How the US dollar became the world's most powerful reserve currency

What is a reserve currency? How did the dollar come to dominate global trade and finance? And why might some countries prefer to steer clear of the role altogether? Read on to find out

The US dollar’s sharp slide in recent months has paused, but fears about its long-term stability linger. As analysts assess the damage done by Donald Trump’s trade wars and the shifting tides of geopolitics, the dollar’s status as the world’s leading reserve currency is once again under scrutiny.

 

But what exactly is a reserve currency? How did the dollar come to dominate global trade and finance? And why might some countries prefer to steer clear of the role altogether?

 

What is a reserve currency?

A reserve currency is a foreign currency held in significant quantities by central banks and financial institutions as part of their foreign exchange reserves. These reserves serve various purposes: they help stabilise a country’s currency, reassure foreign creditors, facilitate international trade, and provide a cushion during times of economic crisis.

 

 

Since global trade is often conducted in a small number of major currencies, countries need access to those currencies to pay for imports or service debts. Holding reserves, usually in the form of highly liquid assets like government bonds, ensures they can do so. The most widely held reserve currencies are also those associated with large, stable, and open financial markets.

 

When did the US dollar become the world’s reserve currency?

Although some economists argue that the US dollar began overtaking the British pound as the leading reserve currency in the 1920s, the turning point came in 1944 at the Bretton Woods Conference.

 

Held in the final phase of World War-II, this meeting of 44 allied nations aimed to establish a new post-war monetary order. Delegates agreed to create the International Monetary Fund (IMF) and the World Bank, and most crucially, to peg their currencies to the US dollar, which in turn would be backed by gold at a fixed rate of $35 per ounce.

 

What made the US dollar the right choice?

The decision was backed by this logic: the US economy was then the world’s largest, and its gold reserves accounted for over two-thirds of global holdings. American industry was intact and booming, unlike Europe and Asia, which had been ravaged by war. The dollar thus became the linchpin of international finance.

 

Dollar-gold convertibility to floating rates

The Bretton Woods system was designed to bring monetary stability and avoid the competitive devaluations and trade barriers that had deepened the Great Depression. But by the 1960s, the US could no longer guarantee full dollar-gold convertibility. This was because there were too many dollars circulating globally and not enough gold to back them.

 

Fearing a run on its reserves, President Richard Nixon ended dollar-gold convertibility in 1971. By 1973, the world had moved to a system of mostly floating exchange rates.

 

How Asia kept the US dollar strong

Asian markets also played a significant role in ensuring the US dollar’s dominance as a global currency, especially as the world moved to adopt floating exchange rates. As the British pound lost its value in the late 1960s, wealthy Chinese families who had made money in industries like rubber and tin started moving their wealth into US dollars instead. According to a report by Bloomberg, the US dollar became the go-to safe currency, replacing the pound as the dominant global currency in Asia. 

 

In 1968, Singapore became a popular place for wealthy Asians to store their money in US dollars. The country created a special market for dollar-based investments, helping to make the dollar stronger. Even though Hong Kong could have played a similar role, it was slower to get started because local banks didn’t want too much money flowing out of the city.

 

Global trust in American institutions, deep and liquid capital markets (particularly US Treasury bonds), and the pricing of key commodities like oil in dollars all helped the currency retain its dominance.

 

Why the dollar’s drop is a double-edged sword for trade

Many countries manage their own currencies by pegging them to the dollar or maintaining tight bands around it. Others, like Panama and Ecuador, use the dollar outright. Even when countries allow their currencies to float, trade in goods and commodities often remains dollar-denominated, which blunts the typical benefits of currency depreciation.

 

When a country’s currency weakens, it can be seen as an advantage for trade partners to import cheaper goods. However, if the exports are priced in dollars and the US dollar depreciates, then the importers may not gain from the currency fluctuation.

 

Why China has resisted a reserve currency status

While having a reserve currency brings benefits, it also has downsides. To supply the world with dollars, the US must run trade and budget deficits, which can create vulnerabilities. Heavy demand for the currency can drive up its value, hurting US exporters.

 

Many countries, including China, have been more cautious. China has taken steps to internationalise its renminbi (also known as Chinese yuan), and the IMF included it in its basket of major reserve currencies in 2016. But Beijing has remained wary of fully opening its capital account, fearing that uncontrolled money flows could destabilise its economy.

 

Switzerland is another case in point. The Swiss franc is highly trusted and does serve as a minor reserve currency. But the Swiss National Bank (SNB) has actively tried to prevent the franc from becoming too attractive. Inflows of speculative capital can drive up the franc’s value, hurting the export-driven economy. Between 2011 and 2015, the SNB even imposed a currency cap against the euro to limit appreciation.

 

In 2014, Swiss officials even clarified that they had no intention of encouraging the franc’s rise as a global reserve.