Reserve currency

A reserve currency (or anchor currency) is a currency which is held in significant quantities by many governments and institutions as part of their foreign exchange reserves. It also tends to be the international pricing currency for products traded on a global market, such as oil, gold, etc.

This permits the issuing country to purchase the commodities at a marginally cheaper rate than other nations, which must exchange their currency with each purchase and pay a transaction cost. (For major currencies, this transaction cost is negligible with respect to the price of the commodity.) It also permits the government issuing the currency to borrow money at a better rate, as there will always be a larger market for that currency than others.

Global currency reserves

History

By some definitions reserve currencies have existed for millennia. These currencies were widely recognized and used for international transactions. However, the modern conception of an international currency as a store of value for the international reserves of central banks and governments is a relatively recent development, arising only in the 19th century coinciding with the emergence of the international gold standard in the decades leading up to the First World War.

After World War II, the international financial system was governed by a formal agreement, the Bretton Woods System. Under this system the US dollar was placed deliberately at the centre of the system, with the US government guaranteeing other central banks that they could sell their US dollar reserves at a fixed rate for gold if they so desired. European countries and Japan deliberately devalued their currencies against the dollar in order to boost exports and development.

In the late 1960s and early 70s the system came apart under pressure from the rising prominence of the other countries, as well as growing deficits in the US. The US dollar remained central due to the lack of competitor currencies.

Recently, nations, especially in Asia, have been stockpiling reserves at levels previously unknown, especially in US dollars, in an effort to strengthen export competitiveness by weakening their own currencies, and also to contain quick and large inflows of capital and buffer against financial crisis such as the Asian financial crisis.

Theory

Economists debate whether or not a single reserve currency will always dominate the global economy. [cite web|url=http://papers.ssrn.com/sol3/papers.cfm?abstract_id=723305 |title=Sterling's Past, Dollar's Future: Historical Perspectives on Reserve Currency Competition |first=Barry |last=Eichengreen |publisher=National Bureau of Economic Research (NBER) |month=May |year=2005 |format=PDF] Many have recently argued that one currency will almost always dominate due to network externalities, especially in the field of invoicing trade and denominating foreign debt securities, meaning that there are strong incentives to conform to the choice that dominates the marketplace. The argument is that, in the absence of sufficiently large shocks, a currency that dominates the marketplace will not lose much ground to challengers.

However, some economists, such as Barry Eichengreen argue that this is not as true when it comes to the denomination of official reserves because the network externalities are not strong. As long as the currency's market is sufficiently liquid, the benefits of reserve diversification are strong, as it ensures against large capital losses. The implication is that the world may well soon begin to move away from a financial system dominated uniquely by the dollar. In the first half of the 20th century multiple currencies did share the status as primary reserve currencies. Although Sterling was the largest currency, both francs and marks shared large portions of the market until the First World War, after which the mark was replaced by dollars. Since the Second World War, the dollar has dominated official reserves, but this is likely a reflection of the unusual domination of the American economy during this period, as well as official discouragement of reserve status from the potential rivals, Germany and Japan.

United States dollar

The United States dollar is the most important reserve currency in the world today. Throughout the last decade, an average of two thirds of the total allocated foreign exchange reserves of countries have been in U.S. dollars. For this reason, the U.S. dollar is said to have "reserve-currency status", making it somewhat easier for the United States to run higher trade deficits with greatly postponed economic impact (see currency crisis). Central bank reserves held in dollar-denominated debt, however, are relatively small compared to private holdings of such debt. In the event that foreign holders of dollar-denominated assets decided to shift holdings to assets denominated in other currencies, there could be serious consequences for the U.S. economy. Changes of this kind are rare, and typically change takes place gradually over time; the markets involved adjust accordingly

Euro

The euro is currently the second most commonly held reserve currency, being approximately a quarter of allocated holdings. After World War II and the rebuilding of the German economy (see the "Wirtschaftswunder"), the German Deutsche Mark gained the status of the second most important reserve currency after the US dollar. When the euro was launched on January 1 1999, replacing the Mark, French Franc and nine other European currencies, it inherited the status of a major reserve currency from the Mark. Since then its contribution to official reserves has risen continually as banks seek to diversify their reserves and trade in the eurozone continues to expand. [cite web|url=http://www.imf.org/external/pubs/ft/wp/2006/wp06153.pdf |title=The Euro’s Challenge to the Dollar: Different Views from Economists and Evidence from COFER (Currency Composition of Foreign Exchange Reserves) and Other Data |first=Ewe-Ghee |last=Lim |publisher=IMF |month=June |year=2006 |format=PDF] The New York Times Book Review also referred to the euro as the "Deutsch-Mark by another name".

Former Federal Reserve Chairman Alan Greenspan said in September 2007 that the euro could replace the U.S. dollar as the world's primary reserve currency. It is "absolutely conceivable that the euro will replace the dollar as reserve currency, or will be traded as an equally important reserve currency." [cite web | title=Reuters | work=Euro could replace dollar as top currency - Greenspan | url=http://www.reuters.com/article/bondsNews/idUSL1771147920070917 | accessdate=September 17 | accessyear=2007] Econometrical analysis suggests, the euro may replace the U.S. dollar as the major reserve currency by 2020 if: (1) the remaining EU members, including the UK, adopt the Euro by 2020 "or" (2) the recent depreciation trend of the dollar persists into the future. [cite journal |last= Menzie |first= Chinn |coauthors= Jeffery Frankel |year= 2006 |month= January |title= Will the Euro Eventually Surpass The Dollar As Leading International Reserve Currency? |journal=NBER |url=http://www.wage.wisc.edu/uploads/Working%20Papers/chinnfrankel_NBER_eurotopcurrency.pdf |format=PDF |accessdate= 2007-10-11 ]

Pound sterling

The United Kingdom's pound sterling was the primary reserve currency of much of the world in the 18th and 19th centuries. The dire economic cost of fighting the First and Second World Wars, the increasing dominance of the USA in world economics (and, importantly, the establishment of the American Federal Reserve Bank in 1913) as well as economic weakness in the UK at various intervals during the second half of the 20th century resulted in Sterling losing its status as the world's most reserved currency.

As from mid 2006 it is the third most widely held reserve currency, having seen a resurgence in popularity in recent years. [cite web | work=The Daily Telegraph | title=Sterling surges to 14-year high | url=http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/01/23/bcnpound23.xml |accessdate=2007-01-24 |date=2007-01-23 |first=Richard |last=Blackden] Analysts say this resurgence is caused by carry-trade investors considering the pound as a stable high-yield proxy to the Euro. [cite web |url=http://www.xak.com/main/newsshow.asp?id=56419 |date=2006-02-08 |title=Currency Strategists: Morgan Says Pound Is Euro Proxy |work=xak.com |publisher=Bloomberg ]

Other notable reserve currencies

The Japanese yen was considered as the third most important reserve currency for several decades, but has recently been on the decline and has now been overtaken by sterling.

The Soviet ruble was also an important reserve currency along with the U.S. Dollar, in the Communist world, from about the 1950's up until the Soviet collapse in 1991.

The Swiss franc is often said to be a reserve currency as well, due to its stability, although the share of all foreign exchange reserves held in Swiss francs is typically just around or even below 0.3%.

Other nations and groups of nations have expressed their desire to see their currencies (or future currencies) be used as reserve currencies, such as Russia, People's Republic of China, and the Gulf Cooperation Council.

The G8 also frequently issues public statements as to exchange rates, though with the exception of Japan, the member states are impotent in their ability to directly affect rates.Clarifyme|date=March 2008 In the past, however, its predecessor bodies could directly manipulate rates to reverse large trade deficits (see Plaza Accord).

The top reserve currency is generally selected by the banking community for the strength and stability of the economy in which it is used. Thus, as a currency becomes less stable, or its economy becomes relatively less dominant, bankers may over time abandon it for a currency issued by a larger or more stable economy. This can take a relatively long time, as recognition is important in determining a reserve currency. For example, it took many years after the United States overtook the UK as the world's largest economy before the dollar overtook Sterling as the dominant global reserve currency.

ee also

*Foreign exchange reserves
*Hard currency
*World currency

References