Key Currency

What Is a Key Currency?

A key currency is a currency that has a relatively stable rate and value in the global market. Key currencies are often used to conduct international trade, loans, etc. For example, the U.S. dollar is one of the seven key currencies in the world. 

As the name suggests, key currency refers to the currency that is key to the international market. It is so essential that almost every country recognizes it, uses it in significant transactions, and even holds it as a reserve in their central banks to save it for a rainy day. So let's break it down.

This currency is issued by economically stable and developed countries to be recognized globally. The U.S. dollar and the British pound are considered key currencies. 

A country's economic stability is another factor determining a key currency. This currency is the basis of the exchange rate and reference value. Hence, its value fluctuates daily but minimally. 

So, some smaller countries want to peg their domestic currency to the countries that issue the key currency. To 'peg' means to set a fixed exchange rate to the other country's currency that contributes to more stable economic activities between two countries in the long term.  

Smaller countries' exchange rates are also influenced by the central bank's holdings of key currencies. Hence, they make key currencies as reserve currencies to finance investments, fulfill international debt obligations, and conduct significant transactions. 

It needs to be mentioned that adopting a key currency avoids the unexpected fluctuations of the exchange rate during the lifespan of a big international deal.

Additionally, the reserve currency amount is strongly associated with the exchange rate between the key currencies and their domestic currency. Nations retain key currencies to pay for globally traded commodities like gold and oil. 

Characteristics Of Key Currencies

Some of the characteristics of key currencies are as follows:

1. Global Recognition: Key currencies are universally recognized and accepted for international transactions, trade, and as reserves by central banks worldwide.

2. Stability: They exhibit relatively stable exchange rates and values in the global market, providing a reliable benchmark for other currencies.

3. Economic Powerhouses: Key currencies are issued by economically stable and developed countries that play significant roles in global trade and finance.

4. Low Fluctuation: While exchange rates may fluctuate, key currencies experience minimal fluctuations compared to other currencies, providing stability for international trade and investments.

5. Basis for Exchange Rates: Key currencies often serve as the basis for determining exchange rates in currency markets, influencing the valuation of other currencies.

6. Pegging: Some smaller countries peg their domestic currencies to key currencies to stabilize their own economies and facilitate international trade.

7. Widespread Usage: Key currencies are widely used in global financial markets, including foreign exchange trading, commodities pricing, and debt issuance.

8. Evolution: As the global economy evolves, the composition of key currencies may change, with emerging economies seeking to attain key currency status and established currencies adapting to shifting economic dynamics.

Major Key Currencies

In the realm of international finance and trade, certain currencies stand out as linchpins of the global monetary system.

These currencies, known as major key currencies, play indispensable roles in facilitating cross-border transactions, serving as reserves for central banks, and influencing exchange rates worldwide.

The stability, economic power, and widespread acceptance of these currencies make them fundamental pillars of the international financial architecture. Let's delve into the major key currencies that wield significant influence in the global economy.

1. The U.S. dollar (USD $)

The U.S. dollar has been the most influential currency in the world for over 70 years. In the Bretton Woods Agreement of 1944, the heads of developed countries promised to tie the value of their currencies to the U.S. dollar.

One report demonstrates that it made up over 60% of all known central bank foreign exchange reserves in 2019. That makes it the de facto global currency. The currency of about 40% of global debt is the dollar.

The U.S. dollar is used in almost 90% of all foreign exchange trade. By the end of 2020, there was $2.04 trillion in circulation in the United States. It is believed that up to half of that value is in foreign circulation.

It is estimated that 14 nations will have pegged their currencies to the U.S. dollar by 2022. Hence, the U.S. dollar is the key of the seven key currencies. It controls the worldwide debt and transaction market as the most accepted reserve currency.

2. The Euro (€)

Nineteen of the European Union's 27 member nations use the Euro as their official currency. As of 2019, the Eurozone is a collection of countries with around 340 million residents.

Additionally, several particular territories of E.U. members located outside of the European continent and the institutions of the E.U. utilize the currency officially.

Worldwide, more than 200 million people use currencies tied to the Euro. After the U.S. dollar, the Euro is the reserve currency that most people own.

At the end of 2008, the world's euro reserves totaled $1.1 trillion, or €850 billion, with 22% of global currency reserves in mature economies.

At the end of 2008, there were 850 billion euros held as reserves worldwide, equivalent to $1.1 trillion, with established economies having 22% of the total but emerging and developing economies holding 31%.

3. The British pound (GBP, stg, £) 

Also known as the British pound sterling, it is the official currency of the United Kingdom and its associated territories. As of mid-2021, sterling is also the fourth most-held reserve currency in global reserves. 

According to a report in 2016, it is currently the fourth most-traded currency in the foreign exchange market, after the United States dollar, the Euro, and the Japanese yen.

4. The Japanese Yen (JPY, 円, ¥)

It serves as Japan's official currency. After the U.S. dollar and the Euro, it is the third most traded currency on the foreign exchange market.

It is also widely utilized as a reserve currency after the U.S. dollar and the Euro. The Japanese Yen is one of Japan's most used funding currencies due to the country's zero interest rates. The low cost of borrowing in the Yen attracts international investors to fund purchases of currencies and get more excellent rates in return.

