Being the nation whose currency holds the status of the world’s reserve currency comes with a few advantages for that country. The most significant of these is the ability to settle balance of payments (difference between what a country imports and what it exports) in one’s own currency which facilitates trade for the reserve nation and reinforces the trade of that currency internationally. The central bank of the reserve country also in effect becomes the world’s bank, and its central bank is able to control financial conditions by expanding or contracting money supply. The Federal Reserve is evidence of this. There is also a geopolitical advantage to having the world’s reserve currency. Deposits and transactions can be monitored, secured, or even halted by the reserve country.

Currently the U.S enjoys this privilege. The question is whether or not they will be able to hold on to this status in the future?

Global trade is still, for the most part, conducted in U.S dollars. Trade data shows that around 88% of global transactions are conducted in dollars. While currencies such as the Yuan have been gaining acceptance internationally, they hold nowhere near the share of FX volume that the dollar commands. See Figure 1.

Being able to settle their balance of payments in their home currency provides the U.S with a big advantage. This not only lowers transaction costs due to lower exchange rate risk but also provides the ability to borrow cheaply in one’s own currency to pay for imports. Having global trade dominated by the dollar creates strong networks for the settlement of trade in that currency. Furthermore, as the reserve currency the dollar tends to appreciate during times of crises despite the U.S running a current account deficit. With the dollar being central to the global financial architecture the U.S is able to control both local and global financial conditions by lowering domestic interest rates and expanding their monetary base.

There is a further political advantage for the U.S holding the reserve status, which is often overlooked, and which is that transactions conducted in dollars anywhere in the world fall under U.S law. Any company or country which conducts transactions in dollars can be sanctioned by the U.S and as most cannot afford to be locked out of the U.S financial system they will tend to comply with sanctions. We see this even in companies that operate under great powers such as China and Russia, who comply with U.S sanctions as they cannot afford to jeopardize trading relations with U.S allies like Europe.
Historically reserve currencies have tended to endure for about 100 years. Wars have tended to end the reign of that country and give rise to a new one whose currency becomes the basis for international trade. Such was the case for Spain, France, the UK, and the United States in a pattern of war and peace since the sixteenth century. See Figure 2. Given that the dollar rose as reserve currency in the 1920’s, it may be reasonable to ask whether there is a chance of this happening now.

Let’s take a look at the makeup of a reserve currency nation. Typically, the reserve nation tends to be the wealthiest or “greatest” nation which ensures that its currency is a store of value and that it can act as a buyer of last resort during a crisis. See Figure 3. Currently there is huge competition in the race to be the next great superpower. China is a larger trading partner than the U.S for many emerging markets and is set to surpass the U.S economy in size over the next decade. Although the Yuan has a long way to go to rival the dollar, its share of global reserves is smaller versus its global trade output meaning that there is room to grow in terms of reserves. To maintain its dominance the reserve nation needs a military presence which is stronger than that of others. U.S military spending remains the biggest in the world and their military presence is the most significant. However, China is aggressively increasing their spend on military and in particular naval power, increasing their military control over parts of Asia.

The reserve currency nation needs to run a trade deficit in order to finance activity in the rest of the world. For this the country requires a very liquid capital market. The U.S Treasury market is by far the most liquid exchange for debt in the world. We are however seeing that euro and yen denominated growth is exploding.

The bottom line is that the U.S dollar is gradually declining as a share of the global currency reserve basket (from around 80% in the 1970’s to around 60% today), just as the U.S economy and military are gradually declining as a share of global output and defence spending. Yet the U.S will remain the first or second largest economy and premier military power for a long time. See Figure 4.

China on the other hand is facing a severe test of its political and economic system. China has recently increased regulation on their major internet companies which has unnerved investors. The amount of policy uncertainty in China is likely to see global flows favour the dollar.

For now, the U.S. dollar remains King and most likely will for a while to come. It is however worth noting the changes to this space with the rise in strength of nations such as China.