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Close look: Reserve currencies - What's the big story?

2 years ago

The US dollar, known the world over as the greenback, has long enjoyed its place as the global reserve currency. That position might sound exclusive but, as ever, there are contenders for the title among the world’s other major currencies. We check out the meaning of this global reserve status, the benefits it brings and who is hot on the dollar’s heels.

Reserve currencies are held by central banks around the world as part of their foreign exchange reserves. They can be used for international transactions or investments. In other words, these currencies are there to meet the overseas commitments of that country. A reserve currency is seen as safe, allowing confidence that the value of a trade made today will be the same when the transaction is completed.

Why would the value change? Currencies rise and fall depending on supply and demand, just like commodities such as gold or oil. As an example, demand for Hong Kong dollars recently rocketed due to the IPO of Ant Group. The ‘central bank’ was then forced to act to prevent a breach of their trading bands. Factors such as shifts in economic prospects or tweaks to interest rates can also impact one currency’s value relative to another.

So who are the rivals for the dollar’s global reserve status? The closest contenders are the euro and China’s renminbi. Why vie for the title? As demand for a country’s currency grows, its borrowing costs naturally fall. This can bring a significant advantage. In the case of the US, it’s worth more than $100bn per year. And that’s unlikely to fade anytime soon. The dollar represents over 60% of global currency reserves. The euro makes a poor second at around 20%.

In times of trouble, such as the pandemic volatility spike in March 2020, the US dollar shines out as the ultimate safe-haven. Despite the US Federal Reserve’s cutting interest rates to zero for the first time ever- there was a rush to buy the greenback and the US dollar index soared. These old habits die hard, and the dollar looks set to dominate currency reserves for many years to come.

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