Why is the dollar the reserve currency?

The US dollar is the most important reserve currency today mainly due to the legacy of the Bretton Woods system. Throughout the last decade, more than 50% of the total sum of international reserves has been in dollars. For this reason, the US dollar is considered to have reserve currency status, allowing the US to run larger trade deficits (financed by seigniorage) with limited economic impact as long as the largest foreign holders of dollars continue to accumulate them.

Before the US dollar, the pound sterling was used as the international reference currency. Like the dollar, the pound initially backed its value in gold (this relationship was called the gold standard). This support was abandoned by the British government at the end of the First World War.

What is a reserve currency?

A reserve currency is a currency that is used in large amounts by many governments and institutions as part of their international reserves. In addition, it also tends to be the currency through which the prices of goods traded in the global market such as oil, gold, etc. are established. More recently some countries, especially in Asia, have been accumulating huge reserves in order to strengthen the competitiveness of their exporters by not allowing the local currency to appreciate. They also do it with the aim of containing large and rapid capital inflows and cushioning major financial crises such as the Asian one.

This allows the issuing country to purchase products at marginally cheaper rates than other nations, which have to exchange their currencies with each purchase, incurring in transaction costs (for major currencies, this transaction cost is negligible compared to other countries with respect to the price of the product). It also allows the government to issue currency to borrow at a better rate since there will always be a larger market for this currency than for others.

Consolidation of the hegemony of the dollar

Three factors have been decisive for the hegemony of the dollar to take place and consolidate: the Bretton Woods Agreement, the price of oil in dollars, and the emergence of unregulated global trade.

Bretton Woods Agreements

These agreements took place in July 1944, under strong influence from the United States, the largest world power already established prior to the end of World War II. Under these conditions, the use of the dollar at a global level is defined and its value was backed in gold. In 1971, during the presidency of Richard Nixon, this relationship is broken. Therefore, the dollar is no longer backed in gold, but exclusively in the confidence granted by its users, consolidating from there its full character as fiduciary currency. Notwithstanding this, it continues its hegemonic presence in global finance.

Quote of oil prices in dollars

It occurs after the oil crisis of 1973. The oil-exporting countries (grouped in the Organization of Petroleum Exporting Countries, OPEC) obtain a significant income from foreign currency in dollars. This money would be partially destined for the development of their economies, but it would also find as a destination the indebtedness of several Latin American countries that were under dictatorial regimes (originating the Latin American debt crisis of the early 1980s). The bulk of these debts was also denominated in dollars.

The emergence of unregulated global financial trade

From the end of the Cold War, the majority of global transactions, including from the countries of the former Soviet Union, would continue to be based on the US dollar. China, as a global economic power, becomes the main creditor of the United States, keeping a large part of its reserves in debt bonds of that North American country. In addition, the inflationary crises in Latin American countries (a consequence of previous debt crises) also contribute, highlighting the cases of Venezuela, Brazil, Argentina, and Ecuador.

Advantages for the United States of using the dollar as a reserve currency

The hegemony of the dollar gives the United States an advantageous position at the international level since it allows it to frequently run budget deficits, incurring extraordinary expenses that are covered by issuing currency.

Likewise, the country should not assume the costs associated with the conversion of its currency for others, since most of the trade with other nations is in dollars.

Impact on the economies of developing countries

In Ecuador, after several inflationary crises, in 1999 a total replacement of its national currency by the dollar was carried out, that is, dollarization. This has generated monetary stabilization but at the same time an increase in the cost of living for Ecuadorians, increasing poverty and reducing the competitiveness of tourism and industry.

In Argentina, the avidity for the US currency has generated severe balance of payments problems during the second half of the 20th century and the beginning of the 21st century. In the 1990s, a convertibility policy was implemented, by which the value of the Argentine peso was fixed to that of the dollar. The aim was to curb inflation and stabilize the national currency, through liberal policies that included trade liberalization and relaxation of employment conditions, facilitating layoffs, and increasing unemployment and poverty. 

