Introduction
Since the end of World War II, the dollar has been the world’s most important currency. It is the most commonly held reserve currency and the most widely used currency for international trade and other transactions around the world. 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.
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But some experts argue that dollar supremacy comes at a cost. Increased foreign demand for U.S. bonds bids up the dollar and makes U.S. exports less competitive, resulting in trade deficits and lost jobs. And the dollar’s role in many global transactions puts pressure on the U.S. Federal Reserve to act as the world’s lender of last resort during economic crises, such as the one triggered by the coronavirus pandemic. Despite the concerns about the dollar’s power, many experts say it is unlikely that the greenback will be replaced as the leading reserve currency any time soon.
What is a reserve currency?
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A reserve currency is a foreign currency that a central bank or treasury holds as part of its country’s formal foreign exchange reserves. Countries hold reserves for a number of reasons, including to weather economic shocks, pay for imports, service debts, and moderate the value of its own currency. Many countries cannot borrow money or pay for foreign goods in their own currencies—since much of international trade is done in dollars—and therefore need to hold reserves to ensure a steady supply of imports during a crisis and assure creditors that debt payments denominated in foreign currency can be made.
By buying and selling currencies on the open market, a central bank can influence the value of its country’s currency, which can provide stability and maintain investor confidence. For instance, if the value of the Brazilian real starts to fall during an economic downturn, the Central Bank of Brazil can step in and use its foreign reserves to bid up its value. Conversely, countries can intervene to stop their currencies from appreciating and make their exports cheaper.
Most countries want to hold their reserves in a currency with large and open financial markets, since they want to be sure that they can access their reserves in a moment of need. Central banks often hold currency in the form of government bonds, such as U.S. Treasuries. The U.S. Treasury market remains by far the world’s largest and most liquid—the easiest to buy into and sell out of—bond market.
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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.
China has by far the most reported foreign exchange reserves of any country, with more than $3 trillion. Japan, in second place, has around $1.3 trillion. India, Russia, Saudi Arabia, Switzerland, and Taiwan also have large reserve holdings. The United States currently holds roughly $140 billion worth of assets in its pool of reserves, including $40 billion worth of foreign currencies.
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How did the U.S. dollar become the world’s leading reserve currency?
The dollar’s status as the global reserve currency was cemented in the aftermath of World War II by the 1944 Bretton Woods Conference, in which forty-four countries agreed to the creation of the IMF and the World Bank. (Some economists have argued that the dollar had overtaken the British pound [PDF] as the leading reserve currency as early as the mid-1920s.) At Bretton Woods, a system of exchange rates was created wherein each country pegged the value of its currency to the dollar, which itself was convertible to gold at the rate of $35 per ounce. This was designed to prevent the “beggar-thy-neighbor” currency wars of the 1930s—a response to the Great Depression—by which countries abandoned the gold standard and devalued their currencies to try to gain a competitive advantage.
By the 1960s, however, the United States did not have enough gold to cover the dollars in circulation outside the United States, leading to fears of a run that could wipe out U.S. gold reserves. Following failed efforts to save the system, President Richard Nixon suspended the dollar’s convertibility to gold in August 1971, marking the beginning of the end of the Bretton Woods exchange rate system. The Smithsonian Agreement, struck a few months later by ten leading developed countries, attempted to salvage the system by devaluing the dollar and allowing exchange rates to fluctuate more, but it was short-lived. By 1973, the current system of mostly floating exchange rates was in place. Many countries still manage their exchange rates either by allowing them to fluctuate only within a certain range or by pegging the value of their currency to another, such as the dollar.
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.
Factors that contribute to the dollar’s dominance include its stable value, the size of the U.S. economy, and the United States’ geopolitical heft. In addition, no other country has a market for its debt akin to the United States’, which totals roughly $18 trillion. “It’s more helpful to think of U.S. Treasuries as the world’s leading reserve asset,” says CFR’s Brad W. Setser. “It’s hard to compete with the dollar if you don’t have a market analogous to the Treasury market.”
What are the benefits for the United States?
The dollar’s status as the leading reserve currency has been called the “exorbitant privilege” of the United States, a phrase coined by former French Finance Minister Valery Giscard d’Estaing in the 1960s. At the time, French officials believed that the world’s appetite for dollars provided cheap financing for U.S. investment abroad. Over time, U.S. trade swung into a sustained deficit, supported in part by global demand for dollar reserves. Such demand helps the United States to issue bonds at a lower cost, since higher demand for a government’s bonds means it doesn’t have to pay as much interest to entice buyers, and helps to keep the cost of the United States’ now substantial external debt down.
Some experts say this benefit is modest, pointing to the fact that other developed countries are also able to borrow at very low rates. Former Federal Reserve Chair Ben Bernanke has argued that the United States’ declining share of the global economy and the rise of other currencies such as the euro and yen have eroded the U.S. advantage. “The exorbitant privilege is not so exorbitant any more,” Bernanke wrote in 2016.
The dollar’s centrality to the system of global payments also increases the power of U.S. financial sanctions. Almost all trade done in U.S. dollars, even trade among other countries, can be subject to U.S. sanctions, because they are handled by so-called correspondent banks with accounts at the Federal Reserve. By cutting off the ability to transact in dollars, the United States can make it difficult for those it blacklists to do business. In 2015, the French bank BNP Paribas was given a record penalty of nearly $9 billion for violating U.S. sanctions by processing dollar payments from Cuba, Iran, and Sudan. “There’s no doubt that if the dollar were not so widely used, the reach of sanctions would be reduced,” says Setser.
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.
What are the costs?
