OPENING CASE The United States dollar has been the world's reserve currency for the last 75 years. At the end of 2020, according to the IMF, 60.5 percent of all known foreign exchange reserves held by Central Banks around the world were U.S. dollars. The next most popular currency is the euro, which accounts for 20.5 percent of all foreign exchange reserves, followed by the Japanese yen (5.92 percent), British pound (4.50 percent), and Chinese yuan (2.13 percent). The dominance of the dollar makes it the de facto global reserve currency, even though it does not hold that title. Some 90 percent of all foreign exchange transactions involve U.S. dollars, 40 percent of the world's debt is issued in dollars, and the dollar is used in two-fifths of international payments. Most globally traded commodities, from oil to copper to sugar, are priced and traded in dollars, as are many industrial products, such as semiconductor chips. As of 2019, there were $1,760 billion worth of dollar notes in circulation, around half of which were circulating abroad. Many of these bills are in eastern Europe and Latin America, where they are often used as hard currency in day-to-day transactions. In Venezuela, for example, the U.S. dollar has supplanted the bolvar as the currency of choice (hyperinflation has made the bolvar all but worthless).

The dollar holds this unique position for a number of reasons. The 1944 Bretton Woods agreement gave the dollar a central position in the world's monetary system. Under that agreement, only the dollar could be converted into gold, while other countries pegged the value of their currency to that of the U.S. dollar. When President Nixon took the U.S. dollar off the gold standard in 1971, the dollar retained its position as the world's reserve currency due to the size of the U.S. economy, which was by far the largest in the world at that time. That is a position that the U.S. economy continues to hold today, even though China is catching up fast. Underpinning the continued strength of the dollar is the faith of foreigners in the ability of the United States Federal Reserve Board to limit inflation and maintain the value of the dollar, and the ability of foreigners to move in and out of dollar-denominated assets with ease.

From time to time, naysayers have predicted the demise of the dollar as the world's reserve currency. In the early 2000s, some analysts thought the euro might increase in importance and ultimately overtake the dollar as the world's reserve currency, or at least match it. However, the European debt crisis that hit several eurozone countries in 2009, including Ireland, Greece, and Spain, damaged faith in the euro and demonstrated the difficulties associated with monetary union in the European Union. Since then, the share of the euro in global foreign exchange reserves has been stuck in the low 20 percent range.

More recently, naysayers have pointed to the economic rise of China and argued that the Chinese yuan may replace the dollar as the world's reserve currency. After all, they note, China is already the world's second-largest economy, the largest contributor to global growth, and the largest exporter. Within the next decade, it will also probably become the world's largest economy, so wouldn't it make sense for the yuan to replace the dollar as the world's reserve currency? The naysayers buttress their arguments by claiming that faith in the dollar is being undermined by U.S. fiscal and monetary policy. The U.S. government has embarked on a debt-driven spending spree, borrowing trillions of dollars, as the country grapples with the effects of COVID-19 on the U.S. economy. This borrowing, coupled with expansion of the money supply by the Federal Reserve, has lead to predictions of inflation that will debase the value of the dollar, and lead foreigners to lose faith in the currency as a stable store of value.

However, while the Chinese would no doubt like the yuan to play a bigger role in international transactions and become a more important reserve currency, the currency remains a bit player in the global economy. For years, the argument was that China's financial markets lacked transparency, and regulations made it difficult for foreigners to issue, purchase, and trade yuan-denominated assets. Since 2015, the Chinese have reformed their financial markets, increasing transparency, access, and investor confidence, but foreigners still do not seem to want to hold on to yuan or use yuan in international transactions. What appears to be holding foreigners back is China's increasingly authoritarian political system under President Xi Jinping. Questions remain about whether China is truly committed to giving up state control over its currency and financial markets.

Two recent events illustrate these concerns. First, in 2020, the Chinese government blocked an initial public offering by Ant Group, the financial arm of the Chinese e-commerce giant Alibaba. Though the reasons for the government action are not publicly known, it seems likely that the Chinese government does not want a private enterprise to play too big a role in its financial system (some 88 percent of Chinese banks are state-controlled). Second, in 2015, China imposed restrictions on capital leaving the country in order to protect the value of the yuan. Although these restrictions were focused on Chinese citizens, and not foreigners, the imposition of capital controls signaled that when cross-border capital flows threaten the stability of the exchange rate and the control of the Chinese monetary authorities, the government will rein those flows in. This spooked foreign investors, who do not want to be limited in their ability to move in and out of yuan-denominated assets.

These events illustrate that, unlike American financial markets, Chinese financial markets are still some way off from being free and open. As long as that is seen to be the case, foreigners are unlikely to want to hold too many yuan-denominated assets, for fear that they might not be able to freely exchange them when needed. In short, absent of significant financial reforms in China, it seems improbable that the yuan will replace the dollar as the global reserve currency anytime soon.

The Future of the U.S. Dollar as the World's Reserve Currency case:

01. Why does the United States hold the position as the world's reserve currency?

02. Do you think the US dollar will continue to be the world's reserve currency? Why?

03. As one of the world's largest economies, China is in a position to influence the global economy. What is preventing China's yuan from becoming the world's reserve currency?