The recent decline in the value of dollar has again put the dollar in the line of fire as a reserve currency. Currently the United States Dollar is the most widely held reserve currency in the world.

What is a reserve currency?

A reserve currency or anchor currency is a currency which is held in significant quantities by many countries in their foreign exchange reserves. It also tends to be the international pricing currency for products traded on a global market such as oil and gold. Holding the reserve currency permits the holding country to purchase the commodities at a marginally lower rate than other nations, who must exchange their currency with each purchase and pay a transaction cost. It also permits the government holding the currency to borrow money at a better rate, as there will always be a larger market for that currency than others.

Currently with an average of two thirds of the total foreign exchange reserves of countries being held in U.S. dollars, US dollar serves as reserve currency. The euro is the second most commonly held reserve currency, comprising approximately a quarter of allocated holdings. Other important reserve currencies are United Kingdom’s pound sterling and the Japanese Yen.

Why replace dollar as reserve currency

The reserve currency is generally selected based on the strength and stability of the economy. Hence  when a currency becomes less stable, or its economy becomes less dominant, that currency should theoretically be replaced by the currency of a more stable economy. Going by that argument with US economy in deep recession and US dollar losing its value day on day it is time to dethrone US dollar from the reserve currency status .In fact that’s what many of the emerging powers like china and Russia are now lobbying for. These countries are among the biggest holders of dollar assets, mostly in the form of U.S. Treasury debt. China infact has the biggest stock pile of foreign reserves in the world.

The main argument put up by these countries is that US has struggled to maintain the dollar’s value. Against major currencies, the dollar has lost 33 percent in value since 2002 .Also with the current financial crisis prompting the United States to commit trillions of dollars to rescue the economy, these countries fear inflation will further debase the dollar. China, which is estimated to hold roughly 70 percent of its massive $1.9 trillion forex reserves in dollars, is especially worried.

Economist also fear that the benefits that United States enjoys as printer of the premier reserve currency promotes imbalances in the world financial system, allowing US to run deficits as it supplies the world with a steady supply of dollars. If the world is unwilling to continue to accumulate dollars, the US will not be able to finance its trade deficit or its budget deficit.

Other currencies that can replace dollar

The euro is the world’s most actively traded currency after the dollar and so is highly liquid. The share of global foreign exchange reserves held in the euro has grown since its 1999 inception and stands at 25.9 percent up from 18.1 percent. However the European Central Bank has refrained from promoting the euro as a reserve currency, because doing so would increase demand for euro and push up its value against the dollar which could hamper euro-zone growth.

With the emergence of China as world’s most powerful economy many feel that Chinese yuan will replace dollar as the reserve currency. China has already signed deals with trading partners to use  yuan as an invoicing currency. But there are major financial and political obstacles for this to happen. China would have to loosen controls over its economy and financial system to allow the currency to flow more freely so as to facilitate central banks and foreigners to invest freely.

China and Russia have recently suggested that the International Monetary Fund’s Special Drawing Right which is essentially a basket of currencies be used as a global reserve currency unit. In 2010  IMF will review the SDR’s composition and emerging economies like China, Russia and Brazil are likely to push for their own currencies to be included.

Is there a need for reserve currency in the current floating exchange rate regime

The big question that still remains is why is there a need for reserve currency in the floating exchange rate regime. To understand this lets first look at why the reserve currency concept was established. Under the dollar-exchange system established at Bretton Woods after World War II, countries committed to keep their own currencies in a narrow band around a par value expressed in U.S. dollars. No reserves were needed to offset upward pressure on the domestic currency since the monetary authority could sell their own currencies for dollars in theoretically unlimited amounts. But to offset downward pressure on the domestic currency, a reserve currency was needed to purchase and support the domestic currency. A country’s ability to defend its currency from downward pressure was thus limited by the amount of the currency held in reserve.

Under floating exchange rates, the exchange rate itself is supposed to trigger the internal economic adjustments necessary to restore and maintain equilibrium rather than changes in domestic policy. The rule of floating exchange rates is to let the market determine the exchange rate without policy interference. With no pegged exchange rate to defend there is no need for a reserve currency. Thus  reserve currencies are a feature of fixed exchange rates, not floating rates.

The only reason for the requirement of reserve currency is the use of the reserve currency in certain global markets like oil  and gold market. Oil is priced in dollar even if the United States is not a party to the trade. Emerging economies like China, Brazil and Russia are questioning the reason for pricing oil in dollar. Their argument is that oil is entirely global so why not accept different currencies from different countries. If this is implemented then the world financial system can do away with reserve currency system.