How do currencies achieve reserve status?

Achieving reserve currency status isn’t a formal process. Instead, it’s like winning a popularity contest.

The most popular currency for global trade and cross-border commerce emerges as the de facto reserve currency. The “popularity” of a currency is simply based on the perception of security and resilience of the issuing country. This is the asset or currency that most central banks across the world prefer to hold in reserve, which is why the dominant asset earns the label of “reserve currency.”

Since 1450, there have been six major reserve currency periods. Portugal dominated the global reserves until 1530 when Spain became stronger. Currencies issued by the Netherlands and France dominated world trade for much of the 17th and 18th centuries. But the emergence of the British empire made the Pound Sterling the reserve currency until the end of the First World War.

The U.S. dollar displaced the pound just as America gained economic superiority over Britain. More than 75% of global transactions have been completed in U.S. dollars since 2008. The dollar also accounts for more than 60% of foreign debt issuance and 59% of global central bank reserves.

Although the dollar’s grip on all these markets and instruments has been gradually declining in recent years, no other currency comes close to these levels. The Chinese renminbi certainly isn’t a viable alternative, but geopolitical and macroeconomic trends support its rise to dominance.

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China’s plan

This year, Chinese leaders made it clear that they wanted to boost the renminbi’s profile as a reserve currency. China’s economy and trade flows are large enough to support such a move. However, the country now needs to convince foreign central bankers to start holding the Chinese Yuan (the principal unit of the renminbi) in reserve.

In July, The People's Bank of China announced a collaboration with five nations and the Bank for International Settlements to achieve this. China, along with Indonesia, Malaysia, Hong Kong, Singapore, and Chile would each contribute 15 billion yuan, about $2.2 billion, to the Renminbi Liquidity Arrangement.

Meanwhile, the Chinese Yuan has already become a de facto reserve currency in Russia. Russian leadership turned to China after facing sanctions from the West due to its invasion of Ukraine earlier this year. Now, 17% of Russia’s foreign reserves are denominated in yuan. The yuan is also the third most demanded currency on The Moscow Exchange.

As these partnerships become stronger, the yuan’s status as a reserve currency could be further entrenched.

The global impact

Economists including Barry Eichengreen of the University of California Berkeley and Camille Macaire of France’s central bank published a paper analyzing the yuan’s potential as a reserve currency. The researchers argue that replacing the dollar isn’t going to be easy or quick. However, they found evidence that yuan reserves were steadily increasing in countries that had tighter trade relations with China.

This growing influence could make the yuan an alternative to the U.S. dollar in a “multipolar” world. In other words, China might chip away at the dollar’s influence over time. The study’s authors said the renminbi’s current position was similar to the U.S. dollar in the 1950s. Based on that comment, it could be just a few decades before the yuan gains parity.

If the forecasts are correct, long-term investors should consider some exposure to yuan-denominated assets and Chinese stocks with significant yuan earnings.

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About the Author

Vishesh Raisinghani

Vishesh Raisinghani

Freelancer

Vishesh Raisinghani is a freelance contributor at Money Wise.

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