The IMF and the International Currency of Trade

 

GLOBAL CONCERN:  The possibility of the dollar being replaced as the world reserve currency has been a topic of discussion in economic circles for nearly two decades. But what could replace the dollar, and how might this affect the dollar’s exchange rate...

“World reserve currency” means a currency that many central banks hold as part of their FX reserves. In theory, any currency could be a world reserve currency. But in practice, central bank FX reserves are dominated by a few currencies. These currencies are typically issued by well-managed central banks on behalf of governments which have a history of meeting their obligations. As a result, they tend to have stable exchange rates and low inflation. This makes them attractive both for international trade and as long-term savings vehicles.

The International Monetary Fund (IMF) recognizes eight world reserve currencies: U.S. dollar, euro, Chinese renminbi (yuan), Japanese yen, British pound, Australian dollar, Canadian dollar and Swiss franc. Of these, USD is by far the most widely used in global FX reserves. Nearly 60 percent of the world’s FX reserves are denominated in dollars. In the second quarter of 2019, the total dollar value of global FX reserves stood at $11.7 trillion, of which $6.8 trillion were in dollars or dollar-denominated assets.1 For this reason, the dollar is often referred to simply as the world reserve currency.

How Does World Reserve Currency Status Affect Exchange Rates?
The dollar’s dominance in FX reserves is thought to confer an “exorbitant privilege” on the U.S., enabling it to borrow large amounts at low interest rates without fear of a “sudden stop.” However, some economists point out that this privilege is not without cost, since it may keep the dollar’s exchange rate too high for balanced trade, hampering U.S. exporters.2 The U.S.’s role as safe asset provider to the world also means that in a financial crisis, it could find itself responsible for bailing out the global financial system, as happened in 2008.3

The second most favored world reserve currency is the euro, which in the second quarter of 2019 accounted for $2.2 trillion of total global FX reserves, or just under 20 percent. Of the remaining 20 percent, the yen and sterling between them account for approximately half.4

Since central bank FX reserves are used to settle international payments, the dominance of the dollar in international trade explains the dollar’s prevalence in global FX reserves. However, trade is not the only reason that central banks keep FX reserves. They also maintain reserves as a buffer against sudden exchange rate swings.

Is the World Moving Toward ‘Multi-Polar’ Reserve Currencies?
Although the dollar is globally dominant, countries also tend to hold the currencies of the dominant trading nation in their vicinity. Thus, European countries outside the Eurozone tend to hold the euro, and Asian countries hold the yen and, increasingly, the renminbi. Some economists argue that this tendency could develop into a full-fledged “multi-polar” system in which the dollar would be the principal reserve currency for the Americas, the euro would be the principal reserve currency for Europe and Africa, and the renminbi for Asia and Australasia.

Should a multi-polar reserve currency system emerge, then global demand for both dollars and dollar-denominated safe assets might subside, while demand for euros and renminbi, and their associated safe assets, might increase. This could mean a lower dollar exchange rate, particularly in relation to the euro and the renminbi, and higher interest rates on dollar-denominated securities, notably U.S. government debt.   TO READ ENTIRE ARTICLE, CLICK HERE...