How Do Countries Lose Their Reserve Currency Status?
A reserve currency is one that is held in significant quantities by governments and institutions as part of their foreign exchange reserves.
These currencies are often used for international transactions and tend to be currencies of the world’s most powerful and stable economies.
The US dollar, the Euro, and the Japanese yen are examples of such currencies.
Key Takeaways – How Do Countries Lose Their Reserve Currency Status?
- Reserve currency status is held by currencies that are widely held by governments and institutions for international transactions. Examples include the US dollar and to a lesser extent the Euro and Japanese yen.
- Factors leading to the loss of reserve currency status include economic and political vulnerabilities, increasing national debt and liabilities, chronic devaluations from past financial crises, and a run on the currency.
- Bad debt problems accompanied by money printing often coincide with a loss of reserve currency status – or at least make the currency vulnerable.
Factors Leading to Loss of Reserve Currency Status
Most fundamentally, the loss in reserve currency status is at its root the same problem as other economic issues:
- expenses are above incomes
- liabilities are above assets
Let’s look at some more specific factors.
Economic and Political Vulnerabilities
In most cases leading to the loss of reserve currency status, an already established loss of economic and political primacy to a rising rival plays a role.
This vulnerability can be seen historically in the decline of the Dutch guilder as the reserve currency when the Dutch fell behind the UK in terms of economic and political power.
The same happened when the UK lost its primacy to the US. The two were roughly even in overall power by 1900.
The US was clearly more powerful after World War II and the UK lost its reserve status by the Suez Canal crisis in 1956-57.
Increasing National Debt and Its Monetization
Another contributing factor is the presence of large and growing debts that are monetized by the central bank printing money and buying government debt.
When the government increases the supply of money and credit, it results in the reduction of the value of money and credit, thereby putting the reserve currency at risk of losing its value.
Chronic Devaluations
The same factors that lead to a country’s debt crisis can lead to the loss of its reserve currency status.
Chronic and large devaluations of a currency due to debt and inflation problems can lead to the eventual loss of the currency’s reserve status.
This devaluation stems from an increase in the supply of money and credit, which reduces their value.
The Dynamics of a Run on the Currency
In the significant cases studied, all economies experienced a classic “run” dynamic.
This means that there were more claims on the central banks than there was hard currency available to satisfy those claims.
Net central bank reserves start falling prior to the actual devaluation, sometimes years ahead.
Role of Debt Problems
The run on the currency and subsequent devaluations usually coincide with significant debt problems.
These problems are often related to wartime spending which puts pressure on the central bank to print more money.
Countries losing wars are in the worst position as it often leads to the total collapse and restructuring of their currencies and economies.
Germany after World War I and II and Japan after World War II are examples.
Japan’s markets fell 96% from 1928 to 1948.
Italy lost 87% over that same period.
However, even victorious nations can lose their reserve currency status if they end up with debts much larger than their assets and reduced competitiveness, as was the case with Great Britain.
Related
Central Banks’ Response to Devaluation
Typically, central banks initially respond to a run on the currency by not increasing the supply of money.
This allows short-term rates to rise to forestall the devaluation.
However, this measure is often too economically painful, leading the central banks to capitulate and devalue.
After the devaluation, they typically cut rates.
Case Studies: The Dutch Guilder, British Pound, and the US Dollar
For the Dutch, the collapse of the guilder was massive and relatively quick in 1780.
The decline was fueled by the loss of the Netherlands as a world power during the Fourth Anglo-Dutch War and its subsequent invasion by France.
The British experienced a more gradual decline, taking two devaluations before the pound fully lost its reserve currency status.
This was largely due to balance of payments strains and the loss of economic and political power to the US.
The US has experienced two significant devaluations in 1933 and 1971, and more gradual devaluations against gold since 2000, but it has not lost its reserve currency status.
FAQs – How Do Countries Lose Their Reserve Currency Status?
What is reserve currency status and why is it important?
Reserve currency refers to a foreign currency that is held in significant amounts by governments and institutions as part of their foreign exchange reserves.
It is used in international transactions and investments.
Reserve currency status grants a country various economic advantages, including lower transaction costs in international trade and the ability to borrow money at lower interest rates.
Furthermore, it provides a layer of economic security, as the country can pay for imports and service its external debts in its own currency.
How does a country lose its reserve currency status?
