How the U.S. Dollar Spread Across the World
The U.S. dollar is currently accepted as the world’s reserve currency, but it hasn't always been this way. Reserve currencies change depending on macroeconomic trends: typically, the reserve currency belongs to the world’s most stable and influential economy. The U.S. dollar has been the official reserve currency since the end of World War II, when the world’s powers agreed to implement the Bretton Woods System, officially setting the U.S. dollar as the anchor currency that could be exchanged at a fixed rate for gold. In 1971, the U.S. ended the dollar's linkage to gold and it became free floating (fiat currency), but it continued to be used a reserve currency by many countries.
The world’s dominant currency seems to change about every 100 years: Portugal held the dominant currency during the 15th and 16th centuries; Spain during the 16th and 17th centuries; Netherlands during the 17th and 18th; France during the 18th and start of the 19th; Britain during the 19th and beginning of the 20th; and the U.S. since about 1929. But the idea of a true reserve currency did not emerge until the 1860s, when Britain and most industrialized nations created central banks and treasuries, and tied their currency to the value of gold.
The U.S. dollar's reserve currency status gives Americans and the U.S. government easier access to low-cost borrowing and also lowers the cost of imports, since there is no need to convert U.S. currency. The stability of the U.S. dollar tends to have the effect of increasing its value relative to other currencies. This actually hurts U.S. exporters because their goods and services are more expensive than competing goods and services in other countries.
How long will the U.S. dollar persist as the global reserve currency? And what could possibly replace it?
When the pound sterling was the dominant currency, more than half of all world trade was invoiced in pound sterling; British banks were expanding and Britain was the number one foreign investor in the world. But eventually, other countries started to put up tariffs and protectionist policies and the pound sterling lost its dominance. As for the U.S., it is no longer the biggest foreign investor (China is) and instead of being the largest exporter of goods and services, it has the largest amount of debt in the world. Nevertheless, the U.S. economy remains relatively stable, and the dollar's share in foreign exchange trades has actually risen slightly since the financial crisis.
The most important determinants of reserve currency status are the size, stability, and liquidity of financial markets. At this point in time, The U.S.’ capital markets are a lot bigger and more liquid than China’s. Although the Chinese government is working on developing its financial markets, progress is slow and the yuan is not yet fully convertible. Moreover, the government frequently intervenes in the Chinese market — now known first and foremost for its instability.
It's hard to imagine the Chinese yuan becoming the dominant reserve currency anytime soon. Some see the recent establishment of the Asian Infrastructure Investment Bank as a signal of the end of the US and the IMF’s economic dominance. But what is more likely is that the U.S. dollar will decline in prominence as other currencies, like the yuan and the euro, become more widely circulated.
No doubt, China's influence on the global economy is growing. But the U.S. remains a stable place to invest, and holds a lot of influence over the global economy — despite what many U.S. dollar doomsdayers are saying. We’re likely to witness a more diverse set of reserve currencies and a gradual movement away from the U.S. dollar. The truth is, though, that no one really knows what will happen to the dollar's reserve currency status 10 to 20 years from now.
What do you think?
Will the Chinese yuan overtake the dollar as the world’s dominant reserve currency? What will be the effect on the US economy?
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Sources: How the U.S. Dollar Spread