Although still a matter of when, China is likely to reach a significant symbolic milestone when the International Monetary Fund (IMF) decides to include the Chinese yuan in its special drawing rights (SDR) basket of reserve currencies currently comprised of the U.S. dollar, euro, British pound and Japanese yen. While having some financial benefits, SDR inclusion would not put the yuan anywhere near the international prestige and reserve status currently held by the U.S. dollar. In theory then, SDR inclusion grants the yuan international reserve currency status, but in practice there is no question that the U.S. dollar is the dominant reserve currency around the globe. Whether or not China obtains a similar status will depend on a number of factors. (For related reading, see: Chinese Yuan an Unlikely Reserve Currency.)

Foreign Currency Reserves and U.S. Dollar Supremacy

Simply put, a reserve currency is a foreign currency held by the central bank or other major financial institutions affording these holders of the foreign currency a number of benefits. Reserves of the foreign currency can be used to meet international debt obligations while a nation’s central bank may use reserves to maintain a more stable exchange rate. Also, many commodities may be priced in a foreign currency and thus holding that currency in reserves means being able to pay for the commodity without first making a currency exchange with the related risks and costs that come with such a transaction.

As most commodities, as well as international debt securities, are priced in dollars it is obvious why the U.S. dollar reigns as the international reserve currency. The price of oil set by the Organization of Petroleum Exporting Countries as well as 50% of international debt securities are denominated in dollars. Further, in spite of the fact that as of 2011, less than 20% of the merchandise trade between China and Korea is with the U.S., the dollar is still the exclusive currency used in foreign-exchange transactions between the two countries.

It is no wonder then that the majority of the foreign currency reserves held around the world are in U.S. dollars. According to the IMF, in the first quarter of this year the global share of U.S. dollar reserves was just over 64%. The next largest share was euros at nearly 21%, followed by the yen, pound, Australian dollar, Canadian dollar and Swiss Franc. China did not make the top five and was grouped in with all other currencies comprising a mere 3.08% of global foreign currency reserves.

How the Dollar became the “World’s Currency”

Undoubtedly, the dollar maintains its supremacy because its dominance is well established and countries continue to maintain high U.S. dollar reserves because it is the most accepted form of payment, comprising 86% of daily foreign exchange transactions as of 2007. But, the dollar has not always held this position so it is worth reflecting on how it got there.

Following the Second World War, America saw booming growth due to a number of factors including technological innovation and having a strong manufacturing base. Also, being a large economy with abundant natural resources the U.S. could supply much of the world’s needs, so having U.S. dollars to purchase American products became important. Having deep and liquid capital markets helped the U.S. become the dominant market for financial assets. Further, the high liquidity and low-risk nature of Treasury bills made them attractive interest-bearing, dollar-denominated assets for central banks around the world. (For more, see: The Reasons Why China Buys U.S. Treasury Bonds.)

Recent academic work has suggested that the most important factor influencing the rise of the U.S. dollar as the preeminent reserve currency is due to the deepening of America’s financial markets. On this score, with the U.S. bond market worth around 220% of GDP, China pales in comparison with a bond market worth only 51%. The network effect of having deep financial markets is that it creates a significantly large demand for the currency in which the financial assets of that market are denominated. Consequently, then, like the telephone, the more a currency is used the more attractive it becomes for others to use it as well.

Understanding the Value of Fiat Currencies

As fiat currencies have no intrinsic value in themselves they become valuable because they are widely used and accepted. Because a currency has been widely accepted in the past it earns a credibility and trust for being widely accepted in the future. Yet, one cannot underestimate the significance of the political institutions that support that currency as well.

The Eurozone crisis and the implications of a Greek exit from the euro provide a clear example of the fragility of any fiat currency. Adoption of the euro was supposed to be irreversible and if Greece were to decide to return to the Greek drachma the fear is what is to stop others from also reverting to an independent national currency. (For more, see: The Origins of Greece's Debt Crisis.)

Why does this matter? It relates back to the widespread use of the currency that made it attractive for others to use it as well. A Greek exit would in some ways be analogous to one of the 50 U.S. states or a large U.S. corporation deciding that it is no longer going to accept U.S. dollars as payment. Not only would this cause a ripple effect in the overall confidence of the U.S. dollar, it would also act as a direct affront to the authority of the U.S. government who has decreed by law that its currency be accepted for all debts, public and private.

Thus, while widespread use of a fiat currency allows users to take its value for granted, it is evident that that value is derived from its issuing authority’s governing stability as well as its ability to enforce the use of its currency. (For related reading, see: The Gold Standard Versus Fiat Currency.)

The Bottom Line

If China ever wishes for the yuan to compete with the U.S. dollar as a widely used international reserve currency, then it is going to need to both deepen its financial markets as well as convince the world of the stability and legitimacy of its political institutions. While the current Xi government has been trying to do both in developing a more market-oriented economy, the recent stock market intervention and the surprising devaluation of the yuan has many wondering whether China really does have the political will to follow through with these objectives.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.