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Why is the US dollar the main currency in the world?

(CNN Spanish) — From the end of World War II to the present – and despite some fluctuations and a decline in the primacy of the US economy – the dollar has been the world’s main currency. At least three factors explain it: foreign exchange reserves, commodity contracts and international financial transactions.

About 60% of the foreign exchange reserves of the various central banks are invested in dollarized assets, explains Eswar Prasad, professor at Cornell University and senior researcher at the Brookings Institution, in a publication of the International Monetary Fund (IMF). These reserves are, to put it briefly, “the funds for the lean times.”

On the other hand, in general, the contracts for the purchase and sale of raw materials are set and paid in dollars, including those for oil. And finally, says the analyst, the greenback is the currency that is used to “name and settle a large part of international financial transactions.”

The Bretton Woods Agreement, the key to the dominance of the dollar

The key to understanding how the dollar became the reserve currency par excellence lies in World War II. Before entering the conflict, Investopedia reviews, the United States was the main supplier of weapons to the allies, among other goods. Most of the countries paid him in gold and this meant that, by the end of the war, the United States was the largest holder of this resource and the rest of the countries had their reserves decimated, so they could not return to a system that stood on the gold metal base.

In 1944, members of the 44 allied countries met at Bretton Wood, in New Hampshire, to design a system for the management of currencies and decided that they would no longer be linked to gold but to the greenback (which in turn was linked to the Prayed).

As a result, countries began to accumulate dollar reserves instead of gold reserves and to buy US Treasury securities to store their dollars.

The system has undergone various changes since then, for example the dollar was delinked from gold after the Richard Nixon administration, but the green currency has continued to be the main reserve currency.

English economist John Maynard Keynes attends the United Nations conference at the Mount Washington Hotel in New Hampshire. Keynes played a leading role in formulating the Bretton Woods agreements and also helped create the International Monetary Fund. (Photo by Hulton Archive/Getty Images)

The “dollar trap”

To understand the supremacy of this currency, one must also know what Prasad calls the “dollar trap.” Foreign investors, a category that includes central banks, have a debt with the United States Government amounting to about US$ 8 trillion, while the obligations of the United States with the rest of the world are estimated at about US$ $53 trillion, according to Prasad in his article at the International Monetary Fund. “Because these liabilities are dollar-denominated, a collapse in the value of the dollar would not affect the amount the United States owes, but it would reduce the value of those assets relative to the currencies of the holding countries,” he explains.

On the other hand, US investors have foreign assets of about US$35 trillion that are mostly denominated in foreign currencies. If the value of those coins grows relative to the dollar, they would be worth more when converted to dollars. “Thus, while the United States is a net debtor to the rest of the world, a fall in the value of its currency would imply a windfall for the United States and a great loss for the rest of the world.” Because of this, he concludes, even those who are against the greenback could fear if it loses value.

The predominance of the dollar, in turn, means that the decisions of the United States have a significant influence on the economy of the rest of the countries because they influence the value of the currency. This added to the fact that it can “severely punish countries, such as Iran and Russia, by imposing sanctions that limit their access to world finances.”

Could the dollar stop being the main currency? This is how reserves evolve

As we explained, the fact that most central bank reserves are in dollars partly explains their supremacy. And although this is the case in absolute terms, the predominance of the dollar in this area has decreased in the last two decades: in 1999, 70% of bank reserves were in dollars and by the last quarter of 2022 the percentage had fallen to 59%, according to IMF data.

Which currencies have gained ground? Other of the traditional ones in the world of reserves, such as the euro, the pound sterling and the yen are not the ones that have benefited the most, says the IMF. Three-quarters of the greenback’s transition to other currencies is in the currencies of smaller economies, such as Canadian and Australian dollars, Swedish krona and South Korean won.

Being the main does not mean that it is the strongest

A strong currency is determined by the amount of goods and services you can buy with it and the amount of other currencies you can receive in exchange for one unit of the initial currency, according to an analysis by Forex.com, a market trading platform. Forex. Since the dollar is the most used currency in the market, it works as a reference point to calculate the value of other currencies. Thus, the more dollars you need to buy 1 single unit of another currency, the stronger it will be. If you require fewer dollars, then it is considered weaker.

In this framework, the three strongest currencies are currently the Kuwaiti Dinar, the Bahraini Dinar and the Omani Rial.

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