IntegrityFX Daily Market Commentary

What is a reserve currency and why is it important?
by Patrick Patterson, Chief Strategist & Administrator of Education

Background…
A reserve currency is a currency that is stored in large quantities by foreign central banks and financial institutions as part of their foreign exchange reserves as a means to pay off international debt obligations, or to influence their domestic exchange rate.

The U.S. dollar is the primary reserve currency. A reserve currency is generally the international pricing currency for goods on the world market. A large percentage of commodities, like precious metals and energy are usually priced in U.S. dollars. Other countries are compelled to hold the U.S. dollar in reserve in order to pay for these commodities and avoid transaction cost.

Importance…
China's central bank has stated repeatedly that a new international currency should replace the U.S. dollar as a reserve currency. The People's Bank of China said the country will push reform of the international currency system to make it more diversified and reasonable.

China currently has approximately $2 trillion in reserves, mostly from the purchase of U.S. treasuries. The current U.S. economic crisis and the resulting quantitative easing along various new monetary policies has the Chinese concerned about the devaluation of the U.S. dollar.

Ramifications…
The International Monetary Fund (IMF) has acknowledged that China’s proposition is a possibility. If the a number of key countries supported the proposition and began selling dollars for an international currency, the U.S. dollar could depreciate dramatically.

At the moment, the U.S. dollar represents about 70% of the worlds foreign currency reserves, so we are several years from an international currency at best. Even the strongest proponent for this idea, China, would not want this move to an international currency to happen too quickly, or they’ll lose their investment in U.S. treasuries.

However, if sentiment were to shift on the news that an international currency was likely, then U.S. dollar devaluation would increase exponentially and the currency markets would be chaos and the U.S. economy would face collapse.