Reserve Currency and Cover Currency: 5 facts every investor should know
Have you ever wondered why the US dollar plays such a big role in the world? Why is the dollar constantly talked about as the "king", even if your daily transactions are in euros? It's no coincidence. The global economy and your financial future are influenced by two important but often misunderstood concepts: reserve currency and cover currency. These terms may seem complicated, but understanding them will help you better navigate the financial world, whether you are an experienced investor or a first-time money saver. This article will dissect the background to these currencies and show you how they affect you.
Reserve currency: kings of currencies
In simple terms reserve currency the currency that other countries' central banks and governments hold in large amounts in their foreign reserves. It is like a safe deposit of cash in the global economy. But why is it important?
First, the reserve currency facilitates international transactions. If a European company buys goods from a Japanese company, the transaction is easier if both parties can use a widely accepted currency such as the US dollar. This reduces the risks of exchange rate fluctuations and transaction costs. Secondly, reserve currency is used to stabilise the exchange rate. If the value of a country's currency starts to fall too quickly, central banks can sell their reserve currency to buy their domestic currency, thereby supporting its value.
At present, the most dominant reserve currency is. US dollar. Its role grew significantly after the Second World War with the creation of the Bretton Woods system, which pegged the dollar to gold and other currencies to the dollar. Although this system ended in the 1970s, the dollar maintained its static position. Today, the US dollar accounts for nearly 60% of the foreign reserves of all the world's central banks.
In addition to the dollar, the euro, the Japanese yen, the British pound sterling, and the increasingly prominent Chinese yuan (renminbi) are also important reserve currencies. The euro is the second most important currency, alongside the US dollar, in international trade and financial transactions between European countries. An interesting fact is that, although China is the world's second largest economy, its currency's share in reserves is still relatively small, which shows the importance of confidence and the availability of open financial markets in achieving reserve currency status.
Cryptocurrency and the eternal role of gold
Historically, the value of currencies was often linked to physical assets. This is called cover currency. The best known example is gold standard, in which the money issued by the state was exchangeable for a certain value of gold. This gave the currency confidence and stability, as its value was based on a real, finite resource. But most of the world's currencies, including the euro and the dollar, are no longer backed by gold. These are called fiat currencies, whose value is based on the trust placed in them by governments. For example, if you hold a 10-euro note, its value is guaranteed by the trust of the European Central Bank and the euro area countries, not by the gold backing.
This is also the main difference between reserve and cover currencies: the value of the reserve currency is based on the strength of the economy, confidence and its liquidity., not on physical assets.
Although gold is no longer the backing for most currencies, its role in the financial world remains crucial. Gold has historically been the ultimate store of value and a financial buffer. It is still held in large quantities by central banks as a hedge against inflation and economic uncertainty. In the investment portfolio, gold serves as an excellent as a diversifier, as its value is usually not directly linked to movements in shares or bonds. It has even been said that gold is a "barbarous relic" - referring to its long-lasting and timeless value, which has been preserved over thousands of years.
What does it all mean for you?
Global reserve currency movements have a direct impact on your daily life. Since most of the world's raw materials and commodities, such as oil, are priced in US dollars, the exchange rate between the euro and the dollar affects your purchasing power. When the dollar strengthens against the euro, imported goods become more expensive. This is one of the reasons why we feel the impact of inflation.
When investing, reserve currencies play an even bigger role. For example, if you invest in the American stock market (S&P 500), you're not only investing in US companies, you're also taking currency risk. The value of your investment in euros can change depending on whether the dollar strengthens or weakens against the euro. It is therefore wise to diversify not only between asset classes (stocks, bonds, real estate) but also between currencies. It is interesting to note that historically the Japanese yen and the Swiss franc have acted as a 'safe haven', tending to increase in value during periods of economic uncertainty.
Global trends: is the time of the dollar over?
Much has been said in recent years about de-dollarisation - the idea that the dollar's dominance of the global economy may be declining. There are a number of factors behind this: geopolitical tensions, the rapid growth of China's economy and the emergence of new technologies such as the dollar. central bank digital currencies (CBDC-d), emergence.
Although the share of the dollar in central bank reserves has fallen slightly in recent years, no real alternative has yet emerged. The US economy remains the largest in the world, with a deep, liquid and transparent financial market. This gives investors the certainty that they can buy or sell their assets quickly and in large volumes at any time. China's yuan, while growing, is still heavily regulated and lacks a reliable rule of law. The European Union has its own challenges in terms of a common monetary policy between different countries. Thus, while the dollar's dominance may decline in the future, the process is slow and uncertain.
Summary
Understanding reserve and cover currencies can help you look beyond the financial world and beyond your bank account. They affect international trade, inflation and the value of your investments.
While global trends may seem big and out of your control, awareness is important. Think about your investment portfolio in a holistic and diversified way. Be aware of the global context in which your investments operate and what your financial objectives are. After all, financial stability is like chess - you need to think several moves ahead and never rely on just one move.
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