What are reserve currencies and why do they matter? Why has the U.S. dollar been the preferred measure for so long?
Aliaga-Díaz: At a high level, an international reserve currency helps global investors and sovereign governments conduct critical transactions like settling payments for exports and imports of goods and services between nations, conduct global portfolio investments, borrow funds, and set prices for commodities such as oil or gold.
International reserve currencies are the linchpin of both world trade and the global financial system. Any commercial or financial transaction between two or more parties is always conducted by exchanging money. The currency that’s widely accepted as the medium of exchange in all transactions is called an international reserve currency. All international prices, international contracts, and financial transactions are quoted in terms of reserve currency units. Since World War II, the U.S. dollar has prominently played this international reserve currency role.
Furthermore, global investors, governments, and sovereign wealth funds typically see reserve currencies as a safe haven to protect their assets during periods of heightened uncertainty—geopolitical events, financial crises, and periods of domestic political unrest. This is the “store of value” characteristic of international reserve currencies.
Hirt: There are three primary reasons the U.S. dollar continues to be the reserve currency of choice globally. One is that the U.S. is a traditionally strong sovereign nation, backed by robust, persistent economic growth. Another is the democratic nature of the U.S. government and its institutions. The international community trusts in the stability of our overarching structures and in the property-rights standards that we maintain. Third is a degree of inertia—the difficulty in changing the structure of global finance revolving around the dollar and U.S. capital markets. Competing nations can boast some of these facets, but the U.S. maintains all three advantages.
Why has the dollar lost some ground as a reserve currency in recent decades?
Aliaga-Díaz: One primary reason is the significant globalization seen over the last few decades and the associated economic growth in many economies. Overall, this has yielded a positive outcome for the global financial system. As the world economy grows over time, the volume of both global financial flows and international trade expands at a fast pace, even faster than the growth of the U.S. economy. As a result, the global demand for reserve currencies starts to surpass the capacity of the U.S.—the sole issuer of the U.S. dollar—to satisfy it. Since the launch of the euro in the 1990s, we saw some international operations shifting toward it and—to a much lesser degree—other major developed-market currencies such as the Japanese yen and the British pound. More recently, there has been a small but growing volume of global transactions quoted in Chinese yuan.
Hirt: The potential for the dollar to lose importance as a reserve currency has been a recurring topic in recent history. It was heavily discussed in the late 1990s, when the euro was introduced to world financial markets, and then again in the late aughts, amid the global financial crisis and China’s subsequent rise in the global power structure. We haven’t seen either of these stories play out to the degree that most observers thought they might.
What would it take to supplant the dollar as the dominant global currency?
Hirt: In short, it would require significant global adoption of another currency to affect the dollar’s dominance. Currency usage entails holdings in reserves but also usage as a means of global trade exchange. Despite some recent announcements of countries bypassing use of the dollar in trade contracts, the U.S. dollar remains dominant as the currency of choice for international transactions.
The U.S. dollar far outpaces rivals as a global currency
Notes: The chart shows how broadly each currency is used across borders, using weighted averages of five metrics: the currency’s share of globally disclosed reserves (25% weight), foreign exchange transaction volume (25%), foreign currency debt issuance (25%), foreign currency and international banking claims (12.5%), and foreign currency and international banking liabilities (12.5%). The renminbi is the currency of China and the yuan is the main unit of the currency.
Sources: The U.S. Federal Reserve’s calculations using data as of December 31, 2022, from the International Monetary Fund, the Bank of International Settlements, and Refinitiv.
Aliaga-Díaz: Despite a decline over the past two decades in the share of U.S. dollar-denominated securities holdings—from 71% in 1999 to 58% in 2022—the dollar remains the dominant global reserve asset by a wide margin. We don’t expect this margin will continue to erode at the same rate over the next few years, largely because we see the peak effect from globalization as behind us. The U.S. dollar is cheap to use and very liquid, so it remains dominant.
Decline in share of U.S dollar reserves attributed to globalization
Note: The “Other” category refers to a basket of currencies dominated by the Canadian dollar, the Australian dollar, and the South Korean won.
