A reserve currency is different from the currency in which payments are settled.

characteristics of a reserve currency: What is reserve currency? What are its features? This is what is kept by the countries in the form of foreign exchange reserves. These are needed to bridge the gap between a country’s international payments and receipts and to act as a buffer to meet any contingencies. Such reserves may be held in the form of gold or any foreign currency that can be used freely – or what is called a fully convertible currency.

First, it is clear that a reserve currency should not be subject to any control of the issuing country. In other words, the Chinese currency can only be a reserve currency if the Chinese government does not and/or is unlikely to exercise any control over its use. The holding of USD as a reserve currency is based on its reliability and its use will not be subject to any controls. This important feature of a reserve currency has been called into question with sanctions imposed by the US on Russia following the Ukraine war. The second requirement for reserve currency is that there should be sufficient availability of that currency to be held as reserves. This may mean that the country is willing to expand its currency by a sufficient amount to be held by other countries as a reserve asset, which means running a current account deficit on an ongoing basis. This is known as Triffin’s Paradox. Third, reserve money should be available for investment in liquid form. Ensuring liquidity in a currency requires well-developed debt and equity markets in that currency.

historical experience: Historically, gold has been used as a reserve currency, as the final settlement of trade was usually done in gold. It was universally accepted, there was no sovereign power controlling its creation or use, and it always enjoyed a standard value in economic transactions. Over time, the supply of gold was no longer sufficient to meet the growing needs of trade and investment. This led to the emergence of reserve currencies. The currencies of major imperialist countries like Britain were accepted for international payments. As long as the countries whose currencies were being held as reserves committed to convert these holdings into gold, these currencies maintained their reserve status. Initially, the UK’s pound sterling (GBP) was the currency of choice, as it could always be converted into gold by the Bank of England. It lost its reserve currency status when it abandoned the gold standard during the Great Depression and went bankrupt after World War II. As the US began to dominate the global economy and was ready to convert unlimited amounts of USD into gold, it became the preferred reserve currency. Countries started holding their reserves in USD instead of GBP. The tendency to hold dollar reserves continued even after the Bretton Woods system ended in 1971 and the US abandoned the gold exchange standard. The exchange rate system that emerged thereafter was a free-floating system with very limited and exceptional intervention by the major convertible currencies. Countries also announced their preferred exchange rate system (‘pegged’ or ‘floating’) and their intervention currency, for which most countries chose the USD. The system has largely remained the same since then. Special Drawing Rights (SDRs) are issued by the International Monetary Fund (IMF) to supplement official reserves of member countries, but they account for only 7% of total reserves and have not been liquidated for a number of reasons. The emergence of the euro as a single currency was a major change for the countries in the eurozone. Many countries, especially those in Africa, link their currencies to the euro and keep the euro as their major reserve currency. The currency composition of allocated reserves in 2022 compiled by the IMF shows that 58% of reserves are in USD and 19% in EUR.

payment settlement currency: Do recent global events after US sanctions threaten the use of the USD as a reserve currency? To some extent, countries today are toying with alternative currencies and even payment systems for their global transactions.

As the Chinese economy began to dominate world exports, there was a demand by countries for the Chinese currency. China allowed limited convertibility by allowing non-residents to hold renminbi accounts for trade payments. In 2015, it launched the Cross-Border Interbank Payment System (CIPS), supported by the People’s Bank of China, which provides clearing and settlement services for its participants in cross-border renminbi (RMB) payments and trading. On an average, CIPS handle 400 to 500 billion worth of transactions on a daily basis. This is still a negligible portion of transactions carried out through global clearing houses such as CHIPS. But it does provide an alternative to USD for making international payments in onshore Chinese currency. But having such a payment system does not mean that the Chinese currency can become a reserve currency, unless it becomes fully convertible.

In 2022, the Reserve Bank of India (RBI) made an additional arrangement for invoicing, payments and settlement of exports/imports in Indian Rupees (INR) through Special Rupee Vostro Accounts (SRVAs). As of March 23, 18 countries were permitted by the Reserve Bank of India to open SRVAs to settle payments in INR. While such arrangements allow for increased invoices of trade in INR without explicit multilateral agreement, they are not much different from India’s bilateral trade and payment arrangements with the former Soviet Union and later Russia, with all its attendant problems. with.

Geopolitical considerations and the COVID-19 experience of supply chain disruptions also forced countries to enter trade blocs and in some cases establish their own payment systems.

However, the role played by reserve assets cannot be replaced or mitigated by these payment arrangements. The need for a national currency serving as a reserve currency with the key characteristics of convertibility, usability, and availability will continue, and in this context, the role of the USD will continue to be important.

C. Rangarajan and Usha Thorat are former Governor and Deputy Governor of the Reserve Bank of India respectively.

Updated: June 19, 2023, 12:38 AM IST