Glossary · Money and central banks
Reserve currency
A reserve currency is one that central banks around the world hold as savings and use for trade and loans. The US dollar is the main one.
Also called: world reserve currency, global reserve currency, dollar dominance, exorbitant privilege
In plain words
Suppose Brazil sells soybeans to China. Neither side much wants the other’s currency, so the deal is likely priced and paid in US dollars. And Brazil’s central bank, which keeps savings for a rainy day, holds many of them in dollars too. A currency the whole world uses and saves in like this is a reserve currency.
The US dollar has been the top reserve currency since World War II; before that, the British pound was. The euro is a distant second; the yen, the pound and several smaller currencies follow far behind.
Central banks hold reserves to defend their own currency in a crisis and to pay for imports if foreign money dries up. They keep them mostly not as cash but as safe government bonds that are easy to sell, such as US Treasuries.
Example
Why the reserve role helps the US
- A country sells oil abroad for $10 billion, and its central bank keeps the dollars as reserves.
- It puts them into US Treasury bills: safe, and sellable within minutes in a crisis.
- Thousands of such decisions add up to a huge, steady demand for US government debt.
- More demand means lower interest rates: on a $1 trillion loan, a rate just 0.25 points lower saves $2.5 billion a year.
That cheaper borrowing is part of what a French finance minister in the 1960s called the dollar’s “exorbitant privilege”.
One level deeper
What makes a reserve currency? A big economy; deep, open financial markets where huge sums can be bought and sold any day; a currency that moves freely in and out of the country; the rule of law; and a record of stable value. The dollar has all of them, plus habit: once the world prices oil and borrows in dollars, switching is costly.
The privilege has a price. World demand for dollars keeps the dollar stronger than it would otherwise be, which makes US exports dearer. And in the 1960s the economist Robert Triffin pointed out that a reserve currency must supply the world with ever more of itself, which can in time undermine trust in it; that dilemma helped end the gold standard.
The IMF tracks the currency mix of official reserves in a survey called COFER. The euro took a share after 1999, and the Chinese yuan joined the IMF’s own reserve basket, the SDR, in 2016, but neither has come close to the dollar.
Why it matters
It lets the US borrow more cheaply and pay for most imports in its own currency, so American companies face little exchange rate risk on most trade.
It gives the Fed’s decisions worldwide reach: when US rates rise, borrowers from Türkiye to Indonesia who owe dollars feel it.
It makes the dollar a safe haven: in a global panic investors rush into dollars and Treasuries, even when the crisis starts in the US, as in 2008.
A common mistake
Myth: A reserve currency is backed by gold or oil.
In fact: It is backed by neither. The dollar is a reserve currency because the world trusts US markets, laws and institutions and finds dollars useful for trade and borrowing. Oil is priced in dollars largely because of the dollar’s role, not the other way round.
Questions people ask
What is the world’s reserve currency?
The US dollar: it makes up the largest share of central banks’ foreign reserves by far, and most international trade, loans and currency trades involve it. The euro is second.
Could the dollar lose its reserve status?
It could fade slowly, as the pound did in the 20th century, if another currency offered the same deep markets, free movement of money and trust. Economists often note that the euro lacks one large government bond market, and that China limits money flowing in and out of the country.
Why do countries hold foreign reserves?
To defend their currency, by selling reserves to buy their own money when it falls; to pay for imports and debts if foreign lending stops; and as a cushion that reassures investors.
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About the numbers
- This page explains a term. It is not investment advice.