Reserve currency

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A reserve currency (or anchor currency) is a currency which is held in significant quantities by many governments and institutions as part of their foreign exchange reserves. It also tends to be the international pricing currency for products traded on a global market, such as oil, gold, etc. More recently, however, nations especially in Asia, have been stockpiling reserves in an effort to strengthen export competitiveness by weakening their own currencies, and also to contain quick and large inflows of capital, and buffer against financial crisis such as the Asian financial crisis.

This permits the issuing country to purchase the commodities at a marginally cheaper rate than other nations, which must exchange their currency with each purchase and pay a transaction cost. (For major currencies, this transaction cost is negligible with respect to the price of the commodity.) It also permits the government issuing the currency to borrow money at a better rate, as there will always be a larger market for that currency than others.

The United States dollar is the most important reserve currency in the world today. At the mid-point of 2006, 65.4% of the identified official foreign exchange reserves in the world were held in United States dollars, 25.4% in euros, 4.2% in pound sterling, and 3.3% in Japanese yen, according to the IMF. [1]. For this reason, the US dollar is said to have "reserve currency status", making it possible for the United States to run significant trade deficits (financed by seigniorage) with limited economic impact (see currency crisis) as long as the major holders of reserve currencies do not issue public statements suggesting otherwise.

The pound sterling was the primary reserve currency of much of the world in the 18th and 19th centuries. But perpetual current account and fiscal deficits financed by cheap credit and unsustainable monetary and fiscal policies and the relative decline of Britain from being the world's pre-eminent military and economic power led to the pound losing this status. The Japanese yen has been on the decline as a reserve currency for the past decade. The Swiss franc is often included in the mix as well, due to its perceived stability.

The G8 also frequently issues public statements as to exchange rates, though with the exception of Japan, the member states are impotent in their ability to directly affect rates. In the past, however, its predecessor bodies could directly manipulate rates to reverse large trade deficits (see Plaza Accord).

The top reserve currency is generally selected by the banking community for the depth, strength, and stability of the economy in which it is used. Thus, as a currency becomes less stable, or its economy shrinks, bankers may abandon it for more stable or deeper economies, although it may take a long time, as recognition is important in determining a reserve currency. For example, it took many years after the United States overtook Great Britain as the financial centre of the world before the dollar became the dominant global reserve currency.

The Euro is already the second most commonly traded reserve currency, and is a strong candidate to displace the dollar as the predominant reserve currency, although it may instead co-dominate. Since the euro was launched in 1999 (largely replacing the Deutschmark as a major reserve currency), its contribution to official reserves has risen continually as banks seek to diversify their reserves and trade in the eurozone continues to expand.[2] Other nations and groups of nations have expressed their desire to see their currencies (or future currencies) be used as reserve currencies, such as Russia, and the Gulf Cooperation Council.

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