When we buy an item from abroad, we usually agree to pay in a set currency. In the case of central banks and governments, this set currency is termed a “reserve currency”.
Central banks and organisations such as the International Monetary Fund (IMF) and World Bank hold reserve currencies to pay for international trade debt and other obligations. But reserve currencies are under debate – with particular focus on the role of the US dollar as the widely accepted “world” reserve currency.
Stability is important for reserve currencies
An agreed and stable reserve currency can be helpful in international trade. It minimises the risk that exchange rate fluctuations will cause payments across boarders to rise or fall unpredictably. Despite their powerful role, the term reserve currency may not be widely understood. An eZonomics poll last month found only 27% of more than 1,300 respondents know the meaning of the term “reserve currency”.
Oil, gold and other commodities are typically priced in the US dollar
The most widely used reserve currency around the world is the United States dollar – reflected in the pricing of oil, gold and several other commodities. In addition, intercompany, international transactions are commonly in US dollars. Part of the reasons why the US dollar has this status is that the US has been the dominant economy in the world since the end of World War II, there are few restrictions on the dollar’s use and the currency is widely accepted.
Will there be more reserve currencies soon?
Prominent economist Barry Eichengreen writes in his new book Exorbitant Privilege that several currencies will soon jointly share the reserve currency role. He challenges the presumption that there is room for only one true global currency and says it was shared in the past. Eichengreen terms the dependence on US dollars an “exorbitant privilege”.
Likewise, the International Monetary Fund ( IMF) managing director Dominique Strauss-Kahn called for discussion on an alternative reserve currency earlier this year.
Beware when borrowing in foreign currencies
There are several lessons for personal finance from reserve currencies. It reminds us that individuals should beware borrowing or investing in foreign currencies. The risks (as well as potential benefits) of borrowing in a foreign currency include exchange rate fluctuations (which can mean a debt in a foreign currency will grow or shrink).
The same holds true if buying items from a vendor that uses a different currency. If the transaction is regular or subject to delays and of a significant size, it might pay to consider using a stable currency to minimises the risk of exchange rate fluctuations causing payments to rise or fall unpredictably.