The Reserve Currency Overhang

Reserve currencies play a complex role in international finance. The ‘reserve’ function itself refers to the fact that assets denominated in these currencies are held in the official reserves of foreign central banks. But this reserve function usually grows out of and is closely connected to the use of the currency — strictly, of assets and instruments denominated in the currency — by the private sector. Its use by commercial companies, traders and investors leads to its use by foreign governments and central banks. They all find the services provided by the reserve currency centre useful in their day-to-day business. At the same time, the currency serves as the domestic money of residents of a specific country or region. It is this dual use of a national currency for international purposes that gives rise to many of its peculiar features. It also gives rise to difficulties — for example, when the issuing central bank follows policies that result in an increase in supply running ahead of demand. For foreign holders, they are assets that must be appropriately managed; for the issuing country, they are liabilities that may be withdrawn.