Despite the high social cost, it was not possible to prevent the constant flight of foreign currency. Both the loss of competitiveness implied by the peso-dollar parity, as well as the high level of indebtedness, were factors that triggered the crisis of December 2001. As of that moment, the parity between the two currencies was broken, and the aforementioned avidity for the dollar continued, which fueled the country’s inflationary problems. In 2011, 45% of the demand for dollars came from small savers.

In Venezuela, the hyperinflation and mega devaluation of the sovereign bolívar have led to measures such as the de facto dollarization of the economy (although this has not yet been made official).

Criticisms and possible alternatives

The monetary hegemony and use of the US dollar as a reserve currency have given rise to numerous criticisms and proposals to establish alternatives. Traditionally, the possibilities of the euro to establish itself as the dominant currency have been discussed, since most of the reserves of the European Central Bank are denominated in dollars.

In the first summit of the bloc made up of Brazil, Russia, India, China, and South Africa (BRICS) the role of the dollar as a world reserve currency has been criticized.BRICS has a combined gross domestic product (GDP) in 2014 that almost doubled that of the USA. The member countries have then agreed to carry out transactions using their own currencies directly, in addition to the creation of their own bank as an alternative to the IMF and the World Bank.


During the Bretton Woods Agreements, the economist John Maynard Keynes proposed to establish an international currency, the Bancor. Initially, the value of this new monetary unit would be established in relation to 30 basic goods or commodities. Bancor’s purpose was to stabilize the average price of basic goods with the value of the international medium of exchange and wealth accumulation (or reserve currency).

Keynes’s initiative is finally scrapped in favor of the US proposal, reserving the same role as Bancor for the dollar, in exchange for the US Federal Reserve holding its value in gold. The US currency would then be adopted as the general currency of exchange and savings worldwide, and its value would be permanently fixed at a rate of $35 per ounce of gold. On the other hand, the value of the rest of the national currencies would be established in relation to the dollar.

Chinese Yuan Advance

The growth of the Chinese economy since the end of the 20th century has given vigor to its currency, the yuan, which has increased its value against the US dollar. This positions the Chinese currency as a possible alternative to be used as a global reserve currency. Starting in the 2010s, the Chinese government has promoted measures aimed at the internationalization of the yuan.

These measures include the presence of Chinese banks in the main financial centers of the world, as well as the realization of mutual monetary support agreements with several countries (financial swaps). Likewise, negotiations have been initiated with the IMF to include the yuan in the SDR basket, which was finalized in October 2016. The yuan became the third currency with the greatest weight in the basket, with 10.92% of the total, above the Japanese yen and the pound sterling.

Libyan gold dinar

Starting in 1986, the Libyan government led by Muammar Gaddafi began to propose the creation of a new international currency, the gold dinar. This currency would be backed by the gold reserves of that country (144 tons in 2011), and in principle, it would have the function of replacing the dollar in international transactions of African countries, with special emphasis on oil exports.

Libya was, in 2011, the country with the greatest government control over this resource in the world. The final proposal was to establish the gold dinar as a single currency for the entire continent, with the support of most Arab and African countries that same year, with the exception of South Africa and the leader of the Arab League. This initiative was rejected by both the United States and the European Union and would have been one of the reasons that motivated the military intervention carried out at that time.

Role of cryptocurrencies

The appearance of the so-called cryptocurrencies, such as Bitcoin, represents a new paradigm in terms of reserve of value. Bitcoin, for example, has increased its unit value from USD 0.003 in 2010 to more than USD 22000 in 2022, although it suffers from sharp variations in its price.

The use of these cryptocurrencies in illegal activities, as well as the impossibility for national states to establish tax policies on transactions carried out through this instrument, are controversial. Bolivia and Ecuador have become the first countries to explicitly prohibit the use of cryptocurrencies, in June and July 2014 respectively. In the particular case of Ecuador, whose economy is dollarized, the creation of a national and official cryptocurrency.

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