As the pillar of the Forex dashboard, the U.S. Dollar is the cornerstone of any Forex trading strategy. It divides the offering of a Forex broker into major and cross pairs. Or, currency pairs that have the USD in their componence and the rest of the pairs.

While the importance of the USD in Forex trading is evident, few traders know why it is so. What makes the USD so crucial to today’s financial system and how come the world today is dollarized to such extent that every country in the world looks at what happens with the monetary policy in the United States?

This article looks at what makes the dollar the world’s reserve currency and when it all started. Moreover, what are the challenges for the dollar and how the Fed balances its tools to control its value.

The Bretton Woods Conference

It all started back in 1944 when world’s nations met in the United States. The Bretton Woods conference was designed to re-establish the international financial order after the Second World War.

With most of Europe and Japan devastated, the United States benefited from economic growth all this time. Moreover, because of war, many nations sent their gold to the United States for safeguarding.

Even without that gold, the United States had the most significant gold reserves in the world at that time. This was an important aspect during the Bretton Woods negotiations as before the conference, most countries were on a so-called gold standard.

Effectively, it meant that they backed the money in circulation by an amount of gold in their central bank’s vault. In other words, the pledge was to redeem the currency for the value in gold.

However, more and more countries found themselves in the impossibility of doing so anymore. War changed everything.

Effective with the Bretton Woods agreement, countries agreed to peg the exchange rate of the dollar to gold. Therefore, other countries pegged their currencies to the dollar, instead of gold. And, the dollar was pegged to gold.

It was a tremendous game of trust, and many nations were reluctant. Ravaged by war and in desperate need of funding to reconstruct their economies, they accepted the American terms.

And so, the road for the dollar as the world’s reserve currency was paved.

The Nixon Shock

As it turned out, the agreement was nothing but a promise. It held true for a couple of decades or so, and then things turned around.

Caught in a long-lasting war in Vietnam and facing mounting pressures back home, the Nixon administration had no choice but to break the promise. It broke the dollar peg to gold in 1971, sending a shockwave throughout the world.

Countries needed to fight inflation in their jurisdiction and started to ask for gold from the United States in exchange for dollars. The United States, on the other hand, didn’t want to see their gold vaults depleted, hence the decision to break the Bretton Woods agreement.

Suddenly, nations around the world found themselves with dollars and no gold to redeem for them.

USD in the 21^st Century

Since that moment on, the world became a dollarized place. To have an idea about the importance of the USD in today’s financial system, we need to explain what makes a global currency: it is one accepted throughout the world.

The USD, Euro and the JPY (Japanese Yen) are the most popular ones. However, when it comes to foreign reserves held by various central banks in the world, the dollar takes the most significant share.

Over sixty-percent of all foreign exchange reserves in the world are in USD. Think of a country, then to its currency, and imagine that it builds foreign exchange reserves mostly in American dollars.

This makes for a healthy appetite for dollars from around the world, and the Fed, the most powerful central bank.

What is very interesting is that people tend to look only at the official electronic currency reserves, but the hard-money or bills follow the same percentages. Over sixty-percent of all USD bills are outside the United States, notably in Russia and Latin America.

People use the USD as a store of value to fight local inflation as they don’t trust the local currency or the ability of the central banks to fight inflation. Think of Venezuela or Argentina and their inflationary spirals.

If people would keep their savings in the local currency, they’ll disappear virtually overnight. Instead, they use the local currency to buy USD as it’ll keep the value regardless of the internal economic events.

Many countries chose to peg their own currency to the USD rates. Or, they let the currency fluctuate only on a tight corridor, drawn by the USD stability.

In Forex trading, USD dominates the headlines too, as over eighty percent of transactions are in dollar-related pairs.

Add to this a commodity, especially oil, the engine of economic growth worldwide. Since Kissinger’s agreement with Saudi Arabia (the Arab country agreed to sell its oil in USD in exchange for U.S. military protection in the region), the USD became the dominant currency in oil transactions.

Following that agreement, Saudi Arabia imposed it to other OPEC (Organization of Petroleum Exporting Countries) countries, and soon all the oil was bought and sold only in USD.

Some even speculate that when some countries wanted to change that (e.g., Iraq switched from USD to Euro its oil selling), the nation was promptly invaded, and oil shipments returned to USD.

Last but not least, over a third of the world’s debt is issued in dollars. Commercial banks and other entities issue debt in dollars, both to the local population and businesses as well as to other nations.

All these factors create a constant demand for USD, highlighting its dominant role in the current financial system.

Conclusion

For all these years, the United States benefited from the exorbitant privilege of having the world’s reserve currency. In a way, because we talk about the largest economy in the world, it is only reasonable.

However, it brings benefits in the sense that the constant demand for its dollars made the United States capable of running enormous deficits all this time. Many fear that the lack of fiscal discipline would undermine the value of the dollar and suddenly their reserves would be worth a lot less than initially planned.

The United States is aware of the power of having the world’s reserve currency. Today’s wars, and increasingly more in the future, aren’t fought anymore on the battlefield, but behind closed doors, with the Treasury and the Fed tightening or loosening the dollar amounts in a particular country/region.

It is easier to put a country on its knees by making its economy incompatible with the world’s reserve currency. Suddenly, the people will see unrest, there’ll be no international financial assistance, and this typically ends up with a regime change without a bullet to be fired.

To sum up, the Fed in the United States sets the interest rates and monetary policy not only for the local currency but for the world’s reserve currency. When doing so, it considers not only the local economy but the global one too.

For as long as the dollar remains the world’s reserve currency, it will bring enormous benefits to its issuer. Can the dollar be replaced as the world’s reserve currency?

History tells us that the dollar replaced the British Pound. So, what would be the next currency to take this role from the American Dollar?