13. What is reserve currency?
A reserve currency refers to foreign exchange reserves held by a central bank or financial institutions of a country. Constituting a certain ratio, foreign currency is an important part of foreign exchange reserves of a country. Foreign exchange reserves are used in international trading and investment as well as repayment of foreign debts owed by the government. On the issuance of the local currency, foreign exchange reserves also serve as a basis of the currency’s level of confidence. Higher or lower foreign exchange reserves influence the stability of the exchange rate of the local currency.
The history of reserve currency
Starting from the 19th century until the first half of the 20th century, the British Pound (GBP) was the major reserve currency of most countries around the world, finally replaced by the Dollar (USD) in the second half of 20th century. Prices of major commodities are usually set according to reserve currency. Therefore, it plays a very important role in global economy.
According to information disclosed by IMF, USD still holds the largest portion of the global reserve currency, standing at 6.794 trillion USD or 61.9% in Q1 of 2020 among foreign exchange reserves throughout the world.
It is followed by:
- Euro (EUR) at 20%
- Japanese Yen (JPY) at 5.6%
- GBP at 4.4%
- Renminbi (CNY) at 1.9%.
Why is USD the most important globally?
In the aftermath of the 1944 Bretton Woods Conference, the USD was pegged to gold. Following the gold standard, a Dollar-Standard System was established. Since then, major countries around the world have set the USD as the main reserve currency. Following decades of development, global trading activities and commodities—particularly oil products—were all priced in USD. This is why many countries use the USD as their reserve base to issue local currency.
The USD faced tremendous depreciation after the 1970s and was unpegged with the gold standard. During this period, most countries globally adopted a floating exchange rate system. However, such changes did not mean that they broke away from the USD-based economic structure and model.
As the largest economy in the world, the US is highly influential in many fields. This includes global politics, technology, diplomacy, and the military. That’s why the USD is still the most important reserve currency, creating global effects such as inflation and asset price trends.
When the overall environment is extremely uncertain, the USD is usually considered as the only safe-haven currency. That’s why governments as well as all individual investors worldwide pay most attention to the economic condition in the US and study the details of monetary policy dictated by the US Federal Reserve (FED).
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