What is a reserve currency?

Central banks around the world may hold different currencies for a variety of purposes. Currencies that central banks tend to hold in large quantities are known as reserve currencies.

Central banks maintain reserve currencies in their coffers for a variety of purposes. For one thing, widely held and recognized currencies can play a key role in doing business on international markets. Using a reserve currency to conduct international trade and financial transactions eliminates the costs involved with settling transactions involving different currencies. Reserve currencies can also help countries maintain stability during economic crises.

The U.S. dollar is the world’s dominant reserve currency, among other currencies including the euro, the yen, the pound, the renminbi, the Canadian dollar, the Swiss franc and the Australian dollar.

What makes a reserve currency

Official reserve currencies have several basic characteristics, the most important of which is size and scale. Reserve issuers have large economies and play a dominant role in international trade. Reserve currencies offer a stable store of value over time and are widely used and traded, underscoring the importance of reserve issuers’ policy credibility and the depth and liquidity of their financial markets.

Why countries hold reserve currencies

Countries hold reserves for a number of reasons, including to pay for imports, to weather economic shocks and to service debts.

International trade

When it comes to global trade, the U.S. dollar is king, significantly outweighing other currencies as the most frequently used currency for international transactions. And, because of its central role as a medium of exchange, the U.S. dollar is also the preeminent currency in the international banking system.

Because U.S. dollars underpin so many international transactions, it is difficult for many countries to use their own currencies to borrow money or pay for foreign goods. For example, a transaction between two countries like Norway and Mexico would likely be done in reserve currencies rather than the currencies of the two countries involved. By holding reserves, countries can ensure that they can continue to receive a steady stream of imports, even during a crisis. Holding reserve currencies also helps demonstrate to creditors that a country can make debt payments denominated in foreign currency.

Hedge against economic turbulence

Reserve currencies are also preferred currencies amid economic crises as a safe haven.

For instance, during the Global Financial Crisis of 2008 and 2009 and the economic havoc brought on by the COVID-19 pandemic in 2020, global investors flocked to U.S. dollars, expecting the dollar to remain relatively stable despite the tumultuous environment. The perceived safety of a currency – and its utility as a reserve currency – can also stem from the role of its issuer on the global stage, especially its geopolitical or military power.

Exchange rates

Countries also hold foreign exchange reserves to intervene in exchange markets and provide foreign exchange liquidity to domestic economic participants. Central banks can buy and sell reserve currencies on the open market to influence the value of their own country’s currency, which provides stability. For instance, if the value of the Argentine peso starts to drop during an economic downturn, the country’s central bank can intervene and use its foreign reserves to bid up the peso’s value.

Exposure to monetary policy

Holding large amounts of a reserve currency involves exposure to the monetary policy of the reserve issuer. As a consequence of the Federal Reserve’s move to tighten monetary policy in its fight to bring inflation down starting in early 2022, the U.S. dollar strengthened. This made it more difficult for U.S. producers and manufacturers to compete in global markets – which can simultaneously benefit U.S. consumers of foreign goods. At the same time, this creates complexities for many other countries that must pay higher interest rates on their dollar-denominated debts.

History of the U.S. dollar as reserve currency

Since the end of World War II, the U.S. dollar has been the world’s most dominant means of exchange. It is the most commonly held reserve currency and the most widely used currency for international trade. The centrality of the dollar to the global economy confers some benefits to the United States, including borrowing money abroad more easily and extending the reach of U.S. financial sanctions.

The dollar’s status as global reserve currency was established at the 1944 Bretton Woods Conference, in which 44 countries agreed to the creation of the International Monetary Fund and the World Bank. Once implemented, its provisions called for each currency in the system to be pegged to the U.S. dollar’s value, which was itself pegged to the value of gold.

Benefits of being the world’s dominant reserve currency

The status of the dollar as the world’s dominant reserve currency, perhaps unsurprisingly, provides some key advantages to the U.S. economy. Since many central banks and financial institutions around the world want to hold U.S. dollars and dollar-backed securities like U.S. Treasury bonds, there is generally strong demand for dollars. That demand makes it easier for the U.S. to borrow with more attractive interest rates.

Though the dollar is currently the most popular reserve currency, the last two decades have seen the emergence of other reserve currencies, including the euro and Japanese yen.

According to the International Monetary Fund, the entity in charge of monitoring the international monetary system, there are eight major reserve currencies: the Australian dollar, the British pound sterling, the Canadian dollar, the Chinese renminbi, the euro, the Japanese yen, the Swiss franc and the U.S. dollar. The U.S. dollar maintains the leading position, accounting for around 57% of global foreign exchange reserves.

Bottom line

Reserve currencies are held by central banks and financial institutions to facilitate trade and investment or to influence domestic exchange rates. The U.S. dollar has functioned as the world’s dominant reserve currency since the end of World War II. Central banks hold approximately 57% of their foreign exchange reserves in dollars, though the dollar’s share of global foreign-exchange reserves has been declining for two decades. Other popular reserve currencies include the euro, the yen, the pound, the renminbi, the Canadian dollar, the Swiss franc and the Australian dollar.

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