What is a reserve currency?

the world order shifting towards multiple currency systems? The murmurs of finding an alternative mode of payment recently grew louder after western nations, led by the US, slapped a host of sanctions on Russia for attacking Ukraine. Iran too had been trying to find an alternative to the US dollar – the world’s reserve currency – to circumvent the sanctions imposed on it for its nuclear programme. 
 

Back home in India, the takers for UPI are growing. France, UAE, Singapore, Nepal and Bhutan are on-board UPI now. And it is fueling India’s ambition to put Rupee on the world map by making it a reserve currency. But what is a reserve currency? 

What is a reserve currency?

A reserve currency is typically a globally-recognized foreign currency that central banks or other financial institutions hold in large quantities as part of their country’s foreign exchange reserves. It is utilised for global transactions involving trade and investments. At present, the US dollar is the world’s predominant reserve currency.  

A reserve currency is also used by central banks to prepare for international debt obligations and to influence their domestic exchange rate. A large proportion of commodities, from gold to oil, are priced in the reserve currency. Thus, other countries have to hold this currency to pay for these commodities.

There is one more reason for holding a reserve currency. Doing so minimizes exchange rate risk since the purchasing country will not need to exchange its currency for the reserve currency while making purchases. Besides import payments and servicing foreign debt, countries also maintain such reserves to overcome economic crises. Let us say a country sees its currency value fall during a recession, then its central bank can use its foreign reserves to maintain the currency value.

Key features of reserve currency

A reserve currency’s main feature is that it must be easily convertible and have a stable value. The factors that determine the usage of a country's currency as a reserve currency are the size and heft of its economy, particularly the importance of the economy in global trade, the openness and depth of the concerned country's financial markets, and its macroeconomic policies.

Since 1944, the US dollar has been the world’s primary reserve currency, which is why other countries closely monitor US monetary policy to make sure that the value of their reserves does not face any negative impact due to inflation or rising prices.

Over the years, the IMF has selected other reserve currencies, which are the Euro, Chinese Renminbi, Japanese Yen, Pounds Sterling, Australian Dollars, Canadian Dollars, and Swiss Francs.

There has been speculation that the Chinese Renminbi will displace the US dollar as the world’s reserve currency in the coming years. It is also believed that the dollar will have to share its influence with other currencies going forward.

As far as the rupee is concerned, meeting the ambition of becoming a reserve currency requires full capital account convertibility, as suggested by the Tarapore Committee in 1997.