What is a reserve currency? A reserve currency is a currency that governments hold in their foreign exchange reserves to settle international claims and intervene in foreign exchange markets. The International Monetary Fund (IMF) grants reserve status to five currencies ¬—the U.S. dollar, the euro, the Japanese yen, the British pound, and the Chinese renminbi—by including them in the IMF’s definition of Special Drawing Rights. Financial markets also treat the Australian dollar, the Canadian dollar, and the Swiss franc as reserve currencies.
World’s reserve currency. Governments overwhelmingly choose one currency – the U.S. dollar – to hold their foreign exchange reserves, making it the world’s reserve currency. IMF members disclosed the currency composition of $9.264 trillion of the $11.121 trillion in their foreign exchange reserves as of June 30, 2017. U.S. dollar-denominated assets comprised 63.79 percent of disclosed foreign exchange reserves; euro-denominated assets, 19.91 percent; yen-denominated assets, 4.64 percent; pound-denominated assets, 4.41 percent; Canadian-dollar-denominated assets, 1.95 percent; Australian dollar-denominated assets, 1.77 percent; renminbi-denominated assets, 1.07 percent; Swiss franc-denominated assets, 0.17 percent; and assets denominated in other currencies, 2.30 percent.
The euro is the only significant challenger to U.S. dollar as the world’s reserve currency. However, the euro remains a regional reserve currency, whose importance is limited to Europe and parts of Africa.
International use of the U.S. dollar. The status of the U.S. dollar as the world’s reserve currency causes its widespread use outside the United States. Consider:
- The value of U.S. currency circulating outside of the United States exceeds one-half value of all U.S. currency. Some studies suggest that the percentage is as high as 70 percent.
- The Bank for International Settlements (BIS) reported that 88 percent of all foreign exchange transactions in 2016 involve the U.S. dollar on one side. In contrast, 31 percent involve the euro, 22 percent involve the Japanese yen, 13 percent involve the United Kingdom pound sterling, 7 percent involve the Australian dollar, 5 percent involve the Canadian dollar, 5 percent involve the Swiss franc, and 4 percent involve the Chinese renminbi on one side.
- Note that the total percentage of currencies used in foreign exchange transactions is 200% since each transaction involves two currencies.
- In 2014, 51.9 percent of international trade by value and 49.4 percent of international trade by volume of transactions were invoiced in U.S. dollars. By contrast, 30.5 percent of international trade by value and 31.0 percent of international trade by volume were invoiced in euros. However, a large portion of international trade in invoiced in euros is among Eurozone member-states and between Eurozone members-states and other European Union member-states, which inflates the importance of the euro in international trade.
- Looking at interregional trade among the Americas, Europe, and the Asia-Pacific, 79.5 percent of international trade by value and 80.3 percent of international trade by volume were invoiced in U.S. dollars.
- Major internationally traded commodities such as oil are priced in U.S. dollars.
- International debt securities, loans, and other claims outside the euro zone are typically denominated in U.S. dollars. At the end of second quarter of 2017, the BIS reported that $13.950 trillion in cross-border claims were denominated in U.S. dollars. That represents 49.3 percent of all cross-border claims and 67.4 percent of cross-border claims excluding intra-euro zone claims.
- According to the IMF, the U.S. dollar provided the basis for the domestic monetary system de jure or de facto in 58 countries and seven non-U.S. territories. The U.S. dollar bloc produced 29.4 percent of the world’s GDP in 2016. When the IMF granted reserve currency status to the Chinese renminbi, the IMF reclassified China as having a “monetary aggregate targeting” framework for monetary policy with “other managed arrangements” for exchange rate policy. However, many economists think that China still practices a de facto anchor to the U.S. dollar. If China were included in the U.S. dollar bloc, it would have produced 44.2 percent of the world’s GDP in 2016. In contrast, the euro bloc produced only 16.5 percent of the world’s GDP in 2016.
So, what does this mean for the global economy?
International accounts. The International Transaction Accounts (ITA) record a country’s cross-border flows in the current, financial, and capital accounts, while the International Investment Position (IIP) records a country’s stock of foreign assets and liabilities. The current account has three components: (1) trade in goods and services; (2) primary income, which records receipts and payments from foreign investments and employee compensation; and (3) secondary income, which records unilateral current transfers such as foreign aid and remittances. The financial account records transactions in financial assets such as securities, loans, and financial derivatives. The capital account records (1) transactions involving non-produced, non-financial assets such as land, mineral rights, copyrights, and patents; and (2) capital transfers related to debt forgiveness and migration. Normally, the capital account is very, very small compared with the current and financial accounts.
Other countries need U.S. dollars to grow. Economic growth will necessarily increase a country’s international trade and investment flows with the rest of the world. Given the international use of the U.S. dollar, households, firms, and governments in other countries will incur U.S. dollar-denominated liabilities when importing goods and services, borrowing funds in foreign markets, or making outward foreign investments. In the United States, the Federal Reserve can satisfy the domestic demand for U.S. dollars through monetary policy. In the rest of world, households, firms, and governments must earn U.S. dollars to pay U.S. dollar-denominated liabilities by:
- Exporting goods and services to the United States or other countries able to pay in U.S. dollars;
- Increasing inward foreign investment from the United States or other countries able to pay in U.S. dollars; or
- Decreasing outward foreign investment to the United States or other countries able to buy in U.S. dollars.
