Reserve currencies – what they are
A much discussed topic lately is the role of the US dollar as a reserve currency. The US dollar is held as a reserve of international purchasing power or liquidity by governments, banks and firms. The US dollar is mostly nominated as the basis of contracts, as the unit for transacting and accounting purposes, across borders between parties outside the US. It was because of the large role played by US firms in global trade and finance that the US dollar became the reserve currency of choice in the twentieth century increasingly replacing the pound sterling as the predominant unit of account in international transactions. The pound sterling had gained this role because of the earlier dominance of the UK in nineteenth century global trade and financial flows.
Until the early seventies the US dollars held by foreign central banks could be exchanged for gold at the rate of 35 dollars per Troy ounce of gold. Since many other central banks also kept their gold at Fort Knox in Kentucky such transactions would take the convenient form of moving gold from one part of the fort to another. The US unilaterally went off the gold standard in 1971. The UK gave up its willingness to exchange gold for pounds finally in 1932 after earlier phases of inconvertibility during the Napoleonic and First World Wars and their aftermaths. Gold is still held as a minor source of international purchasing power by governments and their central banks – still often safely stored for them in Fort Knox.
Reserve currencies emerge in response to market forces
Reserve currencies are not declared by some international agency – they emerge in response to the global needs of trade and finance. The possibility of one reserve currency increasingly replacing another is clearly always possible given the freedom contracting parties have to nominate a convenient unit of account in which to conclude a contract. Governments and banks also have the freedom to choose the most helpful currency or currencies in which to hold their reserves of international purchasing power. These reserves are mostly kept in the form of US dollar deposits in foreign banks including other central banks. Reserves of liquidity are also kept by in the bills and bonds issued by the US government that pay higher rates of interest tan bank deposits.
The advantages to the issuer of a reserve currency
The advantage to the issuer of a currency or bonds or bills held as reserves by others is that these demands reduce their costs of funding government expenditure. The notes issued by a central bank are the non-interest bearing liabilities of the issuing central bank. That foreign holders of these notes, in addition to their domestic holders, are prepared to forgo interest on the their cash – for the convenience it offers – including the ability to evade surveillance by tax authorities – makes issuing notes a particularly cheap source of finance for the government. A large proportion of the actual greenbacks are in fact held outside of the US so helping to fund US government spending.
The costs of issuing notes
Not that issuing the notes is without its costs – the costs are incurred in the protections the issuing government that have to take against counterfeiters as well as highjackers of cash in transit. Government have to insure the safety of the notes issue if economic actors are to be willing to hold them. The difference between the interest governments save by issuing notes rather than bills and bonds and their costs – including the costs of staffing their central banks – is called seignorage and is implicit in the dividends central banks declare to their governments. In South Africa unusually, this central banks income from issuing non interest bearing notes, is still shared in small part with some private owners of Reserve Bank debt in the form of a fixed coupon payment.
The essence of a well respected unit of account and reserve currency
Domestic currencies serve perfectly usefully as the unit of account for the many contracts entered into between domestic parties. Both domestic parties will be well aware of the real value of the contract when fulfilled. Clearly for a foreign currency to be nominated as the unit of account in a contract indicates that something must be considered unsuitable in the domestic currency by one or other of the parties involved. This unsuitability presumably arises out of the relative unpredictability of the exchange value of the domestic currency. Presumably reserve currencies must offer predictability in the rate they can be exchanged for domestic currencies.
Does the US dollar meet the criteria – does any other currency?
An essential quality of a reserve currency must be the predictability of its rate of exchange for all other currencies. It is surely this lack of predictability of the exchange value of the US dollar that calls into question its continued role as the predominant reserve currency. Clearly if a reserve currency strengthens this will be highly acceptable to its holders and vice versa will be uncomfortable when it generally weakens against other currencies. However even unpredictable strength will make the currency less useful for purposes of trade or finance. The requirement is rather predictability of value though predictable strength rather than predictable weakness will clearly to be preferred by holders of a reserve currency.
The US dollar has not been very predictable – not that it has been a one way bet
We show the exchange value of the US dollar against the other major currencies in recent years. Higher numbers indicate strength. As may be seen the US dollar was very strong in the mid eighties. It weakened sharply in the late eighties and traded at these weaker levels more or less stably until the mid nineties when a further period of pronounced strength emerged that was reversed over much of the past decade.
The US is extremely reluctant to commit itself to policies that would stabilise the US dollar at the possible expense of the US economy. But unless its attempts to stabilise the US economy help co-incidentally to stabilise the US dollar far better than has been the case over the past 30 years, the suitability of the US dollar or other US government liabilities as a reserve will remain a live issue. But no other currency has presented itself as suitable as is the US dollar for the purposes of undertaking global trade and finance.
Gold is still making a case as a reserve
No other country, or in the case of the euro, the European governments collectively, seem willing to commit to currency stability while also allowing currency convertibility. The Chinese may offer predictability in the yuan – but not easy convertibility. They fear how such a commitment could qualify them for reserve currency status. They are aware that such a commitment, even when believed, may constrain their freedom to manage their domestic economies. The contest for global currency supremacy can however never be regarded as decided as over. It remains up to the market place and government policies to decide the outcome. While the outcomes remain particularly uncertain as they now are gold is likely to retain its appeal as a contingency against the unpredictability s of other stores of value