Let’s talk about dollars. In response to interest by our clients and readers, we will develop an explicative account of the dollar’s role in world trade and exchanges. Our series about the role of the dollar among different parties, such as global investors, traders, and other economic actors, is the beginning of an ongoing pursuit to fully develop dollar discussion with our community.

Today, let’s talk about what makes the dollar appealing to international actors. In this post, we will discuss:

1)    What percentage of world trade is denominated in US dollars

2)    What makes the dollar so appealing to international actors

In order to explain how international trade denominated in the dollar behaves, we first need to step back to see how banks that use various currencies and/or are in different countries settle transactions between one another. The Bank for International Settlements (BIS) provides the best public data on this subject area.

The Bank for International Settlements (BIS) provides services for central banks, monetary authorities, and international financial institutions. Though the BIS is not the only source for foreign exchange, it is a reliable source for research of the international financial system, including foreign exchanges. The BIS assists in the settlement of foreign exchange trades (FX) across countries, so that central banks can settle exchanges from cross-border financial flows. In this way, countries maintain a more stable international financial system.[1]

Produced by Castle Rock Investment Company

The simple process to transfer dollars to any foreign value is described below, with the BIS as an observational authority. The BIS is responsible for Basel rulings, collecting and publishing research with the cooperation of central banks, and identifying instances of international banking fraud.

What percentage of world trade is denominated in dollars today?

The BIS uses data provided by Central Banks in their Triennial Central Bank Survey (most recently updated in April 2013) to monitor and analyze the foreign exchange market. The US dollar is the dominant currency vehicle in international trade, comprising one side of 87% of foreign exchanges as of April 2013 (according to the Bank for International Settlements’ “Triennial Central Bank Survey”). This means that 87% of settlements between banks on an international level are either to or from US dollars.

Not only is the dollar a popular trading vehicle, it is also very popular to save; dollar holdings abroad are actually larger than the amount used to trade. These values are called “foreign reserves” and are researched globally by the International Monetary Fund (IMF). The US dollar comprises 60.9% of allocated reserves globally, meaning that the dollar denominates the majority of global reserves in government and institutional accounts.

Source: International Monetary Fund, http://www.imf.org/external/np/sta/cofer/eng/
Source: International Monetary Fund, http://www.imf.org/external/np/sta/cofer/eng/

So what makes the dollar universally attractive?

The dollar is popular because it is a hard currency, and more consistent than any other. Due to the framework and history of the international trading system, the dollar has been the dominant currency since the end of WWII and the creation of the Bretton Woods institutions.[2] Currently the dollar does not face strong competition from other currencies, which are either more strictly controlled by their governments through capital controls or do not have the established history of a banking sector capable of providing credit to international institutions and/or governments.[3]

There is no magic number, to the extent of my education and research, to determine when a reserve currency is no longer a reserve currency. Though the current fragmented international monetary system lacks the stability of an idealized model, the exchange system in place is accepted and adopted by all international trading countries. While the reminbi is growing in popularity as a reserve currency for developing countries, it does not significantly compete with the US dollar at this time. The high international demand for dollars, especially in times of crisis, and the current construction of the international trade and banking systems ensure that the US dollar is fundamental to global economic stability.

Do you have questions on or expertise to add to this conversation? What do you hope to hear about? Add to the conversation on LinkedIn or email me directly at Katherine@CastleRockInvesting.com

Katherine Brown is a Research Associate at Castle Rock Investment Company.

[1] For a more expansive account of the ways that the BIS contributes to financial stability, see their website www.bis.org.

[2] The most popular recent book about the establishment of the Bretton Woods system is called The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White and the Making of a New World Order by Benn Steil (2013). I highly recommend it for a historic perspective on our institutions.

[3] Many monetary economists hold this theory, but the most popular is Barry Eichengreen of Berkley, California. For further reading on the dollar, the IMF produces regular research papers that take about 30 pages to say a more complicated version of what I just said in two sentences.