A reserve currency differs from one that payments are settled in

Source- The post is based on the article “A reserve currency differs from one that payments are settled in” published in the “mint” on 19th June 2023.

Syllabus: GS3 – Indian Economy – Money and Currency

Relevance- Issues related to external account

News– There has been a lot of discussions recently on the international usage of the US dollar as a reserve currency.

What is a reserve currency?

It is the currency held by countries as foreign exchange reserves. These are required to meet the gap between a country’s international payments and receipts. It serves as a buffer to meet any contingency.

Such reserves can be held in the form of gold or any foreign currency that can be freely used or fully convertible currency.

What are its characteristics?

It should not be subject to any controls by the country that issues it. USD as a reserve currency is based on its credibility.

The second requirement for a reserve currency is that there should be sufficient availability of that currency to be held as reserves.

Countries should be prepared to expand their currency in amounts sufficient to be held by other countries as a reserve asset. It means running current account deficits on a sustained basis. This is known as the Triffin’s paradox.

A reserve currency should be available for investment in liquid form. Ensuring liquidity in a currency requires well developed debt and equity markets in that currency.

What is the historical experience associated with reserve currency?

Historically, gold has been used as a reserve currency. Over time, the supply of gold was not enough to meet the growing needs of trade and investment.

This saw the emergence of reserve currencies. Currencies of dominant imperialist countries like the UK were accepted for international payments.

Initially, the UK’s pound sterling was the currency of choice. It could always be converted to gold by the Bank of England. It lost its reserve currency status as it abandoned the gold standard during the Great Depression and became bankrupt following World War II.

As the US began to dominate the global economy. it became the preferred reserve currency.  The trend ended in 1971 and the US abandoned the gold exchange standard.

The freely floating exchange rate system emerged after it. Countries declared the exchange rate system of their choice and their currency of intervention. Most countries picked the USD for it. The system has broadly stayed the same since then.

One major change was the emergence of the euro as a single currency for countries in the Eurozone.

The currency composition of allocated reserves in 2022 as compiled by the IMF shows that 58% of reserves are held in USD and 19% in euro.

Do recent global events following US sanctions threaten the use of the USD as a reserve currency?

Countries today are going alternate currency and even payment arrangements for their global transactions.

China allowed limited convertibility by letting non-residents hold renminbi accounts for trade payments.

In 2015, it introduced the Cross-Border Interbank Payment System (CIPS), backed by the People’s Bank of China.

It offers clearing and settlement services for its participants in cross-border renminbi payments and trade. But it does not mean that the Chinese currency can become a reserve currency, unless it becomes fully convertible.

In 2022, the RBI introduced an additional arrangement for invoicing, payment and settlement of exports/imports in Indian rupees through Special Rupee Vostro Accounts.

It allows increased invoicing of trade in INR without multilateral settlement. But, they are not very different from India’s bilateral trade and payment arrangements with Russia.

Geo-political considerations and the covid-19 experience of supply chain disruptions also forced countries to enter trading blocs and set up their own payment arrangements.

The role played by a reserve asset, however, cannot be replaced or minimised by these payment arrangements.

A national currency serving as a reserve currency with key characteristics of convertibility, usability and availability will continue to be needed. The role of the USD will continue to be important.