USD No Longer A Reserve Currency (And Why That Doesn't Matter)

There are two potential definitions of “reserve currency.” The first is quantitative and weak: do other countries hold official foreign exchange reserves in that currency? The second is qualitative and stronger: is the currency at the centre of global financial markets while other countries peg their currency to the reserve currency, necessitating large holdings of official reserves? That is, the stronger definition implies that the reserve status affects economic behaviour beyond a basic fixed income portfolio allocation decision.

The U.S. dollar — along with other major developed currencies — qualify under the weaker, quantitative definition of reserve currency. Other countries hold a lot of official reserves in USD — perhaps not entirely happily at this point — and only selective defaults may change that. However, no foreigner in their right mind would want to peg to USD right now, and any pegs that exist are legacies of the pre-Trump era. Whether USD qualified in 2024 under the stronger definition of “reserve currency” is debateable, but one could argue that USD dominance was still running on fumes at that point, and it could cause countries to attempt a peg strategy in the future.

Throwing in the towel on the strong definition of “reserve currency” has very limited real world effects. At most, it might get excited commentators to stop writing about the “demise of reserve currency status,” but that is unlikely. Like water fluoridation and the World Economic Forum, “reserve currency status” is cemented into the brains of conspiracy theorists around the world and across the political spectrum.

State of Reserves (2023)

Courtesy of the World Bank (link), foreign official reserves holdings (including gold) as of 2023 are as follow for the top 10 holders (USD value in billions, rounded to nearest billion).

1. China $3,450 (BN).

2. Japan $1,295 (BN).

3. Switzerland $864 (BN).

4. United States $773 (BN).

5. India $628 (BN).

6. Russian Federation $597 (BN).

7. Saudi Arabia $458 (BN).

8. Hong Kong $426 (BN).

9. Korea, Republic $421 (BN).

10. Singapore $360 (BN).

The first euro country is Germany (12th) with $323 billion, then Italy (13th) where holdings drop off to $248 billion.

What we see from the above is that the big reserve holders are mainly Asian export-led growth powerhouses, energy exporters, along with India with precautionary reserves, Switzerland due to its massive intervention to keep the franc stable versus the euro (not the dollar), and the U.S.’ legacy gold reserve position.

In other words, the only major reserve holders who conformed to the qualitative definition of “reserve currency” are energy exporters and the Asian export-led growth countries — who generally no longer truly peg their currencies to the USD. China uses CNY fixings as a policy variable, but the value of USDCNY is no longer stable enough to be considered a peg.

In other words, you need to dig down to small emerging markets and possibly energy exporters to find countries that are treating USD as a reserve currency as was the case in earlier currency schemes. Although energy exporters are politically and strategically important, they are not a large weight in global economic output.

USD Exposure: A Problem To Be Managed

Reserve managers without a qualitative justification for holding USD reserves treat USD-denominated bond holdings like any other fixed income manager treats them: an asset class within a portfolio. They will wake up in the morning with a position report with the current weighting in the portfolio, and they will have a desired weighting.

It is a safe bet that reserve managers in aggregate are holding a lot more USD-denominated bonds than they would desire. However, it is also a safe bet that they know that a lot of other bond managers are in the same position. Reserve managers are by their nature cautious, and are unlikely to run screaming for the exit. Luckily, there is an escape valve to reduce USD bond weighting — USD dropping in value in foreign exchange markets.

U.S. Treasurys have a large capitalisation weight in useful global bond market indices (since we need to exclude markets that are non-investable for foreigners like China). There are also the large legacy reserve positions in Asia that would take a long time to unwind. The asymmetry between the euro and USD (euro countries have non-gold reserves, while the U.S. has none) means that USD portfolio weightings will be above capitalisations weight, in the absence of actions that make USD a no-go market for foreigners (e.g., “Mar-a-Lago Accord” forced exchange wackiness).

Reserve Holdings and C$2.20 Gets You a Cup of Coffee

There is considerable folklore about the importance of reserve holdings. Allegedly, reserve holdings reduce bond yields (or in a more “sophisticated” phrasing, reduce term premia).

The problem with that theory is that 100% of bonds are owned by somebody 100% of the time. (If not, somebody needs to talk to the accountants or back office.) Foreign reserve managers normally park their liquidity portfolios at the front of the curve (although larger holders probably run part of their portfolios across the entire curve like an index fund). Why exactly are front end portfolios and index portfolios reducing term premia?

