What Is A Reserve Currency?
A reserve currency is a currency that is widely accepted around the world as a method of payment between countries for goods and services. Reserve currencies are also widely held by governments and central banks as foreign exchange reserves and to settle international debt obligations.
Past And Current Reserve Currencies
The U.S. dollar (USD) has been the primary reserve currency since the end of World War II, which is when it replaced the British pound. Other currencies generally accepted as reserve currencies include the euro, Japanese yen, Swiss franc and Chinese yuan. Most commodities, such as oil, are priced in a reserve currency, usually the USD, which basically mandates that countries hold these currencies in order to pay for things.
Reserve currencies achieve that status largely due to the underlying size and strength of that country's economy and government, and the fact that these currencies circulate widely outside their home countries. That gives governments, businesses and consumers in other countries confidence that they will be paid. Reserve currencies are also sometimes called "hard currencies."
Other than the aforementioned currencies, most countries' currencies are not accepted by other countries for payment. This is generally because they are basically worthless elsewhere.
For example, if Mexico sold oil to Bolivia, it probably would not accept payment in that country's currency, the boliviano. Rather, Bolivia would need to first convert its currency into dollars, or another globally acceptable currency, and then pay Mexico with that.
Foreign Exchange Reserves
Many countries stockpile reserve currencies, which are also called foreign exchange reserves, in order to cover future payments as they come due. Foreign exchange reserves are also used by countries as a safe haven during financial crises and to support the value of their own currencies.
For example, if a country's own currency starts to lose value, which makes imported goods more expensive, it can sell some of its foreign exchange reserves to buy its own currency to prop it up. Similarly, if its currency becomes too strong, which makes its goods more expensive in other countries, it can sell its currency to try to weaken it. Many countries also stockpile reserve currencies in order to buttress their credit ratings.
Reserves can be held in actual cash as well as government bonds and other securities denominated in the reserve currency. For example, U.S. government bonds are considered the safest securities in the world.
Countries acquire reserve currencies by buying them on international currency markets or accumulating them through a trade surplus. For example, for years China has run a trade surplus with the U.S. and other countries, enabling it to increase its reserves of the USD and other currencies.
Many countries also hold gold in their reserves, though using currencies to settle transactions is less cumbersome.
Reserve currencies, also known as hard currencies, are those that are generally accepted worldwide as payment for goods and services and to settle debt obligations due to their wide circulation and reputation for safety. The USD is the primary reserve currency, although other currencies, such as the euro and the Japanese yen, are also considered to be reserve currencies.
Many countries stockpile reserve currencies, which are also called foreign exchange reserves, as a sort of savings account to make future payments and to manipulate or stabilise the value of their own currencies.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…