on the open market, a central bank can influence the value of its country’s currency, which can provide stability and maintain investor confidence. For instance, if the value of the Brazilian real starts to fall during an economic downturn, the Central Bank of Brazil can step in and use its foreign reserves to bid up its value. Conversely, countries can intervene to stop their currencies from appreciating and make their exports cheaper.
Most countries want to hold their reserves in a currency with large and open financial markets, since they want to be sure that they can access their reserves in a moment of need. Central banks often hold currency in the form of government bonds, such as U.S. treasuries. The U.S. treasury market remains by far the world’s largest and most liquid—the easiest to buy into and sell out of—bond market.
The International Monetary Fund (IMF), the body responsible for monitoring the international monetary system, recognizes eight major reserve currencies: the Australian dollar, the British pound sterling, the Canadian dollar, the Chinese renminbi, the euro, the Japanese yen, the Swiss franc, and the U.S. dollar. The U.S. dollar is the most commonly held, making up 59 percent of global foreign exchange reserves.
As of July 2023, China has by far the most reported foreign currency reserves of any country, with more than $3 trillion. Japan, in second place, has around $1.1 trillion. India, Russia, Saudi Arabia, Switzerland, and Taiwan also have large reserve holdings. The United States currently holds roughly $244 billion worth of assets in its pool of reserves, including $36 billion worth of foreign currencies.
How did the U.S. dollar become the world’s leading reserve currency?
The dollar’s status as the global reserve currency was cemented in the aftermath of World War II by the 1944 Bretton Woods Conference, in which forty-four countries agreed to the creation of the IMF and the World Bank. (Some economists argue that the dollar had overtaken the British pound [PDF] as the leading reserve currency as early as the mid-1920s, while others argue that the dollar is the first true reserve currency.) At Bretton Woods, a system of exchange rates was created wherein each country pegged the value of its currency to the dollar, which itself was convertible to gold at the rate of $35 per ounce. This was designed to provide stability, and prevent the “beggar-thy-neighbor” currency wars of the 1930s—a response to the Great Depression—by which countries abandoned the gold standard and devalued their currencies to try to gain a competitive advantage.