Why the US Dollar Rules the World: A Deep Dive into Reserve Currencies (EP.157)

0:28We all need to make smart decisions with our money. network and check out detailed show notes from today's episode by visiting thelongterminvestor.com. Today, we're exploring the U.S. dollar status as the world's leading reserve currency. We'll discuss what it means to be a reserve currency, why the U.S. dollar holds its dominant reserve currency position, and the likelihood of the U.S. dollar losing that status along with the potential implications for lower US dollar demand. Lots to cover here today, so let's dive in. What is reserve currency? I like to think about it as if you are traveling the world.

1:07No matter where you go, there's always one language that almost everybody speaks, at least a little bit, and that's English. It's the lingua franca of international business, diplomacy, and tourism. Similarly, in the world of global finance, there is a universal language of money, and that's a reserve currency. Think about it. Having a currency that's widely accepted and trusted simplifies international trade and finance. When countries engage in trade, they need a reliable medium of exchange. For instance, when a company in Japan buys oil from Saudi Arabia, the transaction is likely settled in dollars.

1:48This eliminates the need for constant currency exchanges, which can be pretty costly and complicated. The other role of a reserve currency is to act as a safe haven for countries and investors during times of economic instability. This trust is not easily earned, and it's built over decades of economic stability, prudent financial policies, and strong institutions. So why is the U.S. dollar the world's dominant reserve currency? Well, it's actually been that way since World War II, thanks to the Bretton Woods Agreement in 1944, in which 44 countries formally adopted the U.S. dollar as an official reserve currency.

2:29Under this agreement, other countries pegged their exchange rates to the dollar, which was convertible to gold at the time. And because the gold-backed U.S. dollar was relatively stable, it enabled other countries to stabilize their currencies. In the beginning of this, the world benefited from a strong and stable dollar, and the U.S. prospered from a favorable exchange rate on its currency. But over time, as the U.S. printed more money to finance its spending, the gold backing behind the U.S. dollar diminished, which led to a chain of events that ultimately concluded with President Nixon ending the gold standard and severing the link between the value of the U.S.

3:07dollar and gold in 1971. And so from that point on, countries have been free to choose any exchange arrangement for their currency. They could, for example, link its value to another country's currency or a basket of currencies or simply let it float freely and allow market forces to determine its value relative to other countries' currencies. And yet, the U.S. dollar remains the dominant reserve currency for a handful of reasons. For starters, economic stability and size. A reserve currency requires a large and stable economy to make it a reliable store of value. The United States, boasting the world's largest economy, provides a vast and secure market for international investors.

3:50This size and robustness instills confidence, which also makes the dollar a safe haven in turbulent times. There's also liquidity and trust. Liquidity is the lifeblood of any financial system, and the U.S. dollar is the most liquid currency on the planet. This means it can be easily exchanged for goods and services or other currencies without causing any significant price fluctuations. When you look at some charts at thelongterminvestor.com, you will see that the sheer volume of dollar-denominated transactions conducted daily around the world underscores its unparalleled liquidity. Trust, however, is an equally critical component.

4:31The U.S. financial system, backed by strong institutions and the rule of law, is viewed as one of the most reliable in the world. And that means investors can trust that their dollar-denominated assets will be honored and protected, which is not a guarantee they feel with every other currency. Another reason the U.S. remains the dominant reserve currency is simply historical precedent. Think about it. The U.S. dollar was the world's undisputed reserve currency for three decades before it decoupled from the price of gold. But even after that, the number of viable options were relatively limited for another few decades.

5:07That made the U.S. dollar like a colossal tree with very deep roots spread far and wide into the global financial system. And because the U.S. has enjoyed its dominant position for so long, those roots are difficult to replace or remove. Plus, there are many international economies that have grown accustomed to the shade and shelter provided by its branches. And that leads me to my last reason that the U.S. dollar remains the dominant currency, and that is global financial infrastructure. Many of the world's major financial institutions, including the IMF and the World Bank, conduct their operations in dollars.

