Oil, gold and other commodities are traded in a reserve currency
A reserve currency is a widely-accepted currency that central banks and governments hold, in reserve, and use to pay for international trade, debt and other obligations. Other major financial institutions such as the IMF and World Bank also use reserve currencies. 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 as well as intercompany, international transactions commonly in US dollars.
But reserve currencies are the topic of international debate at the moment, with the International Monetary Fund (IMF) managing director Dominique Strauss-Kahn calling for discussion on an alternative reserve currency last month.
A stable reserve currency can be good
It can be argued that the US dollar is commonly accepted as the world’s reserve currency. Part of the reasons why it has the 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. Having a stable reserve currency minimises the risk that exchange rate fluctuations will cause international payments to rise or fall unpredictably. Despite the US dollar being commonly held, a wide range of currencies can be used – as well as gold.
Prominent economist Barry Eichengreen’s new book Exorbitant Privilege challenges the presumption that there is room for only one true global currency and argues several currencies will soon jointly share the role.
Beware of the risks of borrowing in a foreign currency
At a personal finance level, individuals should beware borrowing or investing in foreign currencies. There are risks (as well as potential benefits) of borrowing in a foreign currency, with fluctuating exchange rates of particular concern.