The International Monetary Fund (IMF), the body responsible for monitoring the international monetary system, recognizes 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 is by far the most commonly held reserve currency, making up more than 60 percent of global foreign exchange reserves.
Still, the U.S. dollar remains king. In addition to accounting for the bulk of global reserves, the dollar is the currency of choice for international trade. Major commodities such as oil are primarily bought and sold using U.S. dollars. Some countries, including Saudi Arabia, still peg their currencies to the dollar.
The US Dollar Is NO LONGER “THE” Safest Trade Currency!
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Some experts warn, however, that the aggressive use of sanctions threatens dollar hegemony. After the Donald J. Trump administration unilaterally reimposed sanctions on Iran in 2018, other countries, including U.S. allies France, Germany, and the United Kingdom, began developing an alternate, dollar-free system to continue trading with Tehran. More recently, Russia and China have reduced the use of the dollar in their trade with each other.
In 2012, when global reserve growth was high and many countries were intervening heavily in the foreign exchange market, economists C. Fred Bergsten and Joseph E. Gagnon of the Peterson Institute for International Economics (PIIE) found that foreign currency manipulation [PDF] caused the U.S. trade deficit to balloon by up to $500 billion per year, resulting in between one million and five million lost jobs.
The history of paper currency in the United States dates back to colonial times when banknotes were used to fund military operations. The first U.S. dollars as we know them today, though, were printed in 1914. This was a year after the Federal Reserve Act was established.
There are a series of alternatives that could replace the dollar as the next global reserve currency. The euro is the most used reserve after the dollar and could replace the dollar if economic conditions move in its favor. But the European Union (EU) does lack a central Treasury unit, which can make this difficult. China's renminbi could surpass the dollar, a goal that the country's leaders are keen on realizing.
The dollar is at its highest level since 2000, having appreciated 22percent against the yen, 13 percent against the Euro and 6 percent againstemerging market currencies since the start of this year. Such a sharpstrengthening of the dollar in a matter of months has sizablemacroeconomic implications for almost all countries, given the dominance ofthe dollar in international trade and finance.
Other major advanced economies either have much smaller financial markets or, as in the case of Europe and Japan, have relatively weak long-term growth prospects and already high levels of public debt. As a result these currencies are unlikely to return to their former glory anytime soon. But because of the benefits that have accrued to the dollar from its reserve currency status, there should, in principle, be new competitors seeking a share of those benefits.
In addition to capital inflows due to high interest rates, the dollar has also benefitted from strong foreign direct investment in recent years. Direct investment includes ownership in companies or real estate. According to the World Bank, the U.S. attracted the highest level of foreign direct investment of any country in 2021, the most recent period for which there is data. At nearly $5 trillion, it was the second highest on record. We expect the trend to continue as companies shift production closer to major consumers in response to global trade tensions.
Finally, demand for the dollar as a safe haven is likely to continue as a supportive factor in 2023. The ongoing war in Ukraine, trade conflicts, uncertainty about the path of the COVID virus and its impact on economic growth, and political upheaval in many parts of the world have made U.S. investments look relatively attractive over the past few years.
To see the impact of currency and interest rates on bond returns, we can look at the total return of the U.S. Aggregate Bond Index compared to the Global Aggregate Bond Index excluding the U.S. since 2011. During that period, an investor in the U.S. Agg would have earned a cumulative 27% return, while a U.S. dollar-based investor in the Global Agg would have had a cumulative total return of -7.0%.
The US dollar exchange rate has become increasingly politicised. President Donald Trump has called for a weaker exchange rate, a move away from a long-standing and bipartisan rhetorical position favouring a "strong dollar". At the same time, US Democratic presidential hopeful Elizabeth Warren has called for a managed exchange rate to boost employment and exports,[^1] while two members of Congress have sponsored a bill that would tax foreign capital inflows into the United States with a view to balancing its external accounts.[^2] This increased politicisation is partly a symptom of a significant appreciation in the US dollar since President Trump assumed office (Figure 1). As this report will show, this appreciation is not inconsistent with a chaotic trade war and the Federal Reserve cutting interest rates. The US dollar exchange rate often appreciates on increased international political and macroeconomic risk.
