What is a Reserve Currency?

Reserve Currency from Bretton Woods to China's Yuan

Cropped Hand Holding American Currency
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A reserve currency is a currency held in significant quantities by many governments and institutions as a means of international payment. While this used to consist of mostly gold and silver, 1944's Bretton Woods system expanded acceptable reserves to include the U.S. dollar and other currencies. Since 1973, no major currencies can be officially converted into gold.

Regardless, reserve currency is held in order to support the value of national currencies.

For instance, Mexico issues pesos (which are essentially IOUs) to its citizens and repurchases them with U.S. dollars, euros, or other reserve currency around the world held by its central bank. Countries can also hold gold or other precious metals in their official reserves.

In this article, we will take a look at the history and future of reserve currencies, as well as how these currencies impact monetary policies around the world.

Reserve Currency History and Future

The U.S. dollar replaced the British pound sterling as the world's reserve currency circa 1945 in accordance with the Bretton Woods agreements. At the time, the U.S. dollar was the currency with the greatest purchasing power and the only currency backed by gold (although this backing was eliminated in 1973 in a controversial decision).

But the U.S. dollar isn't likely to be the world's reserve currency forever. The euro has become increasingly popular as a reserve currency.

 China is already the largest creditor, and may soon become the largest exporter in the world. This kind of financial dominance explains why China's yuan is also emerging as a key potential reserve currency, although before this is likely to happen China made need to institute several important economic reforms.

These reforms include:

  • Easing restrictions on money entering and leaving China
  • Making the Yuan fully convertible for all transactions,
  • Improving the liquidity of its bond market 
  • Furthering domestic financial reforms aimed at greater transparency.

In late-2015, the Chinese renminbi was approved as a main world currency, signaling its successful efforts to meet some of these goals. The move could pave the way for broader usage of the currency in global trade and eventually the potential for it to be kept as a reserve currency.

Reserve Currency & Monetary Policy

Monetary policy has a strong effect on foreign currency reserves. Most major economies with flexible or floating exchange-rate schemes clear excess supply and demand by purchasing or selling reserve currency. For instance, a country looking to boost the value of its currency can repurchase its national currency with its foreign currency reserves.

Other countries may employ a fixed exchange rate schemes for a variety of reasons. Under this type of system, supply and demand can move the value of its national currency higher or lower. For example, increased demand for a national currency (e.g. due to a relatively strong economy) would lead to a higher value for its currency.

Countries also continuously monitor major reserve currencies to ensure their holdings aren't adversely affected. For instance, significant inflation in the U.S. could cause a devaluation of the dollar and the subsequent devaluation of foreign currency reserves. Ultimately, this limits the monetary policy benefits achievable using these reserves.

Countries with the Most Reserve Currency

Countries hold reserve currency for a number of different reasons. They are an important indicator of ability to repay foreign debt, to defend a national currency, and even to determine sovereign credit ratings.

Here are the five countries with the most foreign reserve currency:

  1. China - $3.5 Trillion
  2. Japan - $1.3 Trillion
  3. Switzerland - $661 Billion
  4. Saudi Arabia - $581 Billion
  5. Russia - $407 Billion

The European Central Bank, which serves the Eurozone, holds foreign currency reserves holds foreign reserve currency in the amount of $700 Billion -- more than Switzerland and less than Japan.

Key Takeaway Points

  • Reserve currency is held in significant quantities by many governments and institutions as a means of international payment.
  • Reserve currency can be used by central banks to pay foreign debts and defend national currency, while also helping to determine sovereign ratings.
  • The largest holders of reserve currency are China, ​Japan, and Switzerland.