First off, let’s get rid of one misconception that you seem to share with dozens of other people on Quora. The dollar is not “the world’s reserve currency.” It is “the world’s major reserve currency.” Any currency can be held as a reserve currency. There are no laws about this and it’s up to each country to decide what they want to hold, of course. Nobody declared that each country has to hold the bulk of its foreign exchange reserves in USD, it’s just the result of individual decisions by each country.
As far as we know, the dollar accounts for 63% of reserves, EUR is 20%, and then there are the rest. Take a look at the IMF’s breakdown of reserves by currency at http://data.imf.org/?sk=E6A5F467...
So why is USD the world’s major reserve currency? Why have most countries elected to hold the bulk of their reserves in USD? To fulfill this role, a country has to have:
- large, liquid financial markets capable of taking huge investments (there are currently at least $6.3tn – that’s trillion dollars -- in reserves held in USD, and probably closer to $7.2tn);
- a reputation for safety and rule of law, so that other countries are willing to invest billions and billions of dollars in that country’s government securities; and
- a willingness to run current account deficits indefinitely, since that’s the counterpart of a financial account surplus. (I’ll explain this later)
I think you’ll find that at the moment, there is only the US that fits all three criteria, and I don’t see any other country volunteering to take its place any time soon. What other country’s bond market could take even half that amount? As far as I know, only Japan, and they have shown zero interest – in fact significant negative interest – in having their currency play this role. (Negative interest = they discourage people from doing this.) The Chinese government bond market is also large and growing, but of course China has an estimated $1tn or more in USD reserves – where can it put that money besides USD?
On the contrary, most countries fight to prevent their currency from being held as a major reserve currency, since that causes the currency to appreciate, dampens growth, and causes unemployment. That’s what all this “currency wars” talk is about. Here’s why:
In order to accumulate foreign exchange reserves, central banks buy assets (mostly government bonds) denominated in the currencies of other countries. In this case, we have foreign central banks buying billions and billions of dollars worth of US government securities. This causes the US to run a financial account surplus. (A financial account surplus means foreigners buy more USD-denominated assets than US-based investors buy in foreign assets.)
If the US runs a financial account surplus, by definition it has to run a current account deficit, unless the government intervenes heavily. The current account is mostly made up of trade in goods & services. (That’s because money coming in has to equal money going out.)
So the fact that the USD is the world’s major reserve currency is one of the main reasons why the country has run a current account deficit for most of the last 30 years. (This by the way is known as the Triffin dilemma
— a dilemma identified in the 1960s by the economist Robert Triffin, who realized that any country that dominated world FX reserves would have a consistent current account deficit that would gradually undermine the value of that currency.)
To put it in simpler terms, if the USD weren’t the world’s major reserve currency, probably its value would have fallen, US exports would be more competitive, and more people in the US would have jobs making goods for exports. On the other hand, probably fewer people in China, Germany and Mexico would have jobs making things for export to the US. Do you think that’s a good thing or a bad thing? Probably your view on this depends on whether you work in a factory in the US or China.
While some people have said that the use of the dollar as the world’s major reserve currency is an “exorbitant privilege,” other people argue that it’s actually an “exorbitant burden” for just this reason. See this article by Prof. Michael Pettis, An Exorbitant Burden or this one on his blog, The Titillating and Terrifying Collapse of the Dollar...Again
So we can see that:
- The USD is not going to lose its position as the world’s major reserve currency any time soon, for a variety of reasons, the simplest of which is that there is no possible alternative under the current monetary system;
- It’s virtually inconceivable that it could lose its position as a reserve currency totally; and
- It might be a good thing for the US economy – or at least the average US worker – if it did lose that position. As several people here have pointed out, GBP used to be the world’s major reserve currency. It’s now a relatively small part of global reserve (4.5%). Yet life seems to go on OK in Britain.
Footnote: By the way, let me explain a bit why the euro can’t fulfill this role. The problem with the euro is that there are no eurozone bonds, there are only national bonds (i.e., bonds issued by the individual countries). Now remember, why does a country issue bonds? Because it has a budget deficit. Therefore, the largest national bond markets are going to be those of the countries with the largest government deficits. These are precisely the countries whose bonds you don’t want to buy. So within the eurozone, the biggest bond market is the perennially fiscally challenged Italy (EUR 2.4tn outstanding), followed by France (EUR 2.09tn). By comparison, there’s only EUR 1.3tn in German bonds outstanding, not far above the EUR 1.23tn for much smaller Spain (49mn people vs 81mn. So the problem with the euro is not the lack of EUR-denominated assets, it’s the lack of attractive, trustworthy EUR-denominated assets.
No matter how indebted the US government gets, at the end of the day the US Treasury and the Fed are going to work together to avoid defaulting. Not necessarily so with the euro, as we’ve seen with Greece — the ECB and the other EU countries won’t necessarily bail out Italy if it can’t pay its bills.
The Swiss definitely don't want their franc to be a reserve currency. In the 1970's, they imposed a 41% tax on Swiss franc accounts opened by foreign depositors. Today, they have a central bank rate of -0.75%, meaning countries that want to hold their reserves in Swiss francs must pay the Swiss central bank for the privilege.
