You have probably noticed by now that the US Dollar is the common denominator between all of the different types of currency pairs—exotics, cross-majors, and major currency pairs.
The US dollar is incredibly important to international commerce, which is partly to do with history as much as it is partly to do with the present.
Historical reasons for dollar’s global role:
1. Bretton Woods Agreement – In 1944, 44 countries met in Bretton Woods, New Hampshire to create a worldwide dollar standard, and the International Monetary Fund. The US Dollar, then backed by gold, would be the world’s currency for international transactions. Nations would trade dollars between eachother throughout the year. But at the end of each year, the dollars would be redeemed for gold through the IMF.
2. Political Risk – We’ll get to this later, but political risk is one of the driving forces behind the Dollar’s strength. The United States has not experienced political problems since the Civil War in the 1860s, and before that, you’d have to look back to the American Revolution in the 1700s. Because of the United States’ limited political risk relative to its peers, it is considered a safe haven for investment capital, and dollars are accepted all around the world.
3. Commodity Currency – While the United States is not an active producer of major commodities, a 1970s agreement with Saudi Arabia chained the oil market to the dollar. Since that time, nearly 100% of all oil bought and sold around the world is priced in the US Dollars. Because oil can be purchased only with dollars, international organizations, businesses, and governments are willing to hold onto the US Dollar, knowing that it is the only currency they can use to buy oil on the open market. Everyone needs oil, so everyone needs to own US dollars.
4. Financial Markets – The United States’ financial markets are some of the most established. The New York Stock Exchange, NASDAQ exchange, commodities exchanges, as well as the worlds’ largest banks, operate as American businesses. As such, many companies list their stock in the United States, even if they are not an American company. With so many businesses engaging in the US capital and currency markets, investors find that holding dollars simply makes sense—it’s the only currency used in the US financial markets.
5. Relative International Importance – The United States is the world’s largest economy. In 2010, US businesses, individuals, and state and local governments accounted for 17% of all goods and services produced around the world. This helps solidify the dollar’s strength in the forex market, since the dollar is required to do business in the United States, the world’s largest economy.
While there is plenty of discussion about removing the United States’ dollar as a global reserve currency, very little has been done to turn talk into action. In fact, during many of the massive downturns in the world economy — the Asian Financial Crisis, the global financial crisis in 2008, and others before them — the world has fled to dollars as a safe place to store wealth.
US Dollar as a Reserve Currency
We thought the best way to showcase the dollar’s importance was to show how many dollars are held by world governments, relative to other currencies. The pie chart below demonstrates how the dollar maintains its importance in world-wide affairs:
You can see easily how this chart affects the foreign exchange market. A majority of all reserves are held in dollars, and when there are more dollars in reserve, and then we know also that there are more dollars changing hands. Where do these dollars change hands? In the forex market, of course.