Q&A: What is a reserve currency?

This question is in the news at the moment. The Chinese central bank has proposed replacing the US dollar as the world’s reserve currency with a new hybrid currency controlled by a beefed up International Monetary Fund.

A reserve currency is sometimes called an anchor currency and is a currency that national governments and other institutions are happy to hold as a key part of their foreign exchange reserves. It also acts as a global pricing currency for many commodities such as gold, oil, wheat and copper.

For decades the reserve currency of choice has been the US dollar – partly because the USA is the world’s biggest economy. For the Americans one of the benefits of this is that the USA can borrow from the rest of the world at a slightly lower interest rate because there has been a lengthy queue of foreign investors willing to purchase $ denominated assets such as US Treasury bonds. China for example has amassed a mountain of foreign exchange reserves arising from their super-charged trade surpluses. The bulk of their $2 trillion worth of foreign exchange reserves are in dollars and a large percentage of US government debt is owned by the Chinese – the fortunes of the two economies are now closely entwined.

China is spooked by the scale of the fiscal stimulus being introduced by the Obama administration and the likely size of the quantitative easing that the US Federal Reserve will undertake to drag the US economy out of a deflationary recession. If the world’s supply of US dollars increases at too fast a rate the US dollar will lose value and China’s huge investments in the US economy will suffer too.

In recent years there has been a shift in holdings of foreign exchange – indeed there are now more euros in circulation than dollars, and the euro’s role as an international reserve currency is growing. By the first half of 2008 the euro accounted for 27 per cent of official foreign reserves, up from 18 per cent soon after its launch. The dollar’s share fell from 71.2 per cent to 62.5 per cent during the same period.

Basically the two requirements for a currency to have reserve status is credibility of a government that it will not default on its debt or attempt to debase it’s currency by printing too much of it. And also pure economic power!

China, India, Russia and Brazil are four emerging economies with growing global power and influence but they are not yet ready to assume the mantle of an economy large enough for their domestic currency to have reserve qualities.

US defends dollar as key currency (BBC news)

Will the dollar reman king? (BBC news)