Foreign Exchange Continues to Remain US Dollar-Centric – Part 1

June 18th, 2012

Foreign exchange reserves are currency held by governments that are used to trade across the world market for commodities such as oil. The volume of foreign exchange transactions across the world is phenomenal and the shifts in money exchange rates can vary by the minute, sometimes with quite disastrous consequences given the current volatility in the market place. One of the most salient points about the worldwide market is just how US dollar centric it still is.

It’s easier to understand this through an example of a foreign exchange transaction. If a wine merchant from Korea would like to import wine from Chile, they would buy the US dollar to complete the transaction and not the Chilean peso. Virtually all exchanges between these two counties are in US dollars, because the best exchange rate for us dollars will be more desirable than trading in local currencies. This pattern is not limited to Chile and Korea, the entire world chooses the US dollar as its main foreign exchange currency, with over 85% of world-wide trade transactions using the dollar. Oil prices are set in dollars and over half of all worldwide debt securities are in dollars. So really the dollar is the world’s currency not just the currency of theUnited States of America.

Many believe that this world domination may not last much longer and that the next decade could see a move towards several leading world currencies fighting for domination as emerging markets strengthen.  This would obviously have a huge impact on the world economy, in particular the ability of theUSto budget and finance its debt deficits.

So how did the dollar end up as the worlds most traded currency in the first place? It began as a result of most countries debt securities being held in the dollar, which then means market traders can offer lower bid ask spreads against the currency. This therefore makes it desirable, easier and convenient to do business with. It’s also considered a safe investment currency, so at times of economic disaster in other world currencies i.e. the current euro zone crisis, investors generally buy back into the dollar, it’s generally considered the safest world currency and will benefit from economic crisis in other countries.

The breadth of use for this foreign exchange reserve currency also plays a huge factor in its strength and fluidity. There are other currencies that could be considered extremely strong, take for instance Switzerland, they are simply too small to compete for even a tiny portion of overall international transactions. In part 2 of this article Best Exchange Rates UK will take a look at how the US dollar may not remain in this position for much longer.