GlossaryFed & inflation
Reserve currency
A currency that central banks and institutions hold in large amounts for trade, savings and crisis protection. The dollar’s dominant role creates steady global demand for Treasury securities.
What makes a reserve currency
Central banks hold foreign currencies in reserve to settle trade, intervene in currency markets and cushion themselves against crises. Most of those reserves are held in US dollars — well over half of the total, according to International Monetary Fund data — far ahead of the euro, the yen and other currencies.
The dollar gained that position after the Second World War, when the Bretton Woods agreement tied other currencies to it. It kept the role after the link to gold ended in the early 1970s, thanks to the size of the US economy, open capital markets, legal protections for investors and, above all, the depth of the market for Treasury securities.
Why it matters for the debt
Reserves have to be held in something safe and easy to sell, and Treasury securities are the default choice. Foreign central banks, oil exporters and export-driven economies accumulate them in large amounts. That steady demand, which is relatively insensitive to price, helps the US borrow more cheaply and in larger amounts than it otherwise could.
In the 1960s, French finance minister Valéry Giscard d’Estaing called this the dollar’s exorbitant privilege: the ability to borrow from the rest of the world in a currency the United States itself issues.
Could it end?
Reserve status changes slowly. The dollar’s share of global reserves has drifted down over two decades, with the gains spread among smaller currencies rather than going to a single rival. The euro lacks a unified government bond market of comparable depth, and China’s capital controls limit the appeal of the renminbi.
The risks most often named are self-inflicted: persistent doubts about the debt path, debt ceiling standoffs that raise even a remote chance of missed payments, and the use of financial sanctions, which encourages some countries to diversify. Heavy gold buying by central banks in recent years is partly read as that kind of diversification.
The limits of the privilege
Reserve currency status lowers borrowing costs but does not make debt costless. It gives the United States more room, not unlimited room, and that room depends on continued confidence that US debt is safe.