People sometimes talk about “reserve currency” status as if it’s something that is taken by force or bestowed on some country. But what does it really mean to be a “reserve” currency? A reserve currency is simply a currency that is in high demand from other countries. It is a highly reliable and viable international currency. Of course, the USA is commonly thought of as the world’s “reserve” currency, but there are actually many reserve currencies like Yen and Euro as well. They’re not necessarily the same caliber reserve currency as dollars, but they’re very high up there.
The reason why US dollars are the highest quality reserve currency is a function of demand. And the reason the dollar is in such high demand around the world is due to the fact that the US dollar is the currency that gives you access to 22% of world’s most high quality and productive output. The way this plays out in international markets is quite simple. China sells the USA pieces of plastic in exchange for Dollars. China doesn’t want the pieces of plastic. They want the Dollars because with those dollars comes domestic investment and domestic employment. China is better off in the long run by trading their pieces of plastic in exchange for domestic investment and employment. So, they end up with a “reserve” of dollars which they can either sit on, invest in T-bonds or implement other strategic measures.
The key point there is to understand that China wants to do a lot of business with the USA. And they want to do a lot of business with the USA because the USA is the world’s largest economy. But it’s not just a large economy. It’s an economy that produces high quality and diverse output. This increases the demand for dollars on global markets because it is essentially the high quality asset in the world. A foreign government might be hesitant to own foreign currency, but when its backed by the most powerful multinational corporations on Earth that alleviates this concern a great deal. But this wasn’t something that was bestowed upon the USA. It was earned through hundreds of years of high quality growth.
This is important to understand during a time when China is positioning to become a reserve currency. But the Chinese must remember something. Foreign countries don’t want to hold Yuan because the Chinese are a large economy. They will want to hold Yuan because they know they can trust the diversity of the output backing that currency as well as the political system that supports it. So far, the biggest hurdle to China’s reserve currency status is not its quantity or quality of output, but its government which insists on manipulating its credibility in an attempt to convince the world that this output is of higher quality than it really is.
NB – A related myth here is the concept of the “petrodollar”. This is usually cloaked in some vague conversation about leaving the gold standard and the Nixon Shock. The basic theory is that the demand for the dollar is primarily maintained because oil is priced in USD. This doesn’t make sense:
- How does a currency like the Euro have any value given their economy is of similar size, but without this supposed PetroEuro system?
- The USA is a net exporter of oil now. Our energy dependence has declined substantially.
- The entire oil global oil market is about $4T. The US economy is a $20T economy. This means that there is at least 80% of US GDP that plays a significant role in USD demand.
- Currencies are fungible. Saudi Arabia doesn’t deny payment in Euros when they sell oil to Europe. They simply exchange oil at the requested exchange rate.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.