The Idea Behind Reserve Currencies

Posted by Allison on 4 April 2009, 10:22

Until recently you may not have heard too much about the concept of reserve currencies, but thanks to the current market turmoil around the world and the wobbliness of the dollar it has become a rather more common phrase.

So what exactly are reserve currencies for and who decides which one is top of the heap?

First of all let's look at the purpose of a reserve currency.  Put simply, it is a currency which is held in vast reserves (hence the name) by different countries.  The main rule to remember is that whatever country the reserve is held in, it will always be a foreign currency to them. 

If we think of a country as a business it is easier to see how the idea of having a reserve currency works.  Let's suppose a business wants to buy a particular commodity, and the business it wants to buy it from wants to be paid in Japanese yen.  If the business doing the buying didn't have the yen available it would cause a delay in buying what it needed, as well as higher costs in transferring their own currency into the one wanted by the seller.

Now if you swap the word business for country, you will get an idea of how important reserve currencies are for each country.

It stands to reason that if major world banks and other similar organisations want to keep a large stock of a particular currency, there should be a large amount of it available for them to keep.  By default it would also be a currency which is extremely popular on the world stage, because otherwise it wouldn't be that easy to exchange for the commodities the organisation needed.  That's why currencies like the dollar, the pound and the Euro are very popular, because they are the world's biggest currencies.

It's a bit like trying to swap apples for pears when everyone would rather have peaches.  If there is no demand for what you are holding, it is next to useless.

That's why there has been a lot of discussion lately about the validity of the dollar as the world's premier reserve currency.  You don't need to be an economics or currency expert to know that the dollar is one of the world's strongest currencies.  It is available in plentiful supply and has been the world's top reserve currency for several decades.

But that could be about to change.

The key thing to remember about reserve currencies is that they don't change overnight.  The most popular currency for countries to store away tends to remain in the lead for several decades at least – and sometimes for a century or more, as in the case of the pound sterling in the 18th and 19th centuries.  So it's clear that whatever happens in the world markets, we can expect a reserve currency to remain as the most popular one for a long time before market conditions do enough damage to topple it from its premier position.

If we want to know how a currency loses its number one spot, we need to look back through history to be able to spot the warning signs.  It's pretty clear that for a currency to maintain its top position it has to be one which people have a lot of confidence in.

Just imagine for a moment that you have a savings account in pounds sterling.  You've got your life savings in there and you know that at any moment you could take any or all of it out and go and spend it on whatever you wish. 

Then disaster strikes.  The economy starts to struggle and the pound becomes weaker.  Before you know it the pound loses its value as inflation goes sky high.  One day you are buying a pint of milk for its regular price and a few days later you find that price has gone up to something ridiculous like £50.  If a pint of milk costs that much, just imagine how much something you really need such as your basic food items and heat and water would cost.

Your life savings don't look very good in pounds sterling any more, but if you had seen the warning signs in the economy you might have swapped your pounds for another currency – one that is much stronger and shows no sign of weakening.  You make the swap while the exchange rate is still good (effectively jumping ship before it sinks) and everyone else starts doing the same thing.

This, in effect, is exactly what happens when governments lose faith in the reserve currency they are currently holding and swap it for something else instead.

Could this happen to the dollar?  Some people think it will never happen, but there is no reason to suppose that it couldn't.  Every reserve currency in the past has been toppled by something else eventually – it's just a case of when it happens rather than if.

An intriguing point to note is how much of the situation is influenced by the actual economic situation and how much is influenced by the way the public (and the banks) react to what's going on.  While there is no firm answer to this it is logical to assume it is a combination of both, although there is no way to work out what percentage of each is responsible for the overall effect.

So what would happen if the dollar did fall from its position as the world's most reserved currency?

Contrary to what some scaremongers might have you believe, the sky certainly wouldn't fall in overnight.  Some people seem to like giving out the impression that the world's top reserve currency would disappear without trace if it lost its pole position.  But that is very far from the truth.  You only need to look at the pound sterling as an example of this.  It may have lost its top position years ago but it is still a powerful currency and especially given the fact that it stands fast against resisting the Euro it has done extremely well to remain as strong as it has.

So there we have it – the world of reserve currencies and their battle to get to the top spot.  The most interesting thing about the whole situation at present is to see how much longer the dollar lasts.  According to some it will still be there long after we have all left the planet for the great hereafter, and according to others it only has days to go.

Whatever turns out to be the truth it will be interesting to see which currency finally manages to take its place.  Many suspect the Euro of doing just this, but others think it is too young a currency to take such a lofty position at the moment.  The pound sterling is still one of the world's most traded currencies, but not many people think it is seriously in the running to regain the top spot.

In the end this could be a two horse race – but it looks set to go on for some time yet.  And who's to say the dollar won't regain some of its earlier strength and see off all comers?