Sources: The U.S. Federal Reserve and the International Monetary Fund. Data are as of December 31, 2022.
What are some implications of the dollar’s dominance?
Hirt: Having a dominant global currency provides ample demand for our debt instruments, which benefits U.S. companies and consumers through liquidity and stability of their currency. It further allows them to theoretically borrow at rates lower than what’s available in the rest of the world. Some estimates cite about 1% in interest rate savings, which—multiplied by the roughly $8 trillion of U.S. Treasuries held overseas—translates to about $80 billion in annual savings for the U.S. government in interest payments.
Being the issuer of the world reserve currency also generates another source of revenue for the U.S. government. This “seigniorage” revenue is the purchasing power created through printing of new U.S. dollar bills. Since about half of the $2.3 trillion bills and coins in circulation is held overseas and with the world economy growing at 3% per year on average, the portion of the new money printing going overseas amounts to about $35 billion, according to the latest Fed data as of year-end 2022.
Aliaga-Díaz: There is another advantage, but it can also be a disadvantage. During times of turbulence, flights to safety increase the demand for U.S. dollars and dollar-denominated U.S. Treasury bonds. This becomes an important tailwind right when U.S. policymakers are trying to stimulate the U.S. economy. Flight-to-safety flows put downward pressure on interest rates right when the Fed would like to ease monetary conditions, creating space for any fiscal stimulus by reducing the cost of debt. However, if flight to safety takes place during normal economic times for the U.S., flows will exert upward pressure on the value of the dollar, which will rise more than other currencies, which can be a disadvantage for U.S. trade.
In all, there are more advantages than disadvantages for the U.S. from having the U.S. dollar as the global reserve currency. However, dollar dominance is never a goal in itself for the U.S. Rather, it’s the stability and strength of U.S. democracy and its institutions, including the independence and credibility of the Federal Reserve, that attracts the rest of the world toward the U.S. dollar, voluntarily adopting it as their international currency of choice.
What would it take for the dollar to lose further share as a reserve currency? How likely is that to happen?
Hirt: Several scenarios point to this possibility, but the probability and potential impact for each is different.
The first and most likely is what we call the “rising tide” scenario, where, over the long run, other nations continue to deepen their capital markets, improve their institutions, and procure currency adoption. Because of the long timeframe involved in this scenario, the world would likely adjust to the change gradually, leading to minimal transition costs, and overall is likely a positive outcome for the global financial system.
The second scenario is what we call the “innovator’s dilemma,” which entails technological innovation that outpaces payment and regulatory innovation and leads to a situation where trust in technology replaces trust in sovereign nations.1 Recent advancements in cryptocurrencies and their exciting blockchain technology are an example. However, beyond cryptos’ lack of oversight, there are some fatal flaws in their monetary economics that, in our view, prevent them from being adopted and widely accepted as a medium of exchange and as a store of value at a large scale.
Tokenization—in this case, anonymous transactions—seems to be cryptos’ main appeal, but that is not needed for large international reserve transactions. Meanwhile, the supposed benefit of substituting a central issuing authority with a fixed algorithmic rule governing its supply actually introduces wild volatility in its value. Supply can’t keep up with wild swings in demand and investors’ sentiment. In addition, the major central banks are starting to leverage blockchain technology to develop their own digital versions of official currencies, without the shortcoming of private cryptos. We believe the probability of this second scenario to be low.
The third potential scenario would involve mismanagement of the economic or political environment in the U.S. This could involve a fiscal crisis or an unprecedented loss of trust in our political system. We call this scenario the “unforced error” and see it as the most negative potential shock, particularly as a transition could come quickly and a financial market penalty would be costly. Given the potential consequences, we expect the probability of this scenario to be low.
Aliaga-Díaz: The reason the dollar is so heavily used as a reserve currency comes down to trust and alternatives. Each of these scenarios describes either an erosion of that trust or advances in alternatives, just by a different impetus and over a different timeline. But people still have a tremendous amount of trust in the U.S. dollar and in the democratic institutions backing it. That’s clearly evident by its continued, widespread global use.
1The phrase was coined by Clayton M. Christensen in his book, The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail, first published in 1997. Subsequent editions had different subtitles.
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