What is a reserve currency?

is the world order moving towards multiple currency systems? Whispers about finding an alternative payment method have recently intensified after Western countries, led by the United States, imposed a slew 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 sanctions imposed on it for its nuclear program.

Back in India, there are more and more UPI takers. France, United Arab Emirates, Singapore, Nepal and Bhutan are now on board UPI. And that fuels India’s ambition to put the 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 usually a globally recognized foreign currency that central banks or other financial institutions hold in large amounts as part of their country’s foreign exchange reserves. It is used for global transactions involving trade and investments. Currently, the US dollar is the world’s main reserve currency.

A reserve currency is also used by central banks to prepare for international debt obligations and to influence their domestic exchange rate. Much of the commodity, from gold to oil, is denominated in the reserve currency. Thus, other countries must hold this currency to pay for these products.

There is one more reason to hold a reserve currency. This minimizes the currency risk since the buying country will not need to exchange its currency for the reserve currency when making purchases. Apart from import payments and external debt service, countries also keep such reserves to weather economic crises. Suppose a country sees the value of its currency fall during a recession, then its central bank can use its foreign exchange reserves to maintain the value of its currency.

Main characteristics of the reserve currency

The main characteristic of a reserve currency is that it should be easily convertible and have a stable value. The factors that determine the use of a country’s currency as a reserve currency are the size and weight of its economy, in particular the importance of the economy in world trade, the openness and depth of markets financial institutions of the country concerned and its macroeconomic policies.

Since 1944, the US dollar has been the world’s main reserve currency, which is why other countries are watching US monetary policy closely to ensure that the value of their reserves is not negatively impacted by inflation or to rising prices.

Over the years, the IMF has selected other reserve currencies, namely the euro, Chinese renminbi, Japanese yen, British pound, Australian dollar, Canadian dollar and Swiss franc.

There has been speculation that the Chinese renminbi will replace 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 in the future.

For the rupee, meeting the ambition of becoming a reserve currency requires full capital account convertibility, as the Tarapore Committee suggested in 1997.

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