The ugly reality is that bond markets are boring most of the time. Analysts that cover them still need to come up with something to write about. The “who will buy the bonds?” stories that come out like clockwork are a great way of coming up with filler articles that are extremely popular with the great many readers who hate government bonds and want the market to collapse. The problem with continuously churning out nonsense is that you begin to believe the nonsense, and so we end up with people believing the logic “Big buyer of bonds = lower yields” without asking rudimentary questions like “why do we give a rat’s <redacted> about change in holders’ weights in the first place?”

Of course, large holders doing something radical will effect prices in the short term. In particular, 30-year bonds are only very loosely tethered to the valuation magnet of the overnight rate, and are a thinly-traded segmented market. Foreigners dumping 30-years en masse would leave a mark. However, that does not say anything about the long-term effect of reserve holdings. Reserve managers are not idiots and try not to move the markets. Even if they increased the demand for ultra-long paper (unlikely), supply is not exogenous: debt management offices calibrate long end issuance to meet expected demand. To the extent that there is a persistent term premium in 30 years due to “supply and demand,” it is the result of debt management offices mismanaging their issuance weights.

But Oil is Denominated in USD!

An allied idea to “loss of reserve currency status” in the conspiracy mongers’ minds is the dreaded possibility of no longer denominating international oil prices in USD. Given that the U.S. is an energy exporter and Europe an energy importer, I do not see any reason for the energy markets to stop pricing in USD.

Nevertheless, this is a nothingburger. Forward currency markets are extremely deep and liquid — multibillion dollar issues are routinely swapped between random currencies all of the time. No matter what currency an invoice is denominated in, friendly bankers at even mid-sized banks are perfectly able to hedge that exposure into your local currency.

Private Sector Issuance?

The speculative part of my thesis is what happens to private sector cross-currency debt issuance.

If you are an exporter, it makes perfect sense to issue debt in the currency of your export markets. Although there is an element of raw stupidity in these decisions — firms and individuals borrowing in a “hard” currency because the nominal interest rate is lower — borrowing in your invoice currency (scaled to your revenue exposure) is the optimal decision for firms with adequate risk management capabilities. For example, some Post-Keynesians have kittens about Canadian firms’ borrowing in USD, using it to prove some point about foreign bond vigilantes. However, these people never bother coming to grips with the fact that there has been a complete absence of firms going bankrupt due to currency mismatches, despite the volatility of USD-CAD. The firms that blow up due to foreign borrowing are the ones with inexperience with floating exchange rates, or worse yet, gulled into complacency by a currency peg (e.g., Asian Crisis).

The destruction of America’s trade partnerships will likely reduce imports into the U.S., reducing the need for issuing USD-denominated debt by foreign firms. The undermining of the rule of law may also dissuade foreign interest in issuance subject to American bankruptcy courts.

Since the currency liabilities of local firms are one of the factors determining the target weightings of reserve portfolios, if USD debt issuance by foreign firms drops, USD reserve weights would also decline.

Reserve Accumulation a Thing of the Past?

The United States was the only country that stomached having distant foreign countries peg their currencies to the local currency as a means of pursuing export-led growth. (There are a variety of pegs to the euro, but those are on the European periphery.) The instability of the American regime means that such strategies are now a thing of the past. Instead, we are in a world of managed trade agreements, and trade imbalances are unlikely to get as extreme.

This means that countries will keep their official reserves as a means of fighting short-term instability, but the massive reserve growth by exporters is no longer going to be a feature of the system. (Switzerland did greatly expand its reserves, but that was entirely a financial markets phenomenon, and it is difficult to think of another country in a similar position.) USD official reserve holdings will have a large weighting — in an aggregate official reserve portfolio that is shrinking versus the size of the global economy.

Concluding Remarks

The instability of American policy means that the USD reserve portfolio weighting will shrink. However, this will not make much of a difference — as it unclear it mattered outside of conspiracy theories for a considerable time. The residual strong “reserve currency” status only mattered if new countries wanted to enter into the “export-led growth with a USD peg model” status, and it is not clear that there were many plausible sizeable candidates for that strategy.

Appendix: Foreign Private Sector Holdings

Based on accounting identities, it is entirely likely that foreign private sector buyers might replace foreign official holders of Treasury securities. Foreigners already hold a lot of American equities, so they can just increase the bond holding within their USD portfolios to effectuate this.

It is extremely likely that the “reserve currency status” bugs would shift the goalposts and just refer to “foreign” holders of U.S. Treasurys. However, it is unclear why I should care if a Japanese insurance company holds a security instead of an American insurance company, but then again, I am not trying to market myself on financial conspiracy websites.