Reserve Currency

Updated on January 31, 2024
Article byHimani Bhatt
Reviewed byDheeraj Vaidya, CFA, FRM

Reserve Currency Meaning

Reserve Currency (RC) is typically a foreign currency that central banks or other financial organizations hold in abundance as part of a country’s foreign exchange reserves. It is utilized for global trade and investment. Currently, the US dollar is the predominant reserve currency across the world and is expected to retain its status in the near future. 

Reserve Currency

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To qualify as an reserve currency, the currency must be from a country of considerable economic size with open and liquid financial marketsFinancial MarketsThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more. The country also must enjoy a significant position in the global market, encouraging trade in its currency. Besides, the currency must be stable and easily convertible into domestic currencies.

Key Takeaways

  • Reserve currency (RC) is a strong foreign currency possessed by central financial authorities in a massive amount to use for international dealings.
  • The US dollar is currently the most dominant RC globally.
  • The main feature of an reserve currency is that it is easily convertible and has a stable value.
  • Factors determining the usage of a currency as an RC are the size of the underlying domestic economy, openness and depth of its financial markets, the importance of the economy in global trade, and its domestic macroeconomic policies.
  • An RC helps pay off the outstanding international debt and control the value of the nation’s currency, balancing its domestic exchange rate.

Reserve Currency Explained

Reserve Currency is a globally-recognized foreign currency held in reserve by a country’s central bank for global transactions. Every country’s central bank has reserves usually made up of gold and a specific foreign currency held in substantial numbers. This foreign currency is deployed in international monetary dealings to make investments and settle debt liabilities.

Besides making payments for imports and servicing foreign debts, nations also hold reserves to overcome economic crises and control the value of their national currency. For instance, if the national currencyNational CurrencyA national currency (NC) is any form of money used by the people of a nation as a medium of exchange to engage in economic transactions.read more value falls during a recession, the central bank can use its foreign reserves to maintain the currency value.

Also, it helps reduce exchange rate risksExchange Rate RisksExchange Rate Risk is the risk of loss the company bears when the transaction is denominated in a currency other than the company operates. It is a risk that occurs due to a change in the relative values of currencies.read more during international dealings as nations needn’t use their own currency for transactions. Therefore, countries persistently monitor the major reserve currency to ensure their assets remain profitable.

The key characteristic of reserve currency is that it can be deftly swapped for other currencies and has the required liquidity and depth for streamlined international transactions. This is because it is issued by developed and stable economies with strong, open financial markets. Thus, the underlying economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more’s supremacy and substantiality play a key role in its currency attaining the RC stature.

Over the past seven decades, the global standing and financial strength of the US has contributed to the US dollar serving as the world’s premier RC. Out of the total of $12,827.45 billion in the International Monetary Fund‘s (IMF) Q3 2021 Currency Composition of Official Foreign Exchange Reserves (COFER), US dollars had the highest claim ($7081.39 billion). 

RC enormously influences economic and monetary policies. At the same time, economic policies have a crucial effect on foreign currency reserves. Therefore, any major development in the policy may generate considerable depreciation or boost in the reserves. 

As per a recent Reuters report, the US economy has created 467,000 jobs in January 2022, a huge milestone after the economic upheaval caused by COVID-19. As a result, the Dollar Index, reporting the value of the US dollar assessed against six other major reserve currencies, registered a growth of 0.1%. 

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Reserve Currency of the World

The US dollar has been designated as the world’s foreign RC for over 70 years. Thence, nations observe the financial regulations of the US to shield against inflation or stagflationStagflationStagflation is an economic scenario where stagnation coincides with inflation.read more and guarantee the security of their reserves. 

The relatively less-accepted currencies are transformed into US dollars to partake in foreign commercial activities. Being the world’s reserve currency, it can easily resist a financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more compared to other currencies. 

The IMF consistently publishes the COFER. Over the years, it has also selected other reserve currencies including:

  1. Euro
  2. Chinese Renminbi
  3. Japanese Yen
  4. Pounds Sterling
  5. Australian Dollars
  6. Canadian Dollars
  7. Swiss Francs

The speculations are rife that the Chinese Renminbi will displace the US dollars as the world’s RC in the coming years. The reports came out after witnessing a downturn in the economy of the US while China experienced a major economic boost. It is also predicted that the US dollar will soon share its influence with other currencies. 

However, it still stays the most dominant currency throughout the globe. During the last one year (Q3 2020-Q3 2021), US dollars have registered a growth of US $154.16 billion in the total foreign exchange reserves.  

Reserve Currency History

The emergence of a stable US economy after the second world-war revolutionized the landscape of RC. With the transformation of the US as the global economic superpower, the US dollar began increasing its share of international tradeInternational TradeInternational Trade refers to the trading or exchange of goods and or services across international borders. read more and gross domestic productGross Domestic ProductGDP or Gross Domestic Product refers to the monetary measurement of the overall market value of the final output produced within a country over a period.read more.

Consequently, at the Bretton Woods conference in 1944, the US dollar was pegged to gold while most other currencies were pegged to dollars. Eventually, the US dollar displaced the British pounds sterling as the major foreign RC in the mid-20th century.

Thus, the US dollar became the primary unit for central banks to hold reserves, indulge in trading, and extend loans. However, in 1973, the new economic policy by US President Richard Nixon dissolved the arrangement of fixed exchange ratesFixed Exchange RatesA fixed exchange rate refers to an exchange rate regime where a country’s currency value will be tied with the value of another country’s currency or a major commodity.read more, disjointed the US dollar from gold, and replaced it with a floating exchange rate system.

Since then, the US dollar has dominated the global market. However, the successive advent of thriving economies produced other international RCs. The Deutschmark was the major RC among the euro legacy currencies. Following the US dollar, it accounted for the largest share of reserves. 

Over time, the nations’ share of reserves declined or surged as their power in the global economic marketplace. Though new currencies were added to the IMF’s list of RCs, the US dollar managed to sustain its top position. 

Frequently Ask Questions (FAQs)

Q#1 – Which currency is the world’s reserve currency (RC)?

A – The US dollar has been considered as the world’s reserve currency since the mid-20th century. Under the Bretton Woods agreement in 1944, it was pegged to gold while the other nations collected reserves of the US dollars.

Q#2 – Will the US dollar collapse anytime soon?

A – The US dollar’s disintegration is a highly unlikely event. With the support of US treasuries, it remains the most sought-after RC for worldwide economic betterment. Its consistent repute and stability have helped it retain the position of the top RC.

Q#3 – Which factors determine the usage of a currency for reserve?

A – Below-mentioned elements decide the use of a currency for reserve:

• Scope of the domestic economy
• Openness, depth, and size of the financial markets
• Relevance of economy in global trade
• Use of currency in the form of the currency peg
• Domestic macroeconomic guidelines

Q#4 – What are the top reserve currencies listed by IMF?

A – Here lies the top 8 reserve currencies listed by IMF:

1. US Dollars
2. Euro
3. Chinese Renminbi
4. Japanese Yen
5. Pounds Sterling
6. Australian Dollars
7. Canadian Dollars
8. Swiss Francs

Recommended Articles

This has been a guide to Reserve Currency (RC) and its meaning. Here we explain the history of reserve currencies of the world (dollar) and those selected by IMF. You may learn more about financing from the following articles –

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