5. The Canadian dollar (CAD)

The Canadian dollar was established in 1871 and is the official currency of Canada. It accounts for 2% of global reserves, i.e., 650 billion dollars. It was pegged to the U.S. dollar. So, CAD's value rose and fell at the same rate as the USD. 

6. Swiss Franc (CHF)

It is the official currency and ledger tender for Switzerland and Liechtenstein. It is one of the most stable currencies in the world due to its transparent government and neutral standpoint in global affairs. Like the Japanese yen, the low bank interest rate of the Swiss Franc also attracts numerous foreign investors.

7. Mexican Peso (MXN)

It is the fifteenth most traded currency in the world and the third most traded currency in America after the U.S. and Canadian dollar.

Mexico's proximity to the United States influences the MXN's role in international trade and finance.

Factors Influencing Key Currencies

Some of the factors that influence key currencies are as follows:

1. Economic Stability: Key currencies are typically issued by countries with robust and stable economies. Factors such as GDP growth, inflation rates, unemployment levels, and fiscal policies contribute to the stability of the currency.

2. Monetary Policy: Central banks' monetary policies, including interest rate decisions, quantitative easing programs, and currency intervention, impact the value and stability of key currencies.

3. Political Stability: Political stability and governance play a crucial role in determining the confidence of investors and market participants in a currency. Political turmoil or instability can lead to currency depreciation or volatility.

4. Foreign Exchange Reserves: The level of foreign exchange reserves held by a country's central bank, particularly in key currencies, can influence market perceptions of currency stability and the ability to intervene in currency markets.

5. Global Economic Conditions: Key currencies are influenced by global economic conditions, including trends in international trade, commodity prices, geopolitical events, and financial market sentiment.

6. Interest Rate Differentials: Interest rate differentials between countries impact currency exchange rates and can attract foreign investment flows, affecting the demand for and value of key currencies.

7. Geopolitical Events: Geopolitical events such as geopolitical tensions, trade disputes, sanctions, and geopolitical alliances can influence investor perceptions of currency risk and stability, impacting key currencies.

8. Technological Developments: Technological advancements, including innovations in financial technology (fintech) and digital currencies, may impact the role and usage of key currencies in international transactions and payments.

9. Regulatory Environment: Regulatory changes, including monetary policy adjustments, capital controls, and government regulations affecting foreign exchange markets, can impact the value and stability of key currencies.

Emerging Key Currencies

Emerging key currency refers to a currency from an emerging market economy that is gaining importance in global financial transactions and reserves. Some of them are:

1. The Chinese yuan (CNY)

CNY refers to the Chinese Yuan, the official currency of the People's Republic of China. Given that China is the second largest economy in the world, CHN deserves the crown of key currency. But hold on, some difficulties need to be explained. 

CNY is popularly known as RMB (renminbi) for Chinese people, which stands for people's currency. It was first issued by the People's Bank of China in 1948 and continues to be used nowadays. 

By the end of 2020, CNY accounted for about 2% of global foreign exchange reserve assets, and 70 central banks worldwide held RMB valued at U.S. $271.6 billion as a store of value. 

Morgan Stanley predicted that the Chinese yuan will be responsible for 5% to 105 global foreign exchange reserve assets by 2030.

Thanks to the growing global impact of the Chinese economy, CNY ranked as the eighth most traded currency in the world as of April 2019. On Dec 1st, 2015, the International Monetary Fund (IMF) announced that it awarded the yuan status as an official reserve currency. 

To solidify the status of CNY, the Chinese government lent money to African and Central Asian countries and required the debt to be paid back in CHY. Since then, some South African countries have held CNY as their reserve currency besides the U.S. dollar.

In 2022, the Chinese yuan became Russia's reserve currency, showing CNY's international influence. 

Furthermore, the Chinese government is promoting its central bank's digital currency- the Digital Currency/Electronic Payment (DCEP). This invention aims to bypass the west-dominated SWIFT messaging system during international transactions.

The DCEP system makes transactions easier for those countries that align with China, which became an alternative strategy to SWIFT systems in the case of economic sanctions.

2. The Indian Rupee (INR)

The Indian Rupee (INR) serves as the official currency of India, a nation distinguished as one of the fastest-growing major economies globally.

India boasts a large and diverse economy characterized by significant potential for further growth and development across various sectors.

India's expanding influence in industries such as information technology, pharmaceuticals, and services has led to an increasing role for the Indian Rupee in global trade and investment.

However, the Indian Rupee remains vulnerable to external factors such as fluctuations in oil prices and geopolitical tensions.

Given India's reliance on imports for certain commodities like oil, changes in global market conditions can impact the value of the rupee and affect the country's economic stability.

Key Currency Controversies

However, even though the Chinese yuan is an influential reserve currency, it still needs to be a global currency as powerful as the U.S. dollar. 

Plus, it is missing from the list of the seven key currencies. The seven key currencies, except the Japanese Yen, are all issued in Western countries with solid capitalist ideologies. 

Regarding the rivalry status between China and the U.S., the public wonders if the CNY will threaten the USD's dominance and even replace it one day. Twenty-first-century geopolitics plays a key role in finding trade partners and punishing rivalries through sