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Generally, reserve currencies are forms of global currencies which are held in considerable quantities by many institutions and governments as a principal means of making international payments. Specifically, foreign currencies are held by governments’ central banks as well as other major financial institutions as a means to pay off international debt obligations or in order to influence domestic exchange rates. In effect, vital international commodities such as gold and oil among others are priced in the reserve currency as they can represent a country’s wealth on a global level where the currency is used to pay for the goods.
Consequently, this implies that holding reserve currencies can be used in minimizing exchange rate risk as nations purchasing these international commodities will conduct the exchange in the reserve currency and not the national currency which may be inferior to the reserve currency. Reserve currencies are usually strong currencies of various countries provided the currencies are being used on a global scale with many countries as well as fewer restrictions that may hinder its use. Reserve currencies used to be acceptable in terms of various precious commodities such gold among others but currencies take precedence over conversion of currencies into other commodities.
Additionally, reserve currencies are held in order to support the value of national currencies as well as vital indicators of a country’s ability to repay foreign debt, defend the national currency in addition to determining sovereign credit ratings. Countries with the most foreign reserve currencies include China, Japan, Russia as well as various non-governmental organizations such as the European Union, European Economic Area and the Eurozone (Kuepper, 2012).
US Dollar as a reserve currency
The British Empire was a major economic force to reckon with before the Second World War due to its vast wealth garnered from the colonies. Its currency, the sterling pound was the reserve currency of choice but due to various adverse effects from the colonies which were fighting for independence led to its decline as the reserve currency. In addition to the two world wars and the dollar’s rising purchasing power, the pound slightly lost its reserve currency status to the American dollar, gradually being accepted instead of the pound after 1945 (Schenk, 2009).
Since then the American dollar has maintained the record of being the major global reserve currency. The dollar further cemented its reserve currency status by engaging in business with many counties around the globe meaning that these countries adopted the dollar as their reserve currency. Additionally, the currency became the main currency for foreign-exchange transaction in international business as well as in international debt securities. Over 50% of various nations’ foreign reserves of central banks were in dollars in addition to the currency being used by the organization of petroleum exporting countries to set oil prices. This highlights the global reserve currency status of the American dollar (Eichengreen, 2011).
Reserve currencies are usually chosen due to a variety of factors including its purchasing power as well as favorable economic reforms such as better liquidity in bond markets. Additionally, monetary policy governing that particular currency is also a strong determinant of the reserve currency to use where monitoring the policy enables countries to guard themselves from being affected by adverse market conditions affecting the currency especially inflation. Additionally, many other market conditions such as rising debts and financial crises as well as benefits linked to currencies’ rise to reserve currency status leading to ‘currency wars’ may determine the rise of a particular currency to reserve currency status (Sharma, 2011).
Being subject to these aspects, currencies can generally therefore rise to reserve currency status by their country’s origin enhancing their financial markets. The American debt crisis has led to predictions that the currency will loose its reserve currency status to other upcoming currencies such as the Chinese Yuan or the Euro as Komijani & Tavakolian (2011) aver. This they support with studies done which indicate significant shares of the Euro in foreign reserves in the rising economies in East Asia such as Japan and China which incidentally have the highest international reserves globally.
This has been compounded by the recent global recession (2007-2011) leading many financial experts to acknowledge that the American dollar will soon loose its position as the major reserve currency. The euro especially has been predicted to take over from the American dollar what with the rising liquidity, maturity and breadth of euro financial markets in addition to the European Union and the Eurozone holding large reserve currencies (Galati & Wooldridge, 2009).
Even though the dollar is used by many countries as the reserve currency, many past, present and potential changes have taken place undermining the dollar’s reserve currency status. Therefore, I believe the dollar will lose its reserve currency status due to various reasons. Since reserve currencies impact global economies profoundly, the dollar’s loss of value in financial markets as well as the negative effects experienced by developing countries’ economies has and will lead the dollar to lose its status as the reserve currency. Additionally, the United Nations fearing that the dollar would lead to global financial instability advised countries to minimize their use of the dollar as their reserve currency. Decisions to be made by various countries especially by the developing countries are likely to see the dollar being abandoned as the reserve currency of choice (Charbonneau, 2010).
The global financial crisis in addition to the American debt crisis and rising trade deficits dealt a deadly blow to the American dollar’s reserve currency status. Developing countries for one will have to re-evaluate their choice of the dollar being the reserve currency of choice due to the far-reaching negative effects brought by the decrease in value of the dollar. The rise of many other countries having more foreign reserves in Euros such as Japan among others also spells doom for the dollar as the reserve currency. This is supported by rise of new favorable and lucrative economies especially China, which has embraced new technologies hence no more monopolies by American corporations making it possible for their currencies to be adopted as reserve currencies. Additionally, the Euro and the Chinese Yuan are predicted to soon replace the dollar as the reserve currency what with China working hard to internationalize its currency.
The lack of support from the United Nations is another indicator that the dollar is about to loose its status. Even though the dollar is not going to lose its global reserve currency status overnight, the above reasons highlight its numbered days in its global reserve currency status. However, the dollar may stay a little longer due to various reasons, one being that the other global currencies near the dollar status, that is, the Chinese Yuan and the Euro have still to undergo some changes. The Euro suffered a setback due to the adverse economic conditions in Europe but ultimately the dollar will lose its reserve status soon unless the American financial markets stabilize.