Clients have been asking about the potential that the U.S. could lose the role as the world reserve currency. To really understand the issue, you need to know what a world reserve currency is and what advantages (if any) it gives the U.S. to be the world’s current leading reserve currency.
World Reserve Currency: Protection & Stability
Almost all countries hold foreign financial reserves, whether they are in bonds or money markets, denominated in another country’s currency. In addition to this, countries will usually hold gold and special drawing rights with the International Monetary Fund. These reserves help protect a country’s currency from large swings in valuation.
For instance, let’s say that large amounts of Japanese Yen were being sold on a global scale. The policy makers in Japan might not like the idea of their currency being depressed due to outside forces. One strategy they might use to maintain the value of their currency is to tap into their foreign reserves (like U.S. dollars) and begin selling dollars and buying Yen. This usually would have the effect of stabilizing the value of their local currency if they held enough U.S. dollars to make an impact on the Yen market.
Currency Liquidity
Think for a second about how many U.S. dollars the Japanese government would need to sell in order to have an impact on a global scale for the Yen. The number is probably billions if not tens of billions of U.S. dollars. What this means is that for a reserve currency to have relevance and make sense for widespread use, it has to be very “liquid”. Liquid means that the currency can be sold quickly and readily without having too much of an impact on the overall price. The U.S. dollar is simply the only currency in the world currently that can make this claim.
Alternatives to the Dollar
Some other currencies used today to bolster foreign reserves are the Euro and the British Pound/Sterling. The Euro is becoming more popular, but is still a very distant second to the U.S. dollar in terms of overall use. In fact, recent estimates suggest that the U.S. dollar comprises 60% of foreign reserves with the Euro making up 20%. With the recent economic troubles in Portugal, Spain, Greece, and Ireland, most experts don’t see the Euro overtaking the dollar anytime in the near future. As far as the British Pound/Sterling goes, it would seem that the British economy is simply too small to support massive global use. This goes back to my earlier point on liquidity.
A dark horse in reserve currency use is the Chinese Renminbi or Yuan. The Chinese economy is certainly big enough to provide enough liquidity to global markets. However, due to tight Chinese government controls and some outright manipulation, other countries have shown hesitancy to adopt this currency on any large scale. So it would seem that the U.S. Dollar is fairly “safe” from being replaced as the world’s primary reserve currency for the time being, but why does it matter if the U.S. dollar is the world reserve currency, does it offer any competitive advantages?
Potential Advantages for U.S. Dollar as Currency Reserve
There are likely two main reasons the U.S. wants to remain as the world’s leading reserve currency. Since much of the reserves other countries hold are in the form of Treasury Bills, this has the effect of keeping a nice steady demand for bonds issued by our government. This demand has helped to keep interest rates relatively stable over time. Also, since the U.S. dollar is so widely accepted, American businesses do not usually need to arrange currency swaps when doing business internationally. It’s not clear what percentage this potentially adds to the bottom line for U.S. corporations, but several economists have said somewhere between 1-3%.
There is potentially a third benefit, referred to as “seigniorage” which is the profit a country makes in the difference of issuing currency versus production costs. Experts are deeply divided on whether this is significant or has a nominal impact. For more, take a look at the Federal Reserve’s white paper on the topic. Ultimately, if the U.S. dollar is less widely used, there will be some unpleasant ripple effects, but by no means would it likely be the doomsday scenario you might have heard about from the media.
Matthew Trujillo, CFP®, is a Certified Financial Planner™ at Center for Financial Planning, Inc. Matt currently assists Center planners and clients, and is a contributor to Money Centered.
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