This safe-haven bid for US dollar assets means that the US dollar often behaves in ways that seem counter-intuitive relative to US economic fundamentals. As Figure 2 shows, the US dollar appreciates in response to economic policy uncertainty. A 1 per cent increase in the Global Economic Policy Uncertainty Index raises the real value of the US dollar by 0.2 per cent, controlling for relative interest rate, inflation and economic growth differentials with the rest of the world. The 60 per cent increase in measured economic policy uncertainty under the Trump administration, due to its trade war with the rest of the world, has added around 12 per cent to the real value of the US dollar holding these other influences constant.[^6] The appreciation exacerbates trade tensions between the United States and the rest of the world by weighing on US export competitiveness, setting in train a protectionist spiral.
The report also examines the extent to which the US dollar and other currencies can be "weaponised" as part of a "currency war". While the United States could resort to intervention in foreign exchange markets or a managed exchange rate as part of its trade war with the rest of the world, these efforts would only introduce increased volatility into financial markets, without changing underlying economic fundamentals. However, the dominance of the US dollar in global finance does provide the United States with a potentially powerful instrument of international economic coercion when used to enforce economic and financial sanctions against state and non-state actors.
The US dollar is the dominant currency for global debt issuance, invoicing and payments, foreign currency reserves, managed exchange rate regimes, and foreign currency turnover and settlements. (Figure 4).
A fixed exchange rate regime fixes the price of the domestic currency unit against one or more foreign currencies. A managed exchange rate allows this price to fluctuate within a range. A fixed or managed exchange rate is maintained by the central bank intervening in the market to buy or sell the local currency against foreign currencies to maintain a desired rate. Many countries anchor their currency to the US dollar because their trade and investment with the rest of the world is largely US dollar-denominated. Around 70 per cent of countries have the US dollar as their anchor or reference currency.[^24] In this context, US dollar reserves are essential to managing the exchange rate. Countries linking their exchange rate to the US dollar include all of Latin America, China, most of the rest of Asia, Africa and the former Soviet Union. This linkage is often motivated by foreign policy and security ties to the United States.[^25]
For currencies that lack well-established and liquid foreign exchange markets, trading against non-US dollar currencies is typically done indirectly via US dollars to take advantage of the depth and liquidity of markets for US dollar assets. This creates a demand for US dollars even for transactions otherwise denominated in other currencies. However, this has little to do with "reserve currency" status.
There is a small benefit that flows to the United States from the fact that foreign central banks hold its currency. It costs virtually nothing for the United States to produce a unit of domestic currency, but foreign central banks pay the face value of the currency when acquiring US dollar reserves. The economic costs of supplying and holding official reserve assets is a function of relative rates of return on reserves compared to domestic assets, which is determined by interest rate differentials and exchange rate movements.
There is another benefit that flows to the United States from the widespread use of the US dollar for international trade and investment. The United States typically imports and borrows in its own currency and so is less exposed to the exchange rate changing the value of its imports and external liabilities, facilitating its ability to borrow internationally. The ability of the United States to borrow in its own currency was famously dubbed an "exorbitant privilege" by a French finance minister in the 1960s. This exorbitant privilege is considered one of the main benefits of "reserve currency" status, but it has little to do with the official reserves held by foreign central banks. It is a function of the size and depth of US dollar capital markets and the desire of foreigners to invest in US dollar assets.
When the Australian dollar rose to record highs in 2011, some commentators suggested that Australia was a victim of monetary easing in other economies, losing international economic competitiveness. But in the context of a terms of trade boom, the appreciation of the Australian dollar served to moderate the impact of higher export prices on the Australian economy. Australia was in no sense a victim of foreign monetary policy. The Reserve Bank of Australia eased its own monetary policy from November 2011 and the Australian dollar exchange rate has depreciated significantly since then. 2ff7e9595c
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