Why the US Dollar Is the Global Currency
A global currency is one that is accepted for trade throughout the world. Some of the world's currencies are accepted for most international transactions. The most popular are the U.S. dollar, the euro, and the yen. Another name for a global currency is the reserve currency.
According to the International Monetary Fund, the U.S. dollar is the most popular. As of the fourth quarter of 2019, it makes up over 60% of all known central bank foreign exchange reserves. That makes it the de facto global currency, even though it doesn't hold an official title.
The next closest reserve currency is the euro. It makes up 20% of known central bank foreign currency reserves. The chance of the euro becoming a world currency was damaged by the eurozone crisis. It revealed the difficulties of a monetary union that's guided by separate political entities.
The relative strength of the U.S. economy supports the value of the dollar. It's the reason the dollar is the most powerful currency. As of the end of 2020, the U.S. had $2.04 trillion in circulation. As much as half that value is estimated to be in circulation abroad. Many of these bills are in the former Soviet Union countries and in Latin America. They are often used as hard currency in day-to-day transactions.
In the foreign exchange market, the dollar rules. Around 90% of forex trading involves the U.S. dollar. The dollar is just one of the world's 185 currencies according to the International Standards Organization List, but most of these currencies are only used inside their own countries.
Theoretically, any nation's currency could replace the dollar as the world's currency, but they won't because they aren't as widely traded
Almost 40% of the world's debt is issued in dollars. As a result, foreign banks need a lot of dollars to conduct business. This became evident during the 2008 financial crisis. Non-American banks had $27 trillion in international liabilities denominated in foreign currencies. Of that, $18 trillion was in U.S. dollars. As a result, the U.S. Federal Reserve had to increase its dollar swap line. That was the only way to keep the world's banks from running out of dollars.
The financial crisis made the dollar even more widely used. In 2018, the banks of Germany, France, and Great Britain held more liabilities denominated in dollars than in their own currencies. Additionally, bank regulations enacted to prevent another crisis can make dollars scarce. That can also happen when the Federal Reserve increases the fed funds rate. That decreases the money supply by making dollars more expensive to borrow.
The dollar's strength is the reason governments are willing to hold the dollar in their foreign exchange reserves. Governments acquire currencies from their international transactions. They also receive them from domestic businesses and travelers who redeem them for local currencies.
Some governments invest their reserves in foreign currencies. China and Japan deliberately buy the currencies of their main export partners. The United States is the largest export partner to both China and Japan. They try to keep their currencies cheaper in comparison so their exports are competitively priced.
The 1944 Bretton Woods agreement kickstarted the dollar into its current position. Before then, most countries were on the gold standard. Their governments promised to redeem their currencies for their value in gold upon demand. The world's developed countries met at Bretton Woods, New Hampshire, to peg the exchange rate for all currencies to the U.S. dollar. At that time, the United States held the largest gold reserves. This agreement allowed other countries to back their currencies with dollars rather than gold.
By the early 1970s, countries began demanding gold for the dollars they held. They needed to combat inflation. Rather than allow Fort Knox to be depleted of all its reserves, President Nixon separated the dollar from gold.
By that time, the dollar had already become the world's dominant reserve currency. But, unpegging the dollar from its value in gold created stagflation. That's a combination of inflation and stagnant growth.
In March 2009, China and Russia called for a new global currency. They wanted the world to create a reserve currency “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies."
China was concerned that the trillions it holds in dollars would be worthless if dollar inflation set in. This could happen as a result of increased U.S. deficit spending and printing of U.S. Treasurys to support U.S. debt. China called for the International Monetary Fund (IMF) to develop a currency to replace the dollar.
In the fourth quarter of 2016, the Chinese renminbi became another one of the world's reserve currencies. As of the first quarter of 2020, the world's central banks held $221 billion worth, according to the IMF. That's a fraction of the $6.8 trillion held in U.S. dollars but it will continue to grow in the future.
China wants its currency to be fully traded on the global foreign exchange markets. It would like the yuan to replace the dollar as the global currency. To do so, China is reforming its economy.
When forex traders talk about the "strongest currency," they usually mean that the currency has a high exchange rate with the U.S. dollar. Even though the U.S. dollar is the world's reserve currency (and arguably the most important currency), some other currencies are "stronger." The Kuwaiti dinar (KWD) is the strongest currency, and $1 will buy you roughly 0.3 KWD.
Despite trillions of dollars in foreign debt and continuous large deficit spending, the United States still holds global trust and confidence in its ability to pay its obligations. For this reason, the U.S. dollar remains the strongest world currency. It may continue to be the top global currency in the years to come.