What Is Reserve Currency?

Definition and Example of Reserve Currency

A reserve currency is a foreign currency or precious metal that is held in large quantities; it may be held by a country’s government, central bank, or other monetary authority. It is used for participating in the global economy, such as through international transactions or investments.

In general, a reserve currency is one that:

• Has the depth and liquidity to allow for reliable and efficient international transactions
• Can be freely and easily exchanged for other currencies
• It is held by many monetary authorities and institutions, in significant amounts

Before the mid-20th century, reserves were mostly gold and silver. Modern reserves are generally made up of strong foreign currencies. Many of them are specifically designated as reserve currencies by the International Monetary Fund (IMF). Reserve currencies can also be foreign currency securities, deposits, and loans.

Starting in the mid-20th century, the US dollar was established as the international reserve currency. Since then, strong economies in many countries have led to the rise of other international reserve currencies.

There are multiple key factors that make a currency useful as a reserve currency, including:

• The size of the economy in the country where that currency comes from
• How important that economy is internationally
• How open its financial markets are
• The currency’s convertibility
• Whether it is used as a regional or international currency peg
• Domestic macroeconomic policies

The countries with the most foreign reserve currency in 2021 were:

1. China: $3.43 trillion
2. Japan: $1.41 trillion
3. Switzerland: $1.11 trillion
4. United States: $716.15 billion
5. India: $638.48 billion
6. Russian Federation: $632.24 billion

These reserves are rounded up to the nearest billion; they include gold, US dollars, and other reserve currencies.

How Reserve Currency Works

Countries hold reserve currency for a number of different reasons. They are a strong indicator of the ability to repay foreign debt. They also can defend a national currency and even determine sovereign credit ratings.

Foreign transactions often involve reserve currencies rather than the currencies of the two countries involved. For instance, in 2008, trade with the US accounted for only 20% of international transactions in Asian countries, even though the bulk of these were conducted in US dollars. These transactions used the US dollar as a reserve currency, which was accepted internationally, rather than the local currencies of the countries involved.

Reserve currencies impact monetary policies and trade around the globe. Monetary policy has a strong effect on foreign currency reserves. Most major economies with flexible or floating exchange rate schemes clear excess supply and demand by buying or selling reserve currency. For instance, a country that wants to increase the value of its currency can repurchase its national currency with its foreign currency reserves.

Other countries may employ fixed exchange rate schemes for a variety of reasons. Under this type of system, supply and demand can move the value of its national currency higher or lower. For instance, increased demand due to a relatively strong economy would lead to a higher value for a country’s currency.

Countries also keep an eye on major reserve currencies to ensure that their holdings aren’t adversely affected. For instance, strong inflation in the US could cause a devaluation of the US dollar. It could also cause the devaluation of foreign currency reserves. In the end, this limits the monetary policy benefits that are achievable using these reserves. It creates only a marginal benefit for a country’s currency if it is considered a reserve currency around the world.

Notable Happenings

Currency reserves used to consist mostly of gold and silver, but the Bretton Woods agreement in 1944 set the US dollar as an international reserve currency and replaced the British pound sterling. This agreement was formed during World War II. It chose the US dollar because of the strength of the US economy, which hadn’t been damaged by the war the way other European and Asian countries’ economies had. The US dollar was also still backed by gold at the time; Its value was set at $35 per ounce. That made the dollar more stable than other currencies and put a system of fixed exchange rates in place.

In 1973, President Nixon’s New Economic Policy brought an end to the Bretton Woods system of fixed exchange rates. It also decoupled the US dollar from the value of gold, which opened up the world to the rise of new reserve currencies.

Types of Reserve Currency

Today, the US dollar isn’t the only reserve currency designated by the IMF and other global organizations. The euro, Chinese renminbi, Japanese yen, and British pound sterling are all popular as reserve currencies, due to the sizes of their economies.