Foreign Exchange

Yelian Garcia on Global Central Banks & the Decline in Foreign Exchange

The dollar’s share of the global foreign reserves hit its lowest point since 2013, as central bankers have begun net sellers or treasuries. As the ‘de-dollarization’ trend continues to pick up steam, a full-time MBA student and CFA candidate, Yelian Garcia explains the fluctuating changes in foreign exchange reserves.

What are Foreign Exchange Reserves?

Foreign exchange reserves are assets held on reserve by a central bank and held in a currency different than the domestic currency of such central bank. Another way of thinking about foreign reserves is that they represent some of the savings of a nation. These foreign exchange reserves are used to back liabilities and implement domestic monetary policy. It is a common practice for most countries around the world to hold a significant amount of their reserves or savings in a foreign currency. Most of these reserves are held in U.S. dollars since it is the most traded currency in the world and most global trade is settled and denominated in the USD. Economists have theorized that it is better to hold at least some portion of reserves in a currency other than the domestic currency for diversification and risk management purposes.

As mentioned above, the US dollar’s share of global central-bank reserves fell to the lowest level since 2013 while holdings for the Chinese yuan rose for a fourth consecutive quarter. China is the world’s largest foreign exchange reserve holder, and the world’s second largest economy, and recently joined the global central bank gold rush by increasing its gold reserves. In the past, China has been reluctant to diversify its the US $3 trillion reserve position into gold but may have decided to make the change as a “safe haven hedge” amidst geopolitical risks in the world. China has long been trying to diversify its reserves away from the US dollar and explicitly announced in 2013 that ‘it is no longer in our best interests to stockpile US dollars.’

The U.S. Dollar as the World’s Dominant Currency

As Yelian Garcia explains, for the past 70 years, the U.S. dollar has been the world’s dominant reserve currency, but this status is slowly being threatened at the margin. Aiming to take center stage in the global economy, China is looking to promote globalization, boost foreign aid, develop advanced technology, and internationalize its currency. There are headwinds, however, including capital controls, lack of regulatory transparency, the poor rule of law, and lack of a deep and liquid market for yuan-denominated assets. These headwinds make it impossible for the yuan to achieve global reserve currency status, but it may very well achieve trade currency status in short to medium run.

The reason for the decline would be political rifts between the United States and other countries, but the numbers do not confirm these conclusions just yet. The ramifications of this change are quite significant. Yelian Garcia states that for more than half a century, the dollar has been the reserve currency of choice for most of the world’s central banks, as it has depth and stability in global markets. This long-held stability has given America some major benefits within global trade and global finance; the widespread use of dollars in global trade makes it cheaper for U.S. multinationals to borrow compared with many of their overseas competitors.

With a slowdown in the world economy, the ongoing trade wars and uneasy financial markets, policymakers are forced to proceed with caution.

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