1. Money
Send to a Friend via Email
You can opt-out at any time. Please refer to our privacy policy for contact information.

What is a Reserve Currency?

Reserve Currency from Bretton Woods to China's Yuan

By

A reserve currency is a currency held in significant quantities by many governments and institutions as a means of international payment. While this used to consist of mostly gold and silver, the Bretton Woods system expanded acceptable reserves to include the U.S. dollar and other currencies. And since 1973, no major currencies can be officially converted into gold.

Regardless, reserve currency is held in order to support the value of national currencies. For instance, Mexico issues pesos (which are essentially IOUs) to its citizens and repurchases them with U.S. dollars, euros, or other reserve currency around the world held by its central bank. Countries can also hold gold or other precious metals in their official reserves.

Reserve Currency History and Future

The U.S. dollar replaced the British pound sterling as the world's reserve currency circa 1945 with the help of the Bretton Woods agreements. At the time, the U.S. dollar was the currency with the greatest purchasing power and the only currency backed by gold (although this backing was eliminated in 1973).

But the U.S. dollar isn't likely to be the world's reserve currency forever. The euro has become increasingly popular as a reserve currency, despite the 2010-2011 sovereign debt crisis that weakened it. And China's yuan is also emerging as a key potential reserve currency, if it's successful in undergoing several important economic reforms.

For example, China would have to ease restrictions on money entering and leaving its country, make it fully convertible for all transactions, help make its bond market more liquid, and continue domestic financial reforms aimed at greater transparency. Still, it's hard for many investors to ignore the fact that China's the largest creditor, and soon exporter, in the world.

Reserve Currency & Monetary Policy

Monetary policy has a strong effect on foreign currency reserves. Most major economies with flexible or floating exchange rate schemes clear excess supply and demand by purchasing or selling reserve currency. For instance, a country looking to boost the value of its currency can repurchase its national currency with its foreign currency reserves.

Other countries may employ a fixed exchange rate schemes for a variety of reasons. Under this type of system, supply and demand can move the value of its national currency higher or lower. For example, increased demand for a national currency (e.g. due to a relatively strong economy) would lead to a higher value for its currency.

Countries also continuously monitor major reserve currencies to ensure that their holdings aren't adversely affected. For instance, significant inflation in the U.S. could cause a devaluation of the dollar and the subsequent devaluation of foreign currency reserves. Ultimately, this then limits the monetary policy benefits achievable using these reserves.

Countries with the Most Reserve Currency

Countries hold reserve currency for a number of different reasons. They are an important indicator of ability to repay foreign debt, to defend a national currency, and even to determine sovereign credit ratings.

Here are the top five countries with the most foreign reserve currency:

  1. China - $3.2 Trillion
  2. Japan - $1.1 Trillion
  3. Russia - $516 Billion
  4. Saudi Arabia - $484 Billion
  5. Brazil - $352 Billion

There are also some non-governmental organizations with reserve currency holdings:

  1. European Economic Area - $1.4 Trillion
  2. European Union - $1.36 Trillion
  3. Eurozone - $840 Billion

Reserve Currency Takeaway Points

  • Reserve currency is held in significant quantities by many governments and institutions as a means of international payment.
  • Reserve currency can be used by central banks to pay foreign debts and defend national currency, while also helping to determine sovereign ratings.
  • The largest holders of reserve currency are China, Japan and Russia.

©2014 About.com. All rights reserved.