Why is the dollar so powerful? | CNBC Explains

You know this as the U.S. dollar.

It’s the official currency of the United States and its territories, but, also,

some other countries use it as their official currency too.

In fact, the U.S. dollar is known as the world’s reserve currency.

So how exactly did this become so powerful?

More than $1.8 trillion of U.S. currency is now in circulation around the world,

and it’s believed that two-thirds of $100 bills and nearly half of $50 bills are held outside the US.

In fact, the U.S. dollar is the de facto global currency, meaning it’s kept by many governments

in reserves and that most people and companies trust it for international trade.

Even as the coronavirus pandemic wreaked havoc across global markets, wiping out

trillions of dollars' worth of assets, the U.S. dollar was unaffected by the turmoil.

At one point, it soared 4% against a basket of major currencies, namely the euro, pound,

yen, Canadian dollar, Swiss franc and Swedish krona.

So why did we see this spike in the value of the U.S. dollar?

The dollar is strong because of the U.S. economy and because people want to hold dollars and

the safety of the U.S. dollar.

In times of uncertainty, investors flee to what’s known as safe havens,

investments expected to hold their value during market turbulence.

And you guessed it, the U.S. currency is seen as such. Why?

Well it hails from the world’s largest economy, the United States, which is generally politically

and economically stable.

And while you can be pretty sure that the U.S. dollar’s value will fluctuate, it probably

won’t plunge the way the Turkish Lira or Argentinian Peso have.

All of that demand for the dollar can cause shortages during times of economic crisis,

which only exacerbates the larger problem.

America’s central bank, the Federal Reserve, is responsible for issuing the currency, and

takes extra measures to prevent a squeeze when there’s a rush for the greenback.

For example, during the financial and coronavirus crises, it set up a number of ‘swap lines’

with other major central banks, making sure there is enough money available for investment and spending.

This helps stabilize currency markets when the desire for the U.S. dollar surges.

So how exactly did the U.S. dollar become the major reserve currency of the world?

Well, for a long time, developed economies tied their currencies to gold.

However, during the first World War, many of these countries abandoned this gold standard

and started paying their military expenses with paper money instead.

Eventually the U.S. dollar, which was still tied to gold, overtook the British pound to

become the world’s leading reserve currency.

During World War II, the United States sold weapons and supplies to many of its allies

and collected its payments in gold.

By 1947, the U.S. had accumulated 70% of the world’s gold reserves, leaving other nations

with a huge disadvantage.

To try to remedy this and other financial matters, 44 Allied countries met

in Bretton Woods, New Hampshire, in 1944.

There, they decided that the world’s currencies would be pegged to the U.S. dollar,

which was in turn linked to gold.

As central banks began to build their reserves over time, these dollars were redeemed for gold,

dwindling the U.S.’s stockpile and igniting concerns about the stability of the U.S. dollar.

In 1971, U.S. President Richard Nixon shocked the world when he de-linked the dollar from gold.

From there, free floating exchange rates were born, meaning exchange rates were no longer

fixed to gold and were determined by market forces instead.

Despite periods of market volatility and the inflation that followed, the U.S. dollar has

remained the world’s reserve currency.

Its sheer volume and America’s efficient banking system made the notes more convenient

and cheaper to trade than other currencies.

Today, the vast majority of foreign exchange transactions are done in U.S. dollars with

no other currencies coming anywhere near that.

In recent decades, the U.S. has even been accused of “weaponizing” its currency

for strategic and geopolitical influence.

One example cited by critics was the Trump administration's sanctions on North Korea

and Iran, which included forbidding them from using the dollar in trade.

Some economies are so reliant on the American notes, that they’re even commonly used in

day-to-day transactions.

At ATMs in Cambodia, you can withdraw the greenback from the machines.

On a global scale, you’ll find commodities like metals, energy and agricultural goods

are usually traded in U.S. dollars.

Here’s an example of how the U.S. dollar influences everyday business deals.

Let’s say a jewelry company in India wants to sell its products to a Canadian department store.

If the Canadian retailer tries to pay in Canadian dollars, the Indian jeweller is likely to say,

“I don’t know how much this is worth.

And I certainly can’t use it in India.”

That department store, meanwhile, could also argue that the rupee won’t go very far in Canada.

So, they’re both likely to transact in U.S. dollars instead.

Those dollars will then be exchanged into rupees in India.

Add together the number of transactions happening like this every day and, well, that’s

a lot of greenback entering foreign economies.

So we’ve established that the U.S. dollar is stable.

But you might be thinking, what about other currencies that are stable too

like what about the Swiss Franc or the Singapore dollar,

both of which come from politically and economically stable countries too.

And yes, while those are fair points, the truth is, those countries just have far less

influence and economic power.

Switzerland’s population is a mere 8 million, while the U.S. has more than 332 million.

Just look at central banks’ foreign exchange reserves worldwide.

While the majority of currency reserves are made up of U.S. dollars, the euro makes up nearly 21%,

the Japanese yen makes up nearly 6% and the pound sterling makes up nearly 5%.

So, could any of these other currencies give the dollar a run for its money?

For years there have been calls for an alternative reserve currency, ranging from countries like

China and Russia to intergovernmental organizations like the United Nations.

In recent years, some central banks have added the Chinese yuan to their reserves.

The cloud of U.S. sanctions has also prompted a desire for some countries to bypass

dollar-denominated trading.

In 2018, Germany’s foreign minister wrote in an op-ed that it is “essential that we

strengthen European autonomy by establishing payment channels independent of the U.S.”

And some are hoping the world’s future reserve currency won’t be tied to a national government at all.

They see cryptocurrencies, such as bitcoin, eventually overthrowing the dollar.

But, even so, any change in the U.S. dollar’s strength certainly wouldn’t happen overnight.

Despite calls for an alternative reserve currency, it’s still hard to imagine any country

capable of taking the mantle from the U.S. as the global currency anytime soon.