Meanwhile, the Chinese renminbi has become the most-traded currency in Russia. Foreign exchange reserves are not only used to back liabilities but also influence monetary policy. After a time they would return to the gold standard, often at greatly depreciated currency values relative to gold. Over time, with successive episodes of monetary inflation, these periods became more frequent and lasted longer, ultimately leading to the total breakdown and abandonment of the gold standard with during the Great Depression and World War 2. While the US dollar has seen its dominance as the world’s reserve currency wane over the past two decades, it’s still the leader by a long shot. In hopes of damaging its economy, the US has enacted severe sanctions against Russia after it invaded Ukraine in February 2022.

The argument is that, in the absence of sufficiently large shocks, a currency that dominates the marketplace will not lose much ground to challengers. Monetary reserves are part of a country’s monetary aggregates, which are broad categories that define and measure the money supply in an economy. In the United States, the standardized monetary aggregates include physical paper and coins, money market shares, savings deposits, and other items, and are termed M0, M1, and M2. Countries like Japan and China—which have the largest trade surpluses—also have the most currency reserves because they receive U.S. dollars and other foreign currencies when they provide exports. However, it has lost its status as the most dominant currency because of the growth of China’s Yuan that replaced it with the Japanese Yen in 2016. Other countries like Russia, Germany, France and Britain are also now using their own currencies to serve as global reserve currencies.

  1. It is followed by the Euro as well as the British Pound which are also used globally.
  2. Right now there are 11 foreign countries that use the U.S. dollar as their official currency.
  3. The United States became the lender of choice for many countries that wanted to buy dollar-denominated U.S. bonds.
  4. By buying and selling currencies on the open market, a central bank can influence the value of its country’s currency, which can provide stability and maintain investor confidence.

Other countries such as the US are using USD as their primary currency for international transactions. Because other countries want to hold a currency in reserve and use it for transactions, the higher demand means lower borrowing costs through depressed bond yields (most reserves are of government bonds). Issuing countries are also able to borrow in their home currencies and are less worried about propping up their currencies to avoid default. 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.

Reserve currency

The value of SDRs are calculated from a basket determined by the IMF of key international currencies, which as of 2016 consisted of the United States dollar, euro, renminbi, yen, and pound sterling. Saudi Arabia also holds considerable foreign exchange reserves, as the country relies mainly on the export of its vast oil reserves. If oil prices begin to rapidly drop, the country’s economy could suffer.

With growing concerns over stability, the countries converted dollar reserves into gold.The demand for gold was such that President Richard Nixon was forced to intervene and de-link the dollar from gold, which led to floating exchange rates. China has positioned its currency as next in line to the U.S. dollar; it has been the largest contributor to world growth since 2008’s global financial crisis. China’s renminbi was named by the IMF as a global reserve currency in 2015. However, the euro still accounts for the largest portion of currency reserves after the U.S. dollar due to the economic size of the European Union. Instead, the greenback’s reserve status has had the largest impact by providing funding for the U.S. government.

Holding large amounts of reserve assets can increase the perceived likelihood of a country being able to repay their foreign debt obligations. As a result, countries with large reserves typically receive preferential borrowing rates. Most international debt is held in USD to maintain stability in lending costs and expected returns. Some commentators posit a more radical shift in currency positioning, where dollar reserves are dumped on the open market. It’s hard to see how tanking the economy of their biggest customer would benefit them.

Foreign Exchange Reserves: What They Are, Why Countries Hold Them

A reserve currency is a foreign currency that a central bank or treasury holds as part of its country’s formal foreign exchange reserves. Countries hold reserves for a number of reasons, including to weather economic shocks, pay for imports, service debts, and moderate the value of their own currencies. In 1944, during World War II, 44 nations met and decided to link their currencies to the U.S. dollar, the U.S. being the strongest power among the Allies. As a result of the Bretton Woods Agreement, the U.S dollar was officially crowned the world’s reserve currency, backed by the world’s largest gold reserves. Instead of keeping supplies of gold, other countries accumulated reserves of U.S. dollars; central banks would maintain fixed exchange rates between their currencies and the greenback.

