Over the years, global investors have typically seen reserve currencies as a safe haven to protect their assets during periods of heightened market uncertainty. We consider why the US dollar has been the preferred measure for so long, and the implications of the potential rise of competing currencies. 

There are three primary reasons why the US dollar continues to be the reserve currency of choice globally. One is that the US is a traditionally strong sovereign nation, backed by robust, persistent economic growth. Another is the democratic nature of the US government and its institutions. The international community trusts in the stability of its overarching structures. Third is a degree of inertia—the difficulty in changing the structure of global finance revolving around the dollar and US capital markets. Competing nations can boast some of these facets, but the US maintains all three advantages.

The dollar has lost some ground as a reserve currency 

However, the dollar has lost some ground as a reserve currency in recent decades. One primary reason is the effect of globalisation and its associated economic growth in many economies. Overall, this has yielded a positive outcome for the global financial system. As the global economy has grown over time, the volume of both global financial flows and international trade has expanded at a fast rate. 

As a result, the global demand for reserve currencies has started to surpass the capacity of the US—the sole issuer of the US dollar—to satisfy it. Since the launch of the euro in the 1990s, we saw some international operations shifting towards it and—to a much lesser degree—other major developed-market currencies such as the Japanese yen and the British pound. More recently, there has been a small but growing volume of global transactions quoted in Chinese yuan.

In short, it would require the significant global adoption of another currency to affect the dollar’s dominance. Despite some recent announcements of countries bypassing use of the dollar in trade contracts, the US dollar remains the dominant currency of choice for international transactions (as illustrated in the chart below).

The US dollar far outpaces rivals as a global currency 

Notes: The chart shows how broadly each currency is used across borders, using weighted averages of five metrics:  the currency’s share of globally disclosed reserves (25% weight), foreign exchange transaction volume (25%), foreign currency debt issuance (25%), foreign currency and international banking claims (12.5%) and foreign currency and international banking liabilities (12.5%). The renminbi is the currency of China and the yuan is the main unit of the currency. 

Source: The US Federal Reserve’s calculations using data as at 31 December 2022, from the International Monetary Fund, the Bank of International Settlements and Refinitiv.

The implications of the dollar’s dominance 

Having a dominant global currency provides ample demand for US debt instruments, which benefits US companies and consumers through liquidity and stability of their currency. It also allows them to theoretically borrow at interest rates that are lower than in the rest of the world. Some estimates cite about 1% in interest rate savings, which—multiplied by the roughly $8 trillion of US Treasuries held overseas—translates to about $80 billion in annual savings for the US government in interest payments. 

Being the issuer of the world reserve currency also generates another source of revenue for the US government. This “seigniorage” revenue is the purchasing power created through the printing of new US dollar notes. Since about half of the $2.3 trillion notes and coins in circulation is held overseas and with the world economy growing at 3% per year on average, the portion of the new money printed going overseas amounts to about $35 billion, according to the latest US Federal Reserve (Fed) data, as at 31 December 2022. 

There is another advantage - but it can also be a disadvantage. During times of turbulence, flights to safety increase the demand for US dollars and dollar-denominated US Treasury bonds. This becomes an important tailwind when US policymakers are trying to stimulate the US economy. 

Flight-to-safety flows put downward pressure on interest rates when the Fed would like to ease monetary conditions, creating space for any fiscal stimulus by reducing the cost of debt. However, if flight to safety takes place during normal economic times for the US, flows will exert upwards pressure on the value of the dollar, which will rise more than other currencies – and this can be a disadvantage for US trade. 

In all, there are more advantages than disadvantages for the US from having the US dollar as the global reserve currency. However, dollar dominance is never a goal in itself for the US. Rather, it’s the stability and strength of the US, including the independence and credibility of the Fed, that attracts the rest of the world towards the US dollar, voluntarily adopting it as their international currency of choice. 

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