The US dollar has been the major international reserve currency since the end of World War 2, some 65 years ago.  The vast majority of international reserves held by governments worldwide are in the form of dollars, over 80 per cent.  

But US leadership of the global economy has been threatened by the global financial crisis and the US's astronomical government debt, as well as by the rise of China and other emerging economies.  For how long can the dollar remain kingpin?  Could the euro or even the Chinese yuan rival or take over from the dollar?  Or should the dollar be replaced by a synthetic currency like the Special Drawing Right (SDR)?

Why hold international reserves?
Why do countries hold international reserves?  Back in the days of fixed exchange rates, reserves were necessary to balance current and capital account transactions.

Today, with floating exchange rates, international reserves are not in principle necessary as the exchange rate can adjust to bring the current and capital accounts into balance.  Experience shows, however, that governments like to intervene in foreign exchange markets to influence or even manipulate the value of their exchange rate. 

China has accumulated some $2 1/2 trillion over the past decade or so as it has maintained a fairly fixed exchange rate in the face of a massive current account surplus giving rise to claims of currency manipulation.  In previous decades, Japan also accumulated substantial international reserves as it held its exchange rate down again with a large current account surplus.

In times of financial instability, liquidity shortages which would otherwise provoke extreme exchange rate volatility can be smoothed by using international reserves.  At the beginning of the recent global financial crisis some international banks withdrew capital from emerging economies leaving them with a "liquidity shortage".  International reserves can provide an insurance against this. 

Oil and other natural resource exporters may also wish to accumulate some of their export proceeds as international reserves, especially when oil prices are high, for future consumption.  This is often done in the form of a sovereign wealth fund.  And national governments which face the prospect of rapidly ageing populations may also wish to accumulate savings in the form of international reserves to finance the future costs of ageing.

Since the 1997 Asian financial crisis, a number of Asian economies have indeed accumulated very large international reserves.  As oil and other commodity prices have been very high over the past decade, oil and commodity exporters have also accumulated large reserves.
According to the CIA Factbook, the world's leading holders of international reserves are: China -- $2.4 trillion; Japan -- $1.0 trillion; Russia -- $0.4 trillion; Saudi Arabia -- $0.4 trillion; Taiwan -- $0.4 trillion; India -- $0.3 trillion; Korea -- $0.3 trillion; Hong Kong -- $0.3 trillion; Brazil -- $0.2 trillion; Singapore -- $0.2 trillion.  (These figures are the dollar equivalent of dollar and non-dollar reserves.) 

Why is the dollar the leading international reserve currency?

As Harvard professor Richard Cooper argues the dollar is not the world’s leading currency by “policy design” just as English is not the leading global language by policy design.  “Both are the evolutionary outcomes of practice and experience”.  After World War 2, the US was clearly the leading world economic and political power.  So markets naturally chose the dollar as the best currency in which to do business, and governments chose the dollar as the best currency in which to hold reserves. 

And once a language or currency takes the lead, it enjoys “network externalities”.  In other words, the more a language is used, the more that it is useful to learn.  Same goes for currencies, the more that they are used for business or reserves, the more that they are acceptable for transactions.   

International reserves are usually invested in government bonds.  And it is here that the dollar has an advantage.  US Treasury bills have a very large, low-risk and highly liquid market.

Could the euro or other currencies be realistic substitutes for the dollar?

Since its inception, the euro has grown in importance as an international reserve currency, especially among euroland’s neighboring countries.  However, in contrast to the US, Europe does not have one single government securities market.  Each national government issues its own euro-denominated securities.  The biggest issuer is the highly unreliable Italy with $2.0 trillion of outstanding debt at end-2009.  Germany, the rock of Europe, has government debt outstanding of $1.6 trillion, but less than one-third of this is short-term, and most Germans hold their government debt investments maturity.  This means that the market is not very liquid, that is, there is not much buying and selling going on.  France’s debt is $1.7 trillion, while that of Spain is $.06 trillion. 