A country may lose its reserve currency status due to chronic and large devaluations, typically triggered by debt crises.
These devaluations are often a result of central banks increasing the supply of money and credit, which can reduce the value of money and credit, thus driving people out of these assets and into inflation-hedge assets and other currencies.
If this situation persists and is coupled with major economic and political decline, it may lead to a loss of reserve currency status.
The process usually involves a run on the currency, which is when there are more claims on the central bank than there is hard currency available to satisfy those claims.
How does increasing the supply of money and credit lead to devaluation of the currency?
When a central bank increases the supply of money and credit, it essentially reduces the value of each unit of money due to the basic principles of supply and demand.
Inflation results in a reduction of purchasing power, making holders of cash and credit worse off.
Over time, this could lead to a shift away from the devaluing currency to more stable or appreciating assets, causing further devaluation of the currency.
How does a debt crisis contribute to a currency losing its reserve status?
A debt crisis puts pressure on a country’s central bank to print more money to finance the debt.
This can lead to inflation and currency devaluation.
As confidence in the value of the currency decreases, people may start to move their investments to more stable assets or currencies.
If this dynamic persists, it could potentially lead to the country losing its reserve currency status.
Are all devaluations systemically destructive?
No, not all devaluations are systemically destructive.
Some devaluations can actually be beneficial to the economy by relieving debt burdens and enabling a needed easing of monetary policy.
However, if the devaluation is severe and persistent, it could lead to a loss of confidence in the currency, and in extreme cases, a breakdown of the monetary system.
Are there common signs that a currency is losing its reserve status?
Yes, a common pattern leading up to a country losing its reserve currency status includes:
- an established loss of economic and political dominance to a rising rival, creating vulnerability;
- large and growing debts monetized by the central bank printing money and buying government debt, leading to…
- a weakening of the currency due to a self-reinforcing run from the currency.
Can a country regain its lost reserve currency status?
Regaining reserve currency status is difficult and rare.
Once lost, it usually implies that the country has been surpassed economically and politically by another country, which has taken over the role of providing a stable and reliable reserve currency.
Restoring confidence in a currency to the point where it is again seen as a safe store of value for foreign governments and institutions would likely require significant structural changes and a prolonged period of economic stability and growth.
In the end, governments have to get their finances in line and ensure they have at least as much revenue than expenses and more assets than liabilities.
Can the reserve currency status be shared among several countries?
While one currency usually dominates as the global reserve, it is possible for the status to be shared among multiple currencies to some extent.
For example, besides the US dollar, the euro and the Japanese yen also make up a significant portion of foreign exchange reserves globally.
However, for a currency to gain substantial reserve status, it requires the country to have large, open, and reliable financial markets, and a history of economic and political stability.
It can also be the case that no currency is particularly attractive. During periods of war time, for example, there is a lack of trust so gold is often the preferred unit of exchange.
When Weimar Germany was tasked with repaying its war reparations debt, it had to be done in gold for fear that they would simply repay in devalued money.
How does wartime spending contribute to a country losing its reserve currency status?
Wartime spending often leads to massive debt accumulation.
To finance these debts, the central bank might resort to printing more money, which could lead to inflation and currency devaluation.
If this cycle persists, the country could lose its reserve currency status.
In extreme cases, countries that lose wars can experience total economic collapse, necessitating a complete restructuring of their currencies and economies.
What are some historical examples of countries losing their reserve currency status?
Historical examples include the Dutch guilder and the British pound.
The Netherlands experienced a quick and severe collapse of the guilder over less than a decade, largely due to a major war loss and subsequent French invasion.
The UK’s loss of reserve currency status was more gradual, with two significant devaluations before the pound fully lost its status.
The UK was hurt by spending on two World Wars, less economic and political influence due to the rise of the US, and lowered cost competitiveness (e.g., a British worker was more expensive than workers in other countries who would do the same thing for less).
In both cases, large debts and increased money printing led to currency devaluation, with political and economic decline contributing to the loss of reserve currency status.
Conclusion
The loss of a country’s reserve currency status is a process involving a mix of economic, political, and monetary factors.
Chronic devaluations, increased national debt, economic and political vulnerabilities, and the dynamics of a run on the currency are key contributing factors.
Understanding these dynamics is important in predicting future shifts in not only currency markets but also global power.