How the US Dollar Became an International Reserve currency
In 1944, during World War II, more than 700 representatives from 44 nations traveled to the Mount Washington Hotel, a secluded resort in the mountains of Bretton Woods, New Hampshire, USA. US, then was the strongest power among the Allies, hence these 44 nations decided to link their currencies to the US dollar.
The Bretton Woods Agreement officially crowned the US dollar as the world’s reserve currency – one that is accepted for trade throughout the world – which was backed by the world’s largest gold reserves. Instead of keeping stocks of gold, other countries began accumulating reserves of US dollars.
According to the International Monetary Fund (IMF), the US dollar is the most popular currency, making up a major share of foreign exchange reserves of all known central banks across the globe. It rules the foreign exchange market and is the de facto currency, even though it doesn’t hold an official title.
Around 90% of forex trading involves the US dollar. Almost 40% of the world's debts and loans (from both, the IMF, and rich countries, to needy countries) are issued in dollars.
The IMF releases an official list of reserve currencies, which include the Euro (introduced in 1999 and the second most held reserve currency), the Japanese Yen and the Great Britain Pound Sterling. The latest addition, introduced in October 2016, has been China's Yuan, also known as Renminbi, which, in Mandarin, means people’s currency.
Eventually, the US government found it too expensive to maintain the promise of holding the gold worth equivalent to the forex reserves maintained by other countries, hence it arranged a divorce between the dollar and gold in 1971. As the US went off the gold standard in the 1970, it led to contemporary floating exchange rates i.e. determining exchange rates on the basis of buying and selling of US Dollars in the international market.
The original arrangement set at Bretton Woods is long dead, but the dollar remains the international reserve currency, and takes the centre stage for global trading and savings.
Promoting the Yuan as International Transaction Currency – China’s New Dominance
After the Yuan was introduced in the basket of foreign reserve currencies of the IMF, China has adopted an aggressive strategy to promote it as medium for settling payments and international trading. As the second largest global economy, China intends to curb the importance of the US Dollar, dominate international trade, and become the world’s largest economy, and a superpower.
As a part of this process, especially in recent times, the People’s Bank of China has encouraged Chinese entities to make large investments in foreign companies and acquire or take control over prime technologies. The motives of the Chinese are not exactly beneficial to other economies. The West is alarmed by these moves, but for now, faith in US institutions, a (relatively) independent Federal Reserve, and sheer inertia make the dollar difficult to dethrone.
China wants the Yuan to replace the US dollar as the world's global currency. Accordingly, China and its allies have greatly emphasized on using the Yuan instead of the dollar in many parts of the world.
In those areas where this shift has occurred, countries are detaching from US patronage. The Yuan is becoming the dominant currency in many countries, and especially with small and troubled economies such as Sri Lanka, Pakistan etc.
Some of the biggest global banks are headquartered in China. The biggest US bank is smaller than the fourth biggest bank of China. While China is reshuffling the cards by gradually promoting the Yuan as a global currency, the Yuan would still require to be successful as a reserve currency.
If it succeeds, the Yuan would be used to price more international contracts. Since most of China’s exports are conventionally priced in US dollars, shifting the pricing to Yuan will reduce China’s worries about the dollar’s value. Also, Chinese exporters would face lower borrowing costs. Central banks across the world will have to include the Yuan in their forex reserves, spiking its demand, and consequentially lowering interest rates for bonds denominated in Yuan. China would also more economic clout compared to the US.
However, there isn’t a singular, universal reserve currency. Although the dollar dominates globally, countries also tend to hold currencies of other dominant trading countries in their vicinity. Thus, European countries outside the Euro zone tend to hold the Euro, while Asian countries hold the Japanese Yen and now, the Chinese Yuan.
Some economists argue that this tendency could develop into a full-fledged “multi-polar” system in which the dollar and other strong currencies would be a part of IMF’s principle reserve currency basket. However, there are currently significant obstacles to adopting the Euro and the Yuan as principal reserve currencies.
Prospects of Adding the Indian Rupee to IMF’s Global Reserve Currency Basket
India, presently the fifth largest economy in the world, is growing and has adopted an export-driven model. It aspires to make the Rupee a global reserve currency and is taking positive, concrete actions in that direction; adopting an export-driven model is one as exports, and not imports, are primary to becoming an international trade currency.
The Indian Rupee is accepted informally in Nepal, Bhutan, Bangladesh, Sri Lanka, and some parts of Maldives, and as legal tender in Zimbabwe. This is because India has large exports to these nations. However, the Covid-19 pandemic is pushing many countries to boycott Chinese products and if India becomes the world production hub, the Rupee has better prospects of gaining strength in the international market.
However, for the Rupee to become an international currency, India must have a higher GDP with a steady growth rate and a strong and stable economy, with reduced national and trade deficits and controlled inflation. India must grow the size of its economy to 8-10 trillion dollars in the next 8-10 years.
The tax base must be increased, and monetary and fiscal policies must be exercised in a timely and efficient manner. Meanwhile, the RBI must successfully market Rupee denominated bonds in international open markets.
India must develop itself as global hub of production and supply of good quality, competitively priced products in electronics, IT, healthcare, dyes and chemicals, automobiles etc. At the same time, it should invest in durable growth in power generation, improvisation and modernization of transport and communications infrastructure, and development of human resources.
If India achieves most of these targets, neighbouring countries and trading partners are likely to start dealing in the Indian Rupee. This way, the Rupee will create niche for itself in the IMF’s global reserve currency basket.
Ajit Phadke, B.Com.(Hons), M.B.A., LL.B, has been operating as a freelance industrial consultant for 35 years and specialises in 100% EOU / Export / Import, Foreign Exchange Rules and Industrial Regulations.