The World’s Reserve Currency
What is a reserve currency and why does it matter?
Elizabeth Carlassare
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The World’s Reserve Currency
Today’s topic is understanding the world’s reserve currency.Recently, Alan Greenspan, the former U.S. Federal Reserve chairman, said it’s possible that the euro could replace the U.S. dollar as the world’s reserve currency of choice. So what exactly is a reserve currency and why does it matter?
What is a Reserve Currency, and Why is it Good?
A reserve currency is money that’s held by many countries as their foreign exchange reserves. It’s also the currency that’s typically used to price commodities, such as oil and gold, that are traded between countries.
A country whose currency is the predominant reserve currency benefits tremendously. In the case of the dollar, the U.S. benefits from the increased demand for the dollar that the reserve currency status creates. Other countries give the U.S. valuable goods in exchange for dollars issued by the Federal Reserve. They also lend the dollars they’ve accumulated back to the U.S. at low interest rates. Most significantly, the U.S. benefits from importing these goods and exporting its inflation to other countries in the form of depreciating dollars.
How Dollar Values Affect Demand
More than 60% of the world’s reserve currency is held in U.S. dollars. So why would Mr. Greenspan think that the euro might replace the dollar as the world’s predominant reserve currency?
For starters, the euro has been gaining ground as a reserve currency since it was introduced in 2002. Now, only five years later, approximately one-fourth of the world’s reserve currency is held in euros.
Second, when the U.S. dollar loses value, as it’s been doing over the past several years, other nations have more reason to move their reserve currency out of dollars and into other currencies that are doing a better job of holding their value, such as the euro. The result is a reduced demand for dollars, which can drive the value of the dollar down even further.
On September 18, 2007, the Federal Reserve lowered the Fed funds rate and the discount rate by half a percent. Lower interest rates typically make borrowing money easier and mean an increased money supply, which tends to create inflation and devalue the dollar. The Fed’s rate cut raised concerns about the dollar continuing to lose value.
In fact, Saudia Arabia, a country that pegs its currency to the dollar, refused to lower its rates in step with the Fed’s rate cut for the first time. And earlier in 2007, Kuwait announced that it would no longer tie its currency to the dollar and instead would use a basket of currencies. Oil exporting countries in the Middle East have been experiencing inflation and would actually need to raise their interest rates to reduce the money supply and lower inflation.
A weaker U.S. dollar means that the dollar may continue to lose ground to the euro as the world’s predominant reserve currency. If the U.S. dollar continues to lose value, countries that hold U.S. dollars as reserves will have an incentive to move more of their reserves to a more stable currency, like the euro.
The Gold Standard for Reserve Currency
The weakening of the U.S. dollar has led to an increase in the demand for gold. Gold has been called the “anti-dollar.” It’s the ultimate reserve currency. When confidence in the dollar is shaken, more financial institutions and people buy gold and the price tends to go up.
For those of you who are curious to see how the world’s reserve currencies have changed over time, here’s a link to a table that shows the percentage of the world’s currency reserves held in different currencies from 1995–2006.
And here’s one last thing I want to tell you: Did you know that Canadian dollars are called loonies? On the back of the coin is a loon, which is how the coin got its unusual name. Last week, the loonie had a really big day. It closed above the U.S. dollar for the first time in more than 30 years. The strength of the Canadian dollar means that prices in the U.S. are low by Canadian standards. In fact, Steve, who lives in Canada and copyedits the Money Girl transcripts, told me that he likes to buy things like books, clothes, and computers in the U.S. because they’re so much cheaper. The loonie, like the euro, has also been gaining strength against the U.S. dollar.
Next week, we’ll take a look at fractional reserve banking, and after that I’ll talk about dollars and anti-dollars to get the full perspective on this situation.
Euro image courtesy of Shutterstock