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US dollar's role as top reserve currency safe even as global share hits new lows

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US dollar's role as top reserve currency safe even as global share hits new lows

The proportion of U.S. dollars held worldwide by government central banks and other financial institutions as foreign exchange reserves fell to its lowest level in more than two decades during the fourth quarter of 2020, a drop largely blamed on U.S. monetary policy changes in response to the COVID-19 pandemic that weakened the greenback throughout the year.

But foreign exchange analysts see no possibility of the dollar losing the title as the world's dominant reserve currency, which it has held for generations.

"There is no immediate threat of the [U.S. dollar] losing its status as the world's reserve currency given the lack of liquid alternatives," Lee Hardman, a currency analyst with MUFG, said in an interview.

As the world's major reserve currency, more central banks and major financial institutions hold the dollar for use in international transactions and investments than any other currency. At the end of the fourth quarter of 2020, about 59% of global foreign exchange reserves were dollars, totaling more than $7 trillion, the International Monetary Fund reported March 31.

It was the first time the dollar's share of the world's currency reserves fell below 60% since 1997. The dollar's value in 1998 rose to its highest level in more than a decade, reflecting strong demand for the currency in the aftermath of a financial crisis in several East Asian countries, according to the IMF.

By comparison, the euro accounted for 21.2% of global reserves in the fourth quarter of 2020 while the Japanese yen accounted for just over 6%, according to the IMF.

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While still accounting for the bulk of reserves, the dollar's share has fallen from 61.8% in the first quarter of 2020 and from 65.4% in the fourth quarter of 2016.

The decline of the dollar in world reserves tracked the dollar's decline as the COVID-19 pandemic took root and the Federal Reserve lowered short-term interest rates and increased the supply of dollars available to central banks in order to ease financial conditions.

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The dollar became "less attractive following the pandemic," said Hardman with MUFG. This was mostly due to the Fed's accommodative monetary policy and government stimulus efforts, which increased U.S. federal budget and current account deficits, he said.

"The [dollar] would likely have declined even more sharply if other advanced currencies had not seen similar deterioration in their own long-term fundamentals," Hardman said.

The Dollar Index, which measures the U.S. currency against a basket of six peers, fell 12.8% from its peak of 102.82 on March 20, 2020, to 89.63 at the end of the year. The dollar has since rallied in 2021, with the Dollar Index closing at 92.34 on April 6.

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To be a reserve currency for foreign central banks, a currency must be from a country with a large, liquid debt market that is accessible to foreign investors, be freely convertible, have an independent central bank, and be used widely in trade and global transactions.

In a March 18 note, Kathy Jones, chief fixed-income strategist with the Schwab Center for Financial Research, argued that the U.S. dollar would likely remain the world's top reserve currency simply because no other currency could meet those standards.

The Chinese renminbi, for example, is not freely convertible to other currencies as it is government managed and "investors can't be sure whether capital controls could be used to limit access their holdings," she wrote.

The euro, on the other hand, is unlikely to become the top reserve currency since its bond markets are "fragmented across many different countries and are less liquid than the U.S. Treasury bond market, limiting the amount that a foreign investor might be able to hold in euros," Jones wrote.

Gaining status as the world's top reserve currency has advantages, she said, which the U.S. currently enjoys.

"It means there is underlying demand for U.S. bonds from foreign central banks and other large investors looking for a safe market in which to invest," Jones wrote. "That allows the U.S. to borrow at lower rates than would otherwise be possible."

But Marshall Gittler, head of investment research at BDSwiss, said becoming the world's major reserve currency can take a heavy toll. Being held as a major reserve currency causes a currency to appreciate and leads to a dip in exports, a dampening of growth and an increase in unemployment, he said.

"The fact that the [dollar] is the world's major reserve currency is a burden for the U.S., not a privilege," Gittler said in an interview.