It's Time to Recognize Reserve Currency Realities
Over the past six months, officials and commentators have raised questions about the reserve currency role of the US dollar and the structure of the international monetary system. None of their questions is new; they all date back at least to the break-up of the Bretton Woods system of fixed exchange rates in the early 1970s, and perhaps to even earlier than that. It is healthy to debate these issues anew even if they do not lead to immediate or dramatic changes in the international monetary system.
It is unreasonable to debate these issues, however, without keeping four facts in mind: (1) The US dollar is not the only global reserve currency; (2) the currency composition of reserves differs substantially among countries; (3) nondollar reserve currencies have increased $2 trillion over the past decade; and (4) increases in reserve currency holdings are logically unrelated to current accounts.
These four facts do not support the view that the US dollar's reserve currency role is either unique or a monopoly, or that its reserve currency role necessarily facilitates the United States' ability to run a current account deficit in today's international financial system.
The US Dollar Is Not the Only Global Reserve Currency
Reserve currencies and current account balances: 1999–2008
(US dollars, billions)
Currency composition of reserves
current account 1999 to 2008
End of 2008
Change in holdings from 1999 Q1
As shown in the table, at the end of 2008 holdings of reserves assets in US dollars were $4.3 trillion, but holdings in reserve currencies other than the dollar were $2.4 trillion.1 One third of all official foreign exchange holdings are in currencies other than the US dollar. Contrary to a widespread perception running through the debate on this subject, the dollar's share in total foreign exchange holdings has been essentially unchanged since the creation of the euro on January 1, 1999.2 Over the ten years to the end of the first quarter of 2009, the dollar's share in the nominal value of foreign exchange reserves has declined on balance by 6.2 percentage points. Adjusting for the effects of exchange rate changes, the decline has been only 4.3 percentage points. The dollar remains the most important reserve currency, but it is not the only such currency.
The Currency Composition of Reserves Differs Substantially among Countries
We know that the reserve holdings of individual countries have increased and decreased at substantially different rates during the past decade. This fact, along with the stability of the dollar's overall share in official currency holdings, suggests that individual countries have different preferences in the currency composition of their reserves and that those preferences probably have changed substantially over the period, but not in a systematic manner.
More than two dozen countries release data on the currency composition of their reserves. The data reveal that there is not a single pattern in the currency composition of countries' reserves and that the currency composition of reserves for individual countries has changed over time.3
Recent research conducted at the European Central Bank also supports this conclusion.4 The researchers exploited time series on the dollar-euro currency composition of reserve holdings of four non–euro area members of the European Union and four non-EU emerging-market countries. It confirms earlier research findings that the dominant explanations of the currency composition of a country's foreign exchange reserve holdings are transactions motives: the currency denomination of a country's external debt, the direction of its trade, and the nature of its own currency arrangements, for example, if its currency is pegged to the euro or the dollar and the strength of any such peg. Relative returns have some, but much smaller, explanatory power. The fact that the fitted relationship is robust for this diverse group of countries and that the explanatory variables change supports the view that countries differ in their currency preferences and their observed behavior changes over time.
Nondollar Reserve Currencies Have Increased $2 Trillion over the Past Decade
As shown in the table, although US dollar holdings have increased by $3.2 trillion since early 1999, holdings of other reserve currencies have increased by almost $2 trillion. This fact hardly seems consistent with claims that the United States has uniquely been exploiting the reserve currency role of its currency over this period. If there has been any exploitation, the United States has had substantial company.
Increases in Reserve Currency Holdings Are Logically Unrelated to Current Accounts
Over the past decade, the United States had a cumulative current account deficit of $5.6 trillion as is shown in the table. Some observers argue that the dollar's reserve currency role has enabled it to run such large deficits. This argument is not supported by the evidence.
First, the United Kingdom also ran a cumulative current account deficit over this period, and official sterling holdings increased by about half of the total amount. Second and more important, the euro area, Japan, and Switzerland had current account surpluses that added up to more than $2 trillion over the decade, and holdings of those three reserve currencies increased by a combined $1.6 trillion.
How can this happen if increases in reserve currency holdings drive current account deficits or are driven by current account deficits? The answer is that there is no necessary, logical relationship between a country's or area's current account position and changes in official asset holdings in the currency of the country or area. If a country's government buys foreign exchange and purchases assets denominated in the currency of another country, that purchase is one component along with private gross capital inflows to the second country. The residents of the country receiving those inflows, at the same time, are purchasing assets of other countries denominated in their currencies.5 The result is an overall—official plus private—net financial inflow or a net outflow for the country that has the opposite sign as the country's current account balance.6
To reinforce this evidence, during the Bretton Woods era the United States had a current account deficit in only three of 25 years starting with 1946 and none between 1960 and 1970 when the Bretton Woods system was breaking down and countries, generally in Western Europe, were complaining that they were being forced to build up their official holdings of dollar assets. Their complaint at the time was that they were financing capital outflows from the United States and building up claims on the dwindling US gold stock. Their complaint was not that they were financing US current account deficits.
Reserve currency holdings and changes in those holdings are only one component of global capital flows, which take many forms. At the end of 2008, foreign official claims were only 23 percent of total foreign financial claims on the United States. Together with private financial flows and the myriad of economic and financial influences on trade and current account transactions, changes in holdings of reserve currencies are but one, relatively small, factor in the international financial system of the 21st century.
1. These figures are based upon the International Monetary Fund's (IMF) data on the Composition of Foreign Exchange Reserves (COFER). The coverage of the COFER data currently is about 60 percent. China accounts for the vast bulk of the missing data. The dollar's share in China's reserve holdings is widely believed to be close to the average for all the countries that participate in the COFER reporting system. Therefore, I have blown up the reported data to the overall total of foreign exchange reserve holdings.
2. The IMF does not report data for the currency composition of reserve holdings for January 1, 1999. The table uses data from the end of the first quarter of 1999 as a proxy.
3. Edwin M. Truman and Anna Wong. 2006. The Case for an International Reserve Diversification Standard. Peterson Institute for International Economics Working Paper 06-02. Washington: Peterson Institute for International Economics.
4. European Central Bank, 2009, The International Role of the Euro, Frankfurt: European Central Bank, 43–47.
5. I am assuming that the assets are denominated in the currency of the country of the currency of issue. This is not always the case, but it is the dominant pattern for the five currencies identified in the table.
6. I am abstracting from any statistical discrepancy in the country's or area's international accounts. I am also abstracting from the possibility that any recycling of official inflows may not be via private capital outflows but be via official capital outflows as the recipient country adds to its own foreign exchange reserve holdings. The latter abstraction is essentially irrelevant to the argument above because over the relevant period the foreign exchange holdings of four of the five individual countries or areas did not change by more than $20 billion. The exception is Japan, whose foreign exchange holdings increased by almost $800 billion over the decade, but that increase was concentrated in the period 2003–05, when the increase in official holdings of yen-denominated assets was less than a quarter of the total for the period as a whole.