FX International Payments
By Megan Doyle
This article explains what international currency reserves are, why central banks hold reserves, the U.S. dollar’s dominance of the foreign exchange (FX) market and of global currency reserves, and what some countries are doing to boost their own currencies in response to USD’s prevalence.
International currency reserves are foreign currencies held by another country’s central bank. Central banks typically choose to reserve international currencies that are inherently stable – USD, for instance – to provide a predictable and consistently effective medium of exchange.2 The most common currency held in reserves is by far the dollar, making up nearly two thirds of the $11.42 trillion total international reserves.3 For comparison sake, the euro – the second most common reserve currency – makes up just under 20 percent of known central bank currency reserves.4 Other popular reserves are the yuan, yen, and sterling.
Typically, countries with the largest trade surpluses – China and Japan, for example – have the greatest foreign reserves because they receive large sums of foreign currency (particularly USD) in exchange for exports.5 These currency reserves are most often held in low-risk assets, such as cash deposits and sovereign bonds, rather than as equity.6
In addition to holding specific foreign currencies as reserves, all central banks hold gold and the International Monetary Fund’s (IMF’s) special drawing rights (SDR) as universal foreign exchange reserve assets. Like foreign currency reserves, both gold and SDRs are primarily held as contingencies in case of potential economic crises or other emergencies.7 Gold, like foreign currencies, can be traded, but an SDR is unique in that it is essentially an artificial currency that can only be allocated by the IMF. SDRs were created in 1969 as a response to concerns about the limitations of dollars and gold as physical assets, acting as a supplement to standard currency reserves.8 SDRs are based on a currency basket consisting of USD, the euro, yen, sterling, and yuan.9 Currently, 33,813 tons of gold,10 or approximately $1.4 trillion USD,11 are held by central banks internationally, and $291 billion in SDRs is allocated to central banks.12
Currency reserves can serve a number of different purposes, but they’re generally used to help promote stability for national economies and their currencies. While currency reserves can help simplify global trade by providing a unified basis for international money exchange and by facilitating global trade, their role in the foreign-exchange market can be a good bit more complicated.13
Currency reserves are often used to provide economies and central banks with the flexibility and resilience needed to hedge against market volatility, such as potential global financial crises or rapid currency devaluation.14 In other words, a country with a floating currency might choose to sell some of their dollar reserves in exchange for their national denomination to influence the FX market. This can lessen exchange rate volatility and restore liquidity in the face of unstable market conditions.15
Similarly, countries with fixed exchange rates can use their reserves to influence the FX market. Countries with currencies pegged to the dollar might use their stash of dollars to influence the foreign exchange market, buying or selling currency to ensure FX rates do not go too far above or below their targeted rate.16
China – the U.S.’s number one trading partner in the first quarter of 201817 and the country with the largest holding of currency reserves – has $3.111 trillion in foreign currency reserves, including $73.7 billion in gold.18 Beyond those numbers, the exact composition of China’s reserves is confidential. Experts estimate, though, that about 67 percent is composed of USD assets.19
Despite the dollar making up almost two thirds of all currency reserves worldwide, the U.S. holds very little reserves in comparison. As of mid-May 2018, the U.S. held foreign currency reserves totaling $42.5 billion – $12.3 billion of which were euros, $2.99 billion yen, and $27.2 billion in other international currencies. In addition, the U.S. holds $50.9 billion in SDRs and $11 billion in gold.20
Most of the U.S.’s top trading partners have foreign currency reserves greater than that of the U.S. Japan, our fourth-largest trading partner during first-quarter 2018, comes in second to China with $1.19 trillion in international currency reserves.21 Although Japan does not disclose individual currency composition, experts estimate its reserves consist largely of short-term U.S. Treasury securities.22 In addition, Japan holds $19.1 billion in SDRs and $32.1 billion in gold.23 Canada, the U.S.’s second-largest trading partner, holds a total of $70.8 billion foreign currency reserves, comprised of $46.821 billion USD, $15 billion euros, $8 billion pounds, and $942 million yen. On top of Canada’s foreign currency reserves, they hold $7.97 billion in SDRs, but no gold.24 Mexico, our third-largest trading partner, holds $164.9 billion in currency reserves, $3.87 billion SDRs, and $5.1 billion in gold with no indication regarding the precise currency makeup.25
Every day, the dollar is used in almost 90 percent of all transactions in the currency exchange market26; the dollar’s vital role is no secret. But how did the USD come to be so prominent? The primary reason is that oil has been priced and paid for in U.S. dollars for over 50 years – a fact that, in conjunction with oil’s important role in the global economy, has led to a strong, stable, and dominant dollar.
In response to the dollar’s global dominance, a growing number of countries have begun to advocate for a new international reserve currency that “is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies,” according to former governor of the People’s Bank of China, Zhou Xiaochuan.27 China, Russia, Venezuela, and Iran have all taken strides towards gaining independence from the dollar, with the intent to quell USD’s dominance in favor of increasing their individual currencies’ profiles.
China, for example, introduced the world’s first yuan-denominated oil contracts in March of 2018. Russia has begun to increase its gold reserves in an attempt to move away from the dollar. Venezuela launched its own cryptocurrency in 2018, and Iran recently “pledged to replace the dollar with the euro in its foreign-currency accounting,” according to the Wall Street Journal.28
But for countries working to ramp up their own currencies and stray from decades-long dependence on the dollar, it’s likely the process will require both time and policy, say analysts. For example, the Chinese yuan currently makes up only 1.2 percent of foreign currency reserves around the world due to Chinese capital controls that prevent the yuan from being freely traded in FX markets. Thus, it’s unlikely the yuan will garner widespread attention unless these capital controls are lifted – a transition that could take years.29,30
Similarly, the IMF has promoted the idea of extending the role of SDRs to include acting as a tradeable currency. In other words, SDRs would become a global currency independent of any sovereign currency, “expanding the range of new assets used around the world in public and private transactions” while boosting “its use as a unit of account,” says economist Mohamed El-Erian.31 However, El-Erian suggests the IMF proposal will face political challenges.32
International currency reserves are a crucial component of the global FX market, helping countries make international payments and hedge against foreign exchange market risks. While the U.S. dollar clearly dominates global reserves, several countries are working towards increasing the potential of their own currencies with the intent to create more balance in the global economy.
Megan Doyle is a business technology writer and researcher based in Wantagh, NY, whose work focuses primarily on financial services technology.
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