What does this mean for the international accounts of the United States? Since other countries must acquire U.S. dollars to grow, the United States must necessarily record deficits in its current account and net borrowing in its financial account in the ITA to supply the rest of world with U.S. dollars. As a result of these flows in the ITA, the IIP of the United States must become increasingly negative over time.
Investment income paradox. The status of the U.S. dollar as the world’s reserve currency and the resulting foreign demand for U.S. dollars explains a paradox – the United States consistently records a positive balance in investment income even though the United States owes more to foreigners every year.
At the end of the second quarter of 2017, the United States had $25.938 trillion of foreign assets, while foreigners held $33.873 trillion in U.S. assets. Of these, foreign governments held $5.980 trillion (17.7 percent of foreign assets in the United States), while foreign households and firms held $27.893 trillion (82.3 percent of foreign assets in the United States). Thus, the United States had an IIP of minus $7.935 trillion.
Despite a negative IIP, the U.S. has normally enjoyed a positive difference between the average rate of return on outward foreign investment and the average rate of return on inward investment. In 2016, the U.S. had a positive $187 billion balance in investment income.
Most of the U.S. assets held by foreign governments are foreign exchange reserves managed by central banks. Central banks are risk adverse in their investment decisions. Most of their U.S. assets are low risk, low yield Treasuries, agency debt and mortgage-backed securities, and commercial bank deposits.
In contrast, the U.S. government holds few reserve assets denominated in foreign currencies – about $41 billion – or 0.16 percent of U.S. foreign assets. Households and firms, who make almost all outward foreign investment from the United States, have a profit-maximizing objective. These risk-return differences between and within asset categories allow the United States consistently to earn higher returns on its outward foreign investment compared with the return earned by foreigners on inward foreign investments in the United States.
Exorbitant privilege. The status of the U.S. dollar as the world’s reserve currency and the resulting foreign demand for U.S. dollars creates what French Finance Minister Valéry Giscard d’Estaing described in in 1965 as an “exorbitant privilege” for the United States. Simply put, the United States can record deficits in its current account, net borrowing in its financial account, and declines in its international investment position for decades without incurring a balance of payments/currency depreciation crisis.
What is the value of the exorbitant privilege to the United States? While difficult to measure, empirical studies suggest the privilege is worth about ½ percent of U.S. GDP (or roughly $100 billion) in a normal year.
A significant part of the U.S. current account deficit and the U.S. trade deficit (whether measured as goods and services or as goods only) is attributable to the U.S. dollar’s status as the world’s reserve currency. Even if every country in the world were to practice free trade and not to engage in any currency manipulation, the United States would still record persistent current account deficits so long as the U.S. dollar remains the world’s reserve currency.
Extraordinary risk. In a global financial crisis, however, the exorbitant privilege becomes an extraordinary risk. The risk-return differences between and within asset categories for U.S. inward and outward foreign investment mean that the United States effectively performs as a global insurer. The rest of the world effectively pays an insurance premium in the form an excess return on the outward foreign investment from the United States relative to inward foreign investment to the United States in normal times. The resulting primary income surpluses help the United States to record persistent trade deficits. In exchange, the United States accepts the risk of larger losses on its outward foreign investment during a global financial crisis than foreign countries accept on their inward foreign investment in the United States.
Different responses to exchange rate fluctuations. Because most imports are invoiced in U.S. dollars, changes in the foreign exchange value of the U.S. dollar affect international trade and investment flows differently in the United States than in other countries. In other countries, the price effects of a change in the foreign exchange value of the U.S. dollar on imports in terms of their local currencies are nearly immediate. In the United States, the price effects in terms of the U.S. dollar on imports are muted and attenuated. When the foreign exchange value of the U.S. dollar decreases, the domestic prices of U.S. imports change slowly as exporters tend to absorb the reduction in their profit margins in terms of U.S. dollars until cost pressures gradually force invoice prices up to reflect the U.S. dollar’s depreciation. When the foreign exchange value of the U.S. dollar increases, the domestic prices for U.S. imports change slowly as exporters tend to pocket the increase in their profit margins in terms of U.S. dollars until competition gradually reduces invoice prices to reflect the U.S. dollar’s appreciation. Thus, import volumes change more slowly in the United States than in other countries in response to fluctuations in the foreign exchange value of the U.S. dollar.
Effects on global growth. An appreciation in the foreign exchange value of the U.S. dollar increases the debt servicing costs of liabilities denominated in U.S. dollars to foreign borrowers (outside of the U.S. dollar bloc) in terms of their local currency.
Foreigners that used such debt to finance projects that generate receipts in their local currency will see their profit margin squeezed and possibly their solvency threatened. Consequently, an appreciating U.S. dollar tends to slow economic growth outside of the United States, especially in countries outside of the U.S. dollar bloc. In turn, slower global growth amplifies the downturn in U.S. exports.
A depreciation in the foreign exchange value of the U.S. dollar decreases the debt servicing costs of liabilities denominated in U.S. dollars to foreign borrowers (outside of the U.S. dollar bloc) in terms of their local currency. Foreigners that used such debt to finance projects that generate receipts in their local currency will see their profit margin improve and possibly their net worth strengthened.
Consequently, a depreciating U.S. dollar tends to accelerate economic growth outside of the United States, especially in countries outside of the U.S. dollar bloc. In turn, faster global growth amplifies the upturn in U.S. exports.
Hamilton is a senior U.S. economist who frequently writes under a nom de plume.