What Is Currency Internationalization?

Currency internationalization is the widespread use of a currency outside the borders of its original country of issue. The level of currency internationalization for a currency is determined by the demand that users in other countries have for that currency. This demand can be driven by the use of the currency to settle international trade, to be held as a reserve currency or a safe-haven currency, or in general use as a medium of indirect exchange in other countries' domestic economies via currency substitution.

Key Takeaways

  • Currency internationalization is the use of a currency outside the borders of its country of issue.
  • The most dominant reserve currency is the USD followed by the euro, the Japanese yen, and the pound sterling.
  • Countries hold foreign currencies in their central reserve banks in order to back liabilities and implement monetary policy.
  • Currencies held in foreign reserves have no restrictions on their purchase and are able to be invoiced by exporters. Foreign and domestic institutions should be able to issue marketable instruments in the internationalized currency.

Understanding Currency Internationalization

An important facet of currency internationalization is that the currency concerned is used not only in transactions by residents of the issuing country but also in transactions between nonresidents; that is, nonresidents use it instead of their own national currencies when transacting in goods, services, or financial assets.

The demand for the use of a currency outside the borders of the issuing country can arise in several ways. Foreign governments and central banks may use the currency as a reserve currency on which to pyramid their own currencies. Foreigners may need to use the currency to settle international trade with partners who want to be paid in that currency. Lastly, foreigners may want to use the currency alongside or in place of their own local currencies to buy and sell goods in their own domestic economies.

Among these uses, use as a bank's reserve currency is the easiest to measure and keep track of as an indicator of currency internationalization. The most dominant reserve currency is the USD, with the euro (EUR) and the Japanese yen a distant second and third. According to the International Monetary Fund, which keeps track of the foreign exchange reserves around the world, as of Q1 2021, 59% of the total foreign exchange reserves are U.S. dollars, 20.5% are held in the euro, 5.89% in the Japanese Yen, and 4.70% in the British pound sterling (GBP).

Currency Internationalization Requirements

The Bank for International Settlements (BIS) highlights some important characteristics that need to be in place for internationalization.

The most critical is that the government of the issuing country has no restrictions on the purchase or sale of that currency by any entity. Secondly, exporters, whether from the country concerned or others, must be able to invoice some, if not all, of their exports in that currency. Third, a range of entities, including private and official companies and banks as well as individuals, should be able to hold the amounts they desire. If enough is held by foreign central banks, then the currency will become a reserve currency. Finally, both domestic and foreign firms and institutions should be able to issue marketable instruments in that country's currency, irrespective of the place of issue.

For example, a Eurobond may be sold by an emerging market to European investors but be denominated in USD; or an American company may issue a dollar bond in Asia.

Benefits of Currency Internationalization

There are a number of benefits to a country whose currency is internationalized. Economically, it enlarges the sphere of the market in which they can participate, without the need to exchange currencies and incur the related transaction costs. It provides more certainty to residents, who can denominate foreign transactions in their home currency. They can also borrow in foreign markets without incurring exchange rate risk, potentially enabling them to find cheaper funding.

In general, the underpinned demand for the currency should dampen interest rates and thus help lower the domestic cost of capital. While a potential cost of internationalization could be destabilizing effects if a foreign loss of confidence were to lead to a sell-off in assets denominated in the currency, most major currencies have large domestic debt markets that could act as a shock absorber in such a scenario.