What Is Reserve Currency?
Definition & Examples of Reserve Currency
A reserve currency is a currency held in significant quantities by governments and institutions. These currencies are used as a means of international payment and to support the value of national currencies.
Learn what makes a reserve currency and how it can impact global trade.
What Is Reserve Currency?
A reserve currency is a foreign currency or precious metal that is held in large quantities by a country's government, central bank, or other monetary authority. It is used for participating in the global economy, such as through international transactions or investments.
In general, a reserve currency is one that:
- Has the depth and liquidity to allow for reliable and efficient international transactions
- Can be freely and easily exchanged for other currencies
- Is held by many monetary authorities and institutions, in significant amounts
Before the mid-twentieth century, reserves were mostly gold and silver. Modern reserves are generally made up of strong foreign currencies, many of them specifically designated as reserve currencies by the International Monetary Fund. Reserve currencies can also be foreign currency securities, deposits, and loans.
Starting in the mid-twentieth century, the U.S. dollar was designated the international reserve currency. Since then, however, strong economies in many countries have led to the rise of other international reserve currencies.
There are several key factors that make a currency useful as a reserve currency. These include:
- The size of the economy in the country where that currency comes from
- How important that economy is internationally
- How open its financial markets are
- The currency's convertibility
- Whether it is used as a regional or international currency peg
- Domestic macroeconomic policies
The countries with the most foreign reserve currency in 2019 were:
- China: $3.2 trillion
- Japan: $1.3 trillion
- Switzerland: $855 billion
- Russian Federation: $555 billion
- United States: $517 billion
- Saudi Arabia: $515 billion
These reserves (which are rounded up to the nearest billion) include gold, U.S. dollars, and other reserve currencies.
The entire Euro Area, as designated by the World Bank, is made up of 19 countries and holds $914 billion in reserve currency.
How Reserve Currency Works
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.
Foreign transactions often involve reserve currencies, which are used internationally, rather than the currencies of the two countries involved. For example, in 2008, researchers found that trade with the U.S. accounted for only 20% of international transactions in Asian countries, even though the bulk of these transactions were conducted in dollars. These international transactions used the U.S. dollar as a reserve currency, which was accepted internationally, rather than the local currencies of the countries in the transactions.
Reserve currencies impact monetary policies and trade around the globe, and 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 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 due to a relatively strong economy would lead to a higher value for a country's 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, creating only a marginal benefit for a country's currency being considered a reserve currency around the world.
While currency reserves used to consist mostly of gold and silver, the Bretton Woods agreement in 1944 established the U.S. dollar as an international reserve currency, replacing the British pound sterling.
This agreement, which was created after World War II, chose the U.S. dollar because of the strength of the U.S. economy, which hadn't been damaged by the war the way other European and Asian countries' economies had. The U.S. dollar was also still backed by gold at the time, with its value being set at $35 per ounce. This made the dollar more stable than other currencies and set a system of fixed exchange rates in place.
The Bretton Woods Agreement also created the World Bank Group (World Bank) and the International Monetary Fund (IMF).
In 1973, President Richard Nixon's New Economic Policy brought an end to the Bretton Woods system of fixed exchange rates and decoupled the dollar from the value of gold. This opened up the world to the rise of new reserve currencies.
Types of Reserve Currency
Today, the U.S. dollar isn't the only reserve currency designated by the International Monetary Fund and other global organizations. The euro, Chinese renminbi, Japanese yen, and British pound sterling are all popular as reserve currencies given the size of their respective economies.
|Allocated International Reserves|
|Reserve Currency||Value* (U.S. dollars, billions)|
|British pound sterling||486.08|
Other currencies that the IMF tracks as reserve currencies include the Australia dollar, Canadian dollar, and Swiss franc.
China has positioned its currency as next in line to the U.S. dollar, having been the largest contributor to world growth since 2008's global financial crisis. China's renminbi was named by the International Monetary Fund as a global reserve currency in 2015. However, the euro still accounts for the largest portion of currency reserves after the dollar due to the economic size of the European Union.
The popularity of reserve currencies is a function of their stability and reputation. For example, the Chinese yuan hasn't taken off as a major reserve currency due to concerns over a sudden devaluation that could send their value lower. The same is true for the euro following the sovereign debt crisis in 2009 and the immigration crisis in 2016-17. These issues have led to concerns over currency volatility, which has kept the U.S. dollar as the most popular reserve currency through the start of the twenty-first century.
- A reserve currency is a foreign currency or precious metal held in significant quantities by governments and institutions.
- These currencies are used as a means of international payment and investment, as well as to support the value of national currencies.
- After World War II, the U.S. dollar was designated as the international reserve currency. Since the 1970s, strong economies in many countries have led to the rise of others.
- Reserve currencies held in large quantities around the world include the U.S. dollar, euro, Japanese yen, Chinese renminbi, and British pound sterling.