The heightened demand for the dollar increases its value, but this comes at a cost. A stronger currency makes imports cheaper and exports more expensive, which can hurt domestic industries that sell their goods abroad and lead to job losses. During times of economic turmoil, investors seek the safety of the dollar, which squeezes exporters at an already difficult time. “When there’s a big international role for your currency, you lose control over it,” Meg Lundsager, a former U.S. executive director at the IMF, told NPR. Some experts argue that the cost of the dollar’s dominance to manufacturing-heavy regions such as the Rust Belt are too high and that the United States should voluntarily abdicate.
Some research has shown that the dollar’s outsize role in international trade can also have negative consequences for the global economy. As a country’s currency weakens, its goods exports should become cheaper and thus more competitive. But because so much trade is conducted in U.S. dollars, other countries do not always see this benefit when their currency depreciates. This phenomenon is likely to amplify the economic crisis caused by the coronavirus pandemic, IMF researchers said in a July 2020 report, as emerging and developing economies are unlikely to gain from the drop in their currencies’ value.
The United States is also harmed by currency manipulation—when another country holds down the value of its currency to maintain a large trade surplus. A country that is running a trade surplus can face pressure to let its currency appreciate, making its goods more expensive and curbing exports. It can instead keep the value of its currency artificially low by accumulating dollar reserves, hurting U.S. exporters in the process.
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.
China has been among the worst offenders, though most experts agree that it has not been heavily intervening to hold its currency down in recent years. Across Asia, however, currency intervention is on the rise again amid the coronavirus pandemic, as countries that have enjoyed relatively strong recoveries have been adding to their reserves.
Are there alternatives to the dollar?
The economic upheaval caused by the coronavirus pandemic has renewed concerns about the downfall of the dollar as the leading reserve currency. Some experts fear that the U.S. government’s massive stimulus spending, adding to a mountain of existing debt, combined with the country’s failure to control the spread of the virus could lead to a crisis of confidence in the greenback.
Yet previous predictions about the dollar’s demise, including after the 2008 financial crisis, have not come to pass. As the economist Barry Eichengreen explains in his book Exorbitant Privilege, this is a testament to both the advantages the dollar enjoys as the leading reserve currency and the lack of credible alternatives. The primacy of the dollar in trade and finance makes it the most attractive currency for countries to hold and therefore difficult to supplant.
Moreover, the most commonly floated alternatives—the euro, the renminbi, and the IMF’s Special Drawing Rights—have their own problems.
Euro. The euro is the second most used reserve currency, accounting for roughly 20 percent of global foreign exchange reserves. The European Union rivals the United States in economic size, exports more, and boasts a strong central bank and robust financial markets—factors that make its currency a viable challenger to the dollar. But the lack of a common Treasury and a unified European bond market limits its attractiveness as a reserve currency, according to Setser.
Renminbi. China, eager for the prestige and perks that come with issuing a global reserve currency, has been trying to increase the role of the renminbi, also known as the yuan. It currently accounts for just 2 percent of global reserves, and China’s efforts have been hamstrung by strict controls on the flow of money through its economy, but global usage of the renminbi has been steadily increasing. China is also pushing to increase the use of the renminbi to denominate its own trade.
Special Drawing Rights (SDR). During the Bretton Woods talks, British economist John Maynard Keynes proposed the creation of an international currency, the “bancor,” which would be administered by a global central bank. While Keynes’s plan never came to fruition, there have been calls to use the IMF’s Special Drawing Rights (SDR) —an internal currency that can be exchanged for hard currency reserves—as a global reserve currency. The value of SDR is based on five currencies: the euro, pound sterling, renminbi, U.S. dollar, and yen. Proponents argue that such a system would be more stable than one based on a national currency whose issuer must respond to both domestic and international needs. The idea of using SDR was endorsed by the governor of China’s central bank, Zhou Xiaochuan, in 2009. Economists including Joseph Stiglitz have also supported a larger role for SDR.
But for SDR to be adopted widely, it would need to function more like an actual currency, accepted in private transactions with a market for SDR-denominated debt, Eichengreen writes. The IMF would also need to be empowered to control the supply of SDR, which, given the United States’ de facto veto power within the organization’s voting structure, would be a tall order.
Cryptocurrencies. Tech evangelists dream of a world where cryptocurrencies such as Bitcoin replace government-backed currencies. Such digital currencies are “mined” and transferred via a decentralized network of computers without any issuing authority. Proponents argue that such a system would prevent countries from printing money since the supply of cryptocurrency is limited, much like the gold standard. But this would constrain a government’s policy options during a crisis. Additionally, cryptocurrencies have fluctuated wildly in value, reducing their attractiveness. Still, some countries are experimenting with their own digital currencies.
What is in the dollar’s future?
Many experts agree that the dollar will not be overtaken as the world’s leading reserve currency anytime soon. More likely, they say, is a future in which it slowly comes to share influence with other currencies, though this trend could be accelerated by the aggressive use of U.S. sanctions and the United States’ waning global leadership.
Some economists say that the dollar playing a smaller global role is nothing to fear, and that it would in fact benefit the United States. PIIE’s Bergsten argues that low interest rates resulting from the dollar’s unique status encouraged American profligacy and contributed to the 2008 financial crisis. He advocates for a greater role for the euro and renminbi, as well as for SDR. “The United States should not only accept a more varied currency regime as an inevitable reality but actively encourage such a development as part of its effort to recalibrate its own international economic position,” he wrote in Foreign Affairs. A weaker dollar resulting from lower reserve demand would make U.S. exports more competitive and potentially create jobs.
Setser also supports a larger role for the euro and renminbi, though he envisions a slow shift to a world with multiple reserve currencies and reserve assets. “Absent a catastrophic U.S. policy error, I would expect the dollar to remain the most important reserve currency for the next several decades,” he says.
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The Dollar: The World's Currency - Council on Foreign Relations
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