Holding a reserve currency minimizes exchange rate risk, as the purchasing nation will not have to exchange its currency for the current reserve currency to make the purchase. Since 1944, the U.S. dollar has been the primary reserve currency used by other countries. As a result, foreign nations closely monitor the monetary policy of the United States to ensure that the value of their reserves is not adversely affected by inflation or rising prices. Economists theorize that it is better to hold the foreign exchange reserves in a currency that is not directly connected to the country’s own currency in order to provide a barrier should there be a market shock. However, this practice has become more difficult as currencies have become increasingly intertwined as global trading has become easier.

Countries legally defined their currencies in terms of fixed weights of gold or silver and banks, including central banks, issued paper notes and certificates of deposit backed by fractional reserves of precious metals. World reserve currencies are a kind of currency held in large quantities by central banks in other nations and is utilized in international trade. In part because of its dominant role as a medium of exchange, the U.S. dollar is also the dominant currency in international banking. As shown in Figure 6, about 60 percent of international and foreign currency liabilities (primarily deposits) and claims (primarily loans) are denominated in U.S. dollars. This share has remained relatively stable since 2000 and is well above that for the euro (about 20 percent).

The majority of developed countries pegged their currencies to gold as a way to stabilize currency exchanges. When World War I broke out in 1914, many countries suspended the gold standard to pay their military expenses with paper money, which devalued their currencies. Britain held to the gold standard to maintain its position as the world’s leading currency and found itself borrowing money for the first time during the third year of the war. As of July 2023, China has by far the most reported foreign currency reserves of any country, with more than $3 trillion. India, Russia, Saudi Arabia, Switzerland, and Taiwan also have large reserve holdings. The United States currently holds roughly $244 billion worth of assets in its pool of reserves, including $36 billion worth of foreign currencies.

The Closing of The Gold Window

When a country has very high debt and a shrinking economy, this can cause a flight of assets and a collapse of the currency. So in order for a dollar to have value, society needs to believe that the United States has value. Given how many taxpayers, businesses and valuable assets are in the US, it’s hard to argue that it doesn’t have value. In fact, the reason why the U.S. was able to move off the gold standard was because it had so much economic value. The SDR are reserve assets which give the recipient country the right to claim a corresponding value of member states reserve currencies when required.

Changing consumer and investor preferences, combined with the possibility of new products, could shift the balance of perceived costs and benefits enough at the margin to overcome some of the inertia that helps to maintain the dollar’s leading role. That said, it is unlikely that technology alone could alter the landscape enough to completely offset the long-standing reasons the dollar has been dominant. As shown in Figure 4, the value of U.S. dollar banknotes held abroad has increased over the barclays trade past two decades, both on an absolute basis and as a fraction of banknotes outstanding. Federal Reserve Board staff estimate that over $950 billion in U.S. dollar banknotes were held by foreigners at the end of the first quarter of 2021, roughly half of total U.S. dollar banknotes outstanding. They also can defend a national currency and even determine sovereign credit ratings. De-dollarization is the shrinking of the influence that the U.S. dollar has on the economies of other countries.

Canadian dollar

Moreover, the decline in the U.S. dollar share has been taken up by a wide range of other currencies, rather than by a single other currency. Thus, while countries have diversified their reserve holdings somewhat over the past two decades, the dollar remains by far the dominant reserve currency. Reserve currencies are typically issued by developed, stable countries. The currency most commonly held as a foreign exchange reserve is the U.S. dollar, which, according to the International Monetary Fund (IMF), comprised nearly 62% of allocated reserves as of late 2012. Other currencies held in reserve include the euro, Japanese yen, Swiss franc and pound sterling.

Even as countries aim to reduce dependency, the dollar was the most widely held reserve currency in 2022. A world currency is any money that can freely be used or exchanged for another currency inside or outside the borders of the country that issues it. The first U.S. dollar (USD) is the official currency of the United States and several other countries. This blog post by CFR’s Brad W. Setser explains how China and other countries hide their foreign exchange reserves. U.S. foreign exchange reserves totaled $247 billion, as of March 25, 2022, compared to China’s over $3 trillion. If you hold U.S. stocks which are denominated in dollars, you need dollars to buy and sell them.