The U.S. dollar’s long-held dominance as the world’s reserve currency is showing signs of subtle but significant shifts. Data from the International Monetary Fund (IMF) reveals a noteworthy trend: central banks globally are holding a smaller proportion of their reserves in U.S. dollars. In fact, by the fourth quarter of 2020, the dollar’s share had dipped to 59%, marking a 25-year low. This development sparks important questions about the future of international finance and the evolving role of different currencies in the global economic landscape.
Some analysts interpret this decline as a reflection of the dollar’s gradually diminishing influence on the world stage. As other currencies become more prominent in international transactions, central banks are exploring diversification to manage risk and potentially enhance returns. These shifts in reserve holdings, while often gradual, can have tangible effects on currency and bond markets, making them a crucial indicator to watch for those involved in international trade and investment.
Our analysis focuses on understanding this long-term trend using the latest IMF data. The chart below vividly illustrates the journey of the U.S. dollar’s reserve share since the euro’s inception in 1999. Notably, the dollar’s share has decreased by a significant 12 percentage points – from a commanding 71% to the aforementioned 59% – since the euro came into being (as seen in the top panel’s blue line). While there have been periods of fluctuation, the overall downward trend is evident. Conversely, the euro’s share has hovered around the 20% mark, while the combined share of other currencies, including the Australian dollar, Canadian dollar, and the Chinese renminbi, has incrementally risen to 9% by the end of 2020 (represented by the green line).
It’s crucial to understand that exchange rate volatility plays a significant role in the composition of central bank reserve portfolios. Fluctuations in the relative values of different government bonds can also exert influence, although this effect tends to be less pronounced due to the generally correlated movements of major currency bond yields. Typically, when the U.S. dollar weakens against major currencies, its share of global reserves tends to decrease. This is because the dollar value of reserves held in other currencies naturally increases, and the opposite occurs when the dollar strengthens. Several factors can drive these exchange rate movements, including diverging economic trajectories between the U.S. and other nations, differing monetary and fiscal policies, and even central banks’ own foreign exchange activities.
The bottom panel of the chart provides further insight by tracking the U.S. dollar’s value against major currencies (indicated by the black line) over the last two decades. While the overall value has remained relatively stable, significant interim fluctuations are apparent. Interestingly, these fluctuations can explain approximately 80% of the short-term (quarterly) changes in the dollar’s share of global reserves since 1999. The remaining 20% of short-term variance is largely attributed to the active decisions of central banks buying and selling currencies to manage their own exchange rates and support their domestic economies.
Looking at the data from the past year, after adjusting for the impact of exchange rate movements (orange line), we observe that the U.S. dollar’s reserve share remained relatively stable. However, when we adopt a broader, long-term perspective, the picture becomes clearer. The fact that the dollar’s value has remained broadly consistent while its share of global reserves has declined suggests a deliberate and gradual shift away from the dollar by central banks.
Looking ahead, many anticipate that this trend of diversification will continue. Emerging market and developing economy central banks, in particular, are expected to further diversify their reserve holdings to mitigate risks and potentially enhance returns by including a broader range of currencies. Some countries, like Russia, have already publicly stated their intentions to reduce their reliance on the U.S. dollar.
Despite these evolving dynamics and structural shifts in the international monetary system over the past six decades, it’s important to emphasize that the U.S. dollar remains the dominant international reserve currency. As our Chart of the Week highlights, while changes to the dollar’s status are underway, they are likely to be gradual and unfold over the long term, reflecting the inherent inertia and deep-rooted structures of global finance. The dollar’s reign isn’t ending overnight, but the subtle shift in central bank reserves signals a move towards a more multi-polar currency world in the decades to come.