In short, the euro-denominated public debt market is much more fragmented and much less liquid than the market for US government securities which amounts to $9.5 trillion, of which $2.5 trillion is short term.  And with Europe’s present sovereign debt crisis in countries like Greece, Ireland, Portugal and Spain, euro-denominated public debt seems a bigger risk today than even the shaky dollar.  Which country will go next?  Belgium?  Beyond the dollar and the euro, government debt markets are tiny by comparison – UK is $1.1 trillion, Canada is $0.9 and Australia is $0.2 trillion.

The Japanese is another possible international reserve currency with its massive $9.7 trillion in public debt (more than the US), of which $2.5 trillion is short term.  But here in Japan there are also a few question marks.  Yields have been extremely low for a very long time as the government tries to stimulate the economy with easy money.  While Japanese markets are in principle free, there is always the risk that the government could interfere in markets with “guidance” in a way that discriminates against foreigners.  Japanese bureaucrats still have their hands on many of the economy’s levers.  For example, a few months back when the Chinese government was buying big quantities of Japanese government bonds, the Japanese finance minister made vocal public protests.  Looking ahead, however, Japan is a risky bet.  With its perennially weak economy, continued fiscal stimulus packages will add even further to public debt.  And as Japan’s rapid population ageing proceeds, the current account will swing from surplus into deficit. 

Could the Chinese yuan become an international reserve?  China’s economy is now the second biggest in the world.  And its government debt is already as much as that of Germany.  But foreigners cannot yet buy Chinese government securities, and the yuan is not yet convertible for capital account transactions.  But in China things are changing quickly.  Trade settlement can now take place in yuan.  The government is also gradually increasing the freedoms for using the yuan.  In a couple of decades, it could be used more and more as an international reserve currency, especially in the East Asian region where China is progressively becoming the hub of regional trade.

In 2009, the People’s Bank of China Governor Zhou raised the possibility of developing a synthetic international reserve like the SDR.  Some academics, especially anti-Washington ones like Joe Stiglitz, are also pushing this idea.  But the SDR is purely an artificial construct (see below) which is not used in international transactions, and in which no bonds or other financial instruments are issued.  For the SDR to really become an international reserve currency, the world’s governments would have to decide to agree to make it an international currency.  This is hardly likely in the immediate future.

Conclusion

Though many may not like it, it seems inevitable that the dollar will remain the main international reserve currency for the foreseeable future.  The euro will grow in importance as a regional reserve currency.  And the Chinese yuan will also likely grow in importance as a regional reserve currency in the Asian region.  The SDR will likely remain a theoretical nicety that academic economists can discuss to their heart’s content.

References:

Cooper, Richard N. "Does the SDR Have a Future", Working Paper 2010-0006, Weatherhead Center for International Affairs, Harvard University, March 2010.
http://www.wcfia.harvard.edu/node/5778

CIA Factbook
https://www.cia.gov/library/publications/the-world-factbook/rankorder/2188rank.html 

Special Drawing Rights (SDRs), Factsheet
http://www.imf.org/external/np/exr/facts/sdr.htm

Special Drawing Rights (SDRs)

The SDR was created by the IMF in 1969 to support the Bretton Woods fixed exchange rate system. A country participating in this system needed official reserves—government or central bank holdings of gold and widely accepted foreign currencies—that could be used to purchase the domestic currency in foreign exchange markets, as required to maintain its exchange rate. But the international supply of two key reserve assets—gold and the U.S. dollar—proved inadequate for supporting the expansion of world trade and financial development that was taking place. Therefore, the international community decided to create a new international reserve asset under the auspices of the IMF.
However, only a few years later, the Bretton Woods system collapsed and the major currencies shifted to a floating exchange rate regime. In addition, the growth in international capital markets facilitated borrowing by creditworthy governments. Both of these developments lessened the need for SDRs.

The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members. Holders of SDRs can obtain these currencies in exchange for their SDRs in two ways: first, through the arrangement of voluntary exchanges between members; and second, by the IMF designating members with strong external positions to purchase SDRs from members with weak external positions. In addition to its role as a supplementary reserve asset, the SDR, serves as the unit of account of the IMF and some other international organizations.