5:45There's also international trade, especially in commodities like oil, that is predominantly priced in dollars. And so this entrenched usage creates a self-reinforcing cycle. The more the dollar is used, the more it is trusted and needed. Now, there has been a rise of competing reserve currencies. And a question that comes up from time to time is, what is the likelihood of the US dollar losing its reserve status? And I get why this is a question, because being the world's leading reserve currency comes with some pretty nice perks. Most notably, it creates a continuous demand for U.S. dollars, which helps keep U.S.

6:25interest rates lower than they might otherwise be. That, in turn, allows the U.S. government to run larger deficits at lower costs because the world is willing to lend money to the U.S. at favorable terms, essentially because they trust the dollar. So being the world's leading currency is pretty great for our country, but that also makes the idea of losing that status seem pretty scary. Not only would a decline in the U.S. dollar's reserve status lead to higher inflation, higher interest rates, and reduced fiscal flexibility, it would also impact our country's ability to influence global economic policies.

7:02Currently, the dollar's dominance allows the U.S. to impose sanctions effectively, regulate international financial flows, and exert significant influence over global economic policies. So I'll repeat the question. What is the likelihood of the U.S. dollar losing its reserve currency status? Well, the thing is, there isn't just one single reserve currency. Yes, the U.S. dollar remains the dominant reserve currency, but nations across the globe already maintain reserves in other currencies. And while the U.S. dollar was largely uncontested for five-ish decades following the Bretton Woods agreement in 1944, international operations made a noticeable shift towards the euro since its launch in the 1990s and, to a much lesser extent, other major developed market currencies such as the Japanese yen and the British pound.

7:53Is that a concern? Well, looking at the data on global currency reserves and usage, I'd say it's not. I have a few charts at thelongterminvestor.com that you can check out, and the first one shows that according to data from the IMF, the US dollar makes up over 58 % of the world's exchange reserves compared to just under 20 % for the euro, just under 6 % for the yen, just under 5 % for the pound, and just over 2 % for the Chinese renminbi. Meanwhile, a recent Vanguard study shows that the U.S. dollar far outpaces rivals in terms of usage, with the U.S. dollar making up 69%, the euro 23.1%, the pound 6.4%, the yen 7.3%, and the renminbi 3%.

8:41And while the U.S. dollar reserves have continued to gradually decline over the past few decades, we haven't seen matching increases in the share of these other big four currencies, the euro, the yen, the pound. Instead, there has been a rise in share for what are referred to as non-traditional reserve currencies, such as the Australian dollar, Canadian dollar, South Korean won, Singaporean dollar, the Nordic currencies, and the Chinese renminbi. Now, the country among those non-traditional reserve currencies that tends to get the most attention is China's renminbi, in large part because of the market share gains it experienced since the mid to late 2000s, when the Chinese government began advancing a variety of policies to promote renminbi internationalization.

9:26But if you look at the currency reserve data, that trend appears to be stalling out. So I would be skeptical if you hear people using China as a reason that the U.S. dollar will lose its reserve currency status. Over the course of multiple decades, it's perfectly reasonable to expect China's economy and currency to gain market share relative to the U.S., but I'd say it's hardly worth worrying about from a long-term investing perspective. Similarly, I suspect we'll continue to see a variety of politicians, market forecasters, newsletter writers, and even gold and cryptocurrency evangelists using the declining status of the dollar in a manner I would just associate as a scare tactic.

10:10It is true that the U.S. must manage its economic policies carefully to maintain the trust that currently exists in the dollar, and excessive debt or fiscal mismanagement could erode confidence in the dollar, which would lead to some of those potential challenges in maintaining its dominant reserve currency status. But the fact of the matter is that there isn't one single global currency reserve. The significant globalization we've seen in the last few decades has certainly led to there being many reserve currencies, but the U.S. dollar still dwarfs them all. The U.S. dollar's status as the world's reserve currency is built on a foundation of economic might, historical precedent, unmatched liquidity, and deep-seated trust.

10:52While the landscape of global finance is constantly evolving, these core strengths ensure that the dollar remains the bedrock of international trade and investment. If you enjoyed this episode and found it informative, please leave a review for The Long-Term Investor on your favorite podcast platform. Your feedback helps us reach more listeners and continue delivering valuable content. As always, thank you for tuning in and until next time to Long-Term Investing. Thanks for listening to the Long-Term Investor Podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com.

11:33Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.