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Every country in the world has a stockpile of money from other countries
Reserve currencies are large amounts of foreign currency that countries’ central banks hold on deposit. Why would countries hold large amounts of another country’s money? And which other countries’ money is most often used as reserve currencies?
Central banks hold reserve currencies for lots of different reasons:
- to have options on hand in case of a political, economic or military crisis
- to inspire confidence in international investors
- to prepare for investments and transactions, and to pay international debts
- to minimize exchange rate risk by reducing the need to buy that currency on the market
- to buy commodities that are priced in that foreign currency, such as oil
“Reserve currencies are large amounts of foreign currency that countries’ central banks hold on deposit.”
Worth its weight in gold?
In 1944, 44 countries agreed to adopt the U.S. dollar as an official reserve currency. The U.S. emerged from World War II as the world’s dominant economic power. That the greenback should be the global currency reserve made sense in a world where, at one point, the United States’ Gross Domestic Product represented 50% of the world’s economic output. Other countries pegged their currency to the U.S. dollar, which itself was pegged to the value of gold. At least, for a while.
What happened was this: There was nothing to stop the U.S. from printing more and more dollars when it needed some to pay for things like the Vietnam War and “Great Society” social programs, etc. When the dollar was backed by gold, more dollars meant that the value of the gold was spread amongst more dollars. Countries that had stockpiled American dollars as their reserve currencies were anxious that their gold value was dropping, so they decided to cash in those dollars for gold instead.
The run on gold was so worrisome that Nixon decoupled the dollar from the “gold standard.” Instead, the American dollar became subject to floating exchange rates relative to other currencies that we’re now all used to.
If not the American dollar, then what?
The International Monetary Fund tracks foreign currency reserve balances quarterly in a report called “Currency Composition of Official Foreign Exchange Reserves (COFER).” COFER tracks eight currencies: U.S. dollar; Euro, Chinese renminbi, Japanese yen, pound sterling. Australian dollar, Canadian dollar, and Swiss franc.
As of September 30, 2019, the top foreign reserve currencies on the planet (and combined balances held by foreign countries) were:
- United States Dollar $6.74 trillion (61.82%) (all figures expressed in USD)
- Euro $2.21 trillion (20.24%)
- Japanese Yen $572 billion (5.25%)
- Pound Sterling $495 billion (4.54%)
- Chinese Renminbi $213 billion (1.95%)
- Canadian Dollar $210 billion (1.92%)
- Australian Dollar $182 billion (1.67%)
- Swiss Franc $15 billion (0.15%)
Patterns over time
“That the greenback should be the global currency reserve made sense in a world where, at one point, the United States’ Gross Domestic Product represented 50% of the world’s economic output.”
Fluctuations in the value of foreign reserve holdings worldwide should not be ignored. Even the difference of a percentage point equals enormous sums of money on a planet-wide scale. Reserve currency use has fluctuated since 2004.
From 2004 to 2019, the United States dollar has amounted to between 62.1% (2009) and 65.1% (2014) of international reserves.
From 2004 to 2019, the Euro has amounted to between 21.2% (2014) and 27.7% (2009) of international reserves.
From 2004 to 2019, the Japanese Yen has amounted to between 2.9% (2009) and 5.3% (2019) of international reserves.
From 2004 to 2019, the Pound Sterling has amounted to 3.5% (2004) to 4.5% (2019) of international reserves.
The use of “other” currencies to make up international reserve holdings has increased significantly from 2004 to 2019: 2.0% in 2004, 3.0% in 2009, 6.5% in 2014, and 8.2% in 2019.
It will be fascinating and important to watch for the emergence of new (maybe even electronic?) currencies as reserve options.
A deeper dive — Related reading from the 101:
Cryptocurrencies are growing in popularity and economic significance. Could they one day be a reserve currency?
For a long time, the United States dollar was coupled to the value of gold.