The international role of the USD could preclude the dollar losing reserve currency status for many reasons. And one of these reasons is, besides its network effect, the size of the dollar’s relative percentage of world forex reserves. However, these are just some of the reasons why the U.S. Dollar won’t lose reserve currency status.
There’s obviously quite a bit more that goes into it, so I’ll cover this in more depth. As a source for this article, I’m using the data and graphs provided by the Federal Reserve in their explanation of the international role of the US Dollar.
But, that is not to say that this is the only interpretation of the future of the Dollar’s reserve currency status. In future articles I’ll discuss the counterpoint to this argument, highlighting data and reasons why the US Dollar may lose its status as the world’s go-to currency.
The Historic Role of the US Dollar
According to the Federal Reserve, “for most of the last century, the preeminent role of the USD in the global economy has been supported by the size and strength of the U.S. economy… its stability and openness of trade and capital flows and strong property rights and rule of law.”
So, by most measures, the US dollar is the dominant world currency and plays an outsized international role, relative to the US share of global Gross Domestic Product (GDP). The US GDP was approximately 23-25% of the world GDP as of Q4 2020, but the US Dollar accounted for almost 60% of internationally disclosed forex reserves. The US dollar, therefore, enjoys well over double the percentage of FOREX (FX) reserves compared to its share of the global economy in terms of its GDP.
With the dollar being used for the majority of countries’ FX reserves, it stands to reason that this will continue due to widespread confidence in its function as a store of value. That is, in the opinion of the Federal Reserve.
The key function of a currency is that it serves as “a store of value which can be saved and retrieved in the future without a significant loss of purchasing power”. The US dollar accounted for most of the world’s stored value at more than 70% historically, followed by the Euro at around 20%. The rest of the major nation’s currencies account for the remaining 10% combined. However, by 2020, the US Dollar declined to around 60%. The Federal Reserve explained the reason for this as being the expansion in the number of currencies utilized, rather than a single currency being preferred over the US dollar.
It’s noteworthy that the Chinese Renminbi accounted for 2% in 2020 after accounting for zero percent in 2015.
While most countries have diversified their reserve holdings somewhat over the past two decades, the US dollar remains, by far, the dominant reserve currency.
US Treasury Securities
According to the Federal Reserve, “the bulk of official dollar reserves are held in the form of U.S treasury securities”. They are in high demand by both official and private foreign investors. By the end of the first quarter of 2021, $7 trillion, or 33% of marketable treasury securities outstanding, were held by foreign investors, both official and private.
Foreign treasury securities holdings increased in the years up to 2010 to around 50% and have slowly declined since then. Domestic treasury securities holdings have fluctuated between 35% and 50% over the past two decades.
An interesting point is made by the Federal Reserve’s graph (below) showing the foreign investment in the Eurozone. Since 2010, there’s been a slow but steady increase in foreign investment into the Euro area, while the US has seen a slow decline. And in 2020, the Eurozone saw an increase in foreign investors that exceeded the US market as a percentage of foreign investors in general government debt securities.
A similar trend plays out in the Japanese markets, where the percentage of foreign investors in Japanese government debt securities has steadily increased from below 10% in 2005 to around 30% in 2020.
The Federal Reserve reports that “Foreign investors also hold substantial amounts of paper banknotes. The value of US dollar banknotes held abroad has increased over the past two decades in both absolute and as a fraction of banknotes outstanding”.
In the mid- to late-2000s, the number of banknotes held by foreign entities was around 32% and slowly increased until it reached just over 40% by 2020. In this same period, the number of US banknotes in circulation went from just over $200 billion around 2005 and escalated to almost $1,000 billion by 2020.
So, the bulk of official foreign reserves are held in US treasury securities, but they appear to be separate from the foreign country’s FX reserves. However, treasury securities also appear to be utilized as a form of money. For larger institutions and large investors, they operate in a way that offers security in the form of risk mitigation against pure currency holdings. Rather than holding US dollars, where there is a significant amount of risk in holding cash, treasury securities have the US government as the counterparty.
With treasury securities being used as collateral in the repo market and money markets, it makes more sense when you see that they are like US dollars, but not necessarily paper currency. They are all forms of money denominated in US dollars. This goes back to the discussion on central bank digital currencies and whether the currency itself should bear interest, as that is essentially what a US treasury does. The dollars in your bank account are just a form of debt with commercial banks holding the liability for the dollars that you own.
The difference is that the treasury securities are backed by the US government and those “dollars” bear interest.
There are similarities with respect to bank reserves, where, before they had IOER or Interest On Excess Reserves. Now they have IORB, which is Interest On Reserve Balances (as they are all technically an excess). I discuss elsewhere how the two systems meshed into one another and now there is no reserve requirement anymore.
Anchor Currency
But getting back to another reason why the US currency won’t lose its reserve status; many countries anchor their currency value to the US dollar. They leverage its store of value in this way by pegging their currency to the dollar. About 50% of the world’s GDP in 2005 was produced in countries with currencies anchored to the US dollar. That figure excludes the US itself.
In conclusion, unless the network effects of the US dollar with the Euro/Dollar system and shadow banking, in general, can be replaced by something similar, or better than that network, then it is unlikely that the US dollar will be replaced any time soon. But that is not to say that it will never die out. Every fiat currency in history has gone to zero eventually, as that is its fundamental value.
What it comes down to for individuals, is to understand the risks and diversify accordingly.
Alternatives
With the world changing so fast and the growth of alternative forms of money. Central banks are turning toward central bank digital currencies in order to maintain their grip on money. For more on CBDCs, click HERE.
References
[1] https://www.federalreserve.gov/econres/notes/feds-notes/the-international-role-of-the-u-s-dollar-20211006.htm
