Your Cambodian riel notes are probably great conversation pieces, the late King Norodom Sihanouk’s solemn visage glancing at the people to your left as you regale them with tales of your visit to Angkor Wat and Angkor Thom. But as international trading commodities, those notes don’t have quite as much utility. In fact, the overwhelming majority of currencies are of limited use outside their countries of issue. Even though there are 180 currencies in circulation throughout the world and majority of worldwide foreign exchange transactions involve a mere half-dozen of those currencies. It’s an extreme instance of the Pareto principle, with real-world applications. Here’s a look at those select currencies, and how they came to dominate the markets.
As any international traveler will confirm, the demand for United States Dollars across the globe is enormous and without serious competition. The cab drivers at the Ulan Bator airport in Mongolia will take only one non-Mongolian currency, and it’s neither the Russian ruble or the Chinese yuan. Thanks to a relatively stable government, a historically dynamic economy, and consistent value (low inflation) over time, the U.S. dollar serves as the de facto universal medium of exchange. Or to use the chosen term of art, the world’s primary reserve currency.
As the reserve currency, the U.S. dollar is the predominant one held by foreign governments for international transactions. The advantage to American travelers abroad is obvious, but the U.S. dollar’s exalted status also benefits those who never leave the country. American individuals and institutions not only save on transaction costs when purchasing across borders, but can borrow money at lower rates. Furthermore, imports to the United States cost less thanks to the U.S. dollar’s consistent store of value vis-à-vis other currencies. (Though the inevitable flip side to this is that U.S. exports are correspondingly more expensive.)
The U.S. dollar’s dominance across the world is not slim. Any time a pair of currencies are traded for each other in the marketplace, there’s a 44% chance that one of the currencies being purchased or sold is the redoubtable greenback. Some countries’ economies are so intertwined with or dependent on the United States’ that those nations have unofficially adopted the U.S. dollar as their own. The Bahamian dollar and the Bermudian dollar, for instance, are set de jure as exactly equivalent to their U.S. counterpart.
A currency transaction requires a second currency, of course. And when U.S. dollars (or any other currency) are traded, a plurality of the time they’re being traded for a currency that didn’t even exist in physical form until this century - the euro. As the official currency of everywhere from Portugal to Finland, from Slovenia to Slovakia, the second most-traded currency in the world is used daily by more than half a billion people throughout both Europe and Africa, dwarfing even the U.S. dollar in that respect. As the eurozone continues to expand – it began this year by welcoming Latvia, and Lithuania is scheduled come on board in 2015 – the euro’s importance in foreign exchange will only increase.
Americans who were alive and conscious during the late 1980s may remember the mildly xenophobic fear that Japan was finally about to emerge from the ashes of ruin and take over the world, economically speaking. The Japanese yen tripled in value relative to the U.S. dollar, and Japanese interests took advantage of this by purchasing positions in various U.S. institutions. With Japan’s economy so contingent on international trade, the yen became gradually more important in forex markets. But in recent years, Japan’s central bank has kept interest rates as close to zero as possible. While the Federal Reserve Bank of the United States has ostensibly adopted a similar policy, one result is that the yen has lost nearly a quarter of its value vs. the U.S. dollar over the last couple of years.
In the 1950s, the United States economy was even larger relative to the rest of the world’s than it is today. Yet even then, the U.S. dollar still had yet to claim the title of universal reserve currency. In the declining stages of the British Empire, the sun had not quite yet set on the pound sterling as the medium of choice for international transactions - a position it had occupied since time out of mind. Much like the euro today, several countries – most but not all of them Commonwealth members - used the pound either side-by-side with their own domestically minted currencies, or in place thereof. Today, the pound is the world’s fourth most-traded currency, appearing in about 6% of all forex transactions.
Why did the pound fall out of favor? The short answer is that nature abhors a vacuum. During World War II, the U.K. government set the value of the pound in terms of the U.S. dollar at a fixed rate. That it wasn’t the other way around testified to the reality of the latter’s importance. A series of British financial calamities led to the pound being devalued in 1949, and again in 1967, which decimated the savings of prudent Britons and, by extension, served to solidify the U.S. dollar’s status as the world’s reserve currency.
One of those countries that had derived its own currency’s value from the pound sterling got out just in time to escape that last devaluation. The Australian dollar was created in 1966 to replace Australia’s defunct pound, and has since gone on to serve as something of a reserve currency for much of the Asia-Pacific region and Oceania, trading at levels disproportionate to the size of the Australian economy. The “Aussie” has gained significant ground against other major currencies in recent years, and currently trades at close to an all-time zenith against the U.S. dollar.
Another country whose currency carries greater global significance than would be expected is Switzerland. The Swiss franc is the sixth most-traded currency in the world, despite being legal tender in only two countries (the other being Liechtenstein), which combined are smaller than several U.S. counties. The Swiss National Bank being another central monetary authority with a zero-inflation policy, the franc’s value has remained remarkably stable in terms of the U.S. dollar since 2012. Switzerland’s own internal stability and decentralized political structure have made the franc desirable in world currency markets. Switzerland has made no provision for ever joining the eurozone, even though every surrounding country uses the euro. In all of continental Western Europe, Switzerland and Norway remain the only holdouts.
The Bottom Line
Some investors want foreign currencies in order to hedge against the volatility of their own nations’ currencies. Others want a position in a reputable security that doesn’t require taking possession of anything physical. Regardless of the reason, forex is an integral part of 21st century finance. And the more widely used and reliable the currency, the greater the likelihood of people buying and selling it every day.