Great Greenbacks: Why the U.S. Dollar Dominates Reserve Currency

A reserve currency is held by a nation’s central banks in significant quantities and widely used to conduct international trade and financial proceedings, thus eliminating the costs of settling transactions involving different currencies.

Any reserve currency must be easily convertible and have a stable value. The factors that determine the usage of a country’s currency as a reserve currency are the size and heft of its economy, particularly the importance of the economy in global trade, the openness and depth of the concerned country’s financial markets, and its macroeconomic policies.

From the Pound to the Dollar

In the last 200 years, there have only been two reserve currencies—the British pound from the early 1800s to the end of World War II, and the U.S. dollar since then. It’s a testament to the power of reserve currency status that the pound remained on top for decades even after the U.S. overtook Great Britain’s as the top economy in the world in the 1870s.

The U.S. dollar has been the primary reserve currency used by other countries since the Bretton Woods Agreement in 1944, a formal agreement by delegates from 44 nations to formally adopt the dollar as an official reserve currency. This agreement followed the significant position held by the United States in international trade; at the end of World War II, the U.S. GDP represented 50% of the global GDP. Since the dollar was relatively stable, it enabled other countries to stabilize their currencies.

Since the end of World War II, the dollar has maintained its preeminence through a number of major shifts, including the collapse of fixed exchange rates, globalization of trade and finance, development of new technologies, and geopolitical changes. The second-most-held currency in the global economy is the euro, which was introduced in 1999 and is the official currency of 20 of the 27 member states of the European Union.

Dollar on Top

As of 2022, central banks held about 60% of their foreign exchange reserves in dollars, down from a recent peak of just above 70% in the 2000s (The euro was launched in 1999), but well above the early 1990s, when it was near 50%.

About half of international trade is invoiced in dollars, and about half of all international loans and global debt securities are denominated in dollars. In foreign exchange markets, where currencies are traded, dollars are involved in nearly 90% of all transactions.

There has been talk of trying to create an alternative to the dollar. The euro looked like it might have a chance at the beginning of the 21st century. But the 2008 financial crisis and various political and economic shocks in Europe since then have diminished the standing of a central European currency as a world standard.

As for the yen, Japan has its own issues with a stagnant economy and shrinking population. China’s yuan, also called the renminbi, is unlikely to become a reserve currency anytime soon, given the extreme capital controls that its government places on the use of its national currency.

Safety First

The dollar is the preferred currency for investors during major economic crises as a “safe haven” currency.

During the global financial crisis of 2008-09 and the economic turmoil associated with the pandemic in 2020, investors—who expected the dollar would retain its value—sought U.S. dollars. In both crises, the U.S. Federal Reserve adopted extraordinary monetary authorities and currency swap lines with other central banks to provide liquidity and dollars.

The Fed estimates that between 1999 and 2019 the dollar accounted for 96% of international trade transactions in the Americas, 74% in Asia, and 79% around the rest of the world. Globally, banks used dollars for approximately 60% of their nondomestic deposits and loans. Adding to this, in the foreign exchange market today, the U.S. dollar is on one side of almost 90% of all transactions.

The U.S. dollar now accounts for 58% of foreign exchange reserves held by overseas central banks. However, transacting in a currency and holding a currency as a store of value are two different things. The latter needs very deep financial markets to ensure sufficient liquidity to buy and sell large volumes without creating market disruption. As of right now, the only market and currency in the world that can provide that is the U.S Treasury market and the U.S. dollar.

The U.S. economy generally benefits from the dollar’s status as the world’s dominant reserve currency. Because many central banks and financial institutions around the world want to hold U.S. dollars and dollar-backed securities such as U.S. Treasury bonds, there is strong demand for U.S. dollars. That demand, in turn, allows the United States to borrow more cheaply (at lower interest rates) than it would otherwise.

Strong demand for dollars also allows the U.S. government, firms, and consumers to borrow from foreign creditors in dollars rather than foreign currencies. As a result, the value of that debt does not depend on fluctuations in exchange rates. When other governments, firms, and individuals borrow in foreign currencies, they incur the risk that swings in exchange rates will cause their real debt level (the size of the debt in the borrower’s national currency) to increase, potentially quickly and significantly. U.S. firms and consumers also benefit by saving on transaction costs.

Yuan vs. Dollar

China’s growing role in the global economy since the 1990s has prompted the Chinese government to consider how to promote the use of the renminbi (yuan) in global trade. To date, this push has been limited by the government’s own caution in liberalizing China’s capital account, as well as investor concerns about potential risks associated with the lack of transparency and predictability of the government’s role in the market.

The renminbi plays a marginal role in international finance. According to the Bank for International Settlements (BIS), the renminbi is the eighth most traded currency. It is the sixth most active currency for global payments by value, with a share of 1.66%. By contrast, the U.S. dollar and the euro combined account for 75% of all transactions.

There is simply no credible alternative today to the dollar. Over the past 20 years, the dollar’s representation in aggregate global central bank holding has fallen from 71% to 58%—but no single currency has reaped the benefits, which have instead spread out across the euro, pound, and the renminbi, with none seeing more than a 3% gain.

Tough Club to Join

The conditions for entry into the reserve currency club are few, but onerous.

First, the currency needs to be fully convertible on international exchanges. This means the entity issuing the currency can’t impose broad capital controls that might prevent the export of the currency.

Second, it needs a deep and liquid pool of assets denominated in that currency. In the case of the U.S. dollar, the $23 trillion government bond market provides this liquidity. The euro’s creation briefly promised a similarly competitive bond market, but Germany’s reluctance to borrow combined with Italy’s taste for spending created a liquidity crisis during the last decade that limited the amount of investment-grade bonds available. And the subsequent negative interest rate dynamics in the eurozone reduced the pool of interest-bearing bonds further.

Finally, the currency needs to be insulated from interference by domestic politicians and based in a jurisdiction with a strict adherence to law. Confidence in a currency leads to its stability, which is important if it is to act as a store of value. While the euro meets two of these three criteria, the yuan is still working toward these goals.

Conclusion: No Worries on the Dollar

In our view, there is no viable replacement for the dollar at this time. The euro can absorb some redirected flows from new reserves accumulation, but the math on shifting the $7 trillion stock of dollar reserves into the German bond market does not work. The eurozone would almost certainly look to limit inflows from countries that had just weaponized bond markets.

We expect the U.S. dollar to keep its preeminent reserve-currency status for the foreseeable future. It’s important to realize that reserve status is something that, historically, has been gained or lost over a long period of time. While some decline in the share of dollar reserve assets makes sense in a multipolar world, the dollar isn’t going away anytime soon.

If you like reading our “Bowen Reports Blogs”, Bowen Asset does have a Facebook page: https://www.facebook.com/BowenAsset Please check it out as we frequently make comments on the page about not just finance and economic events that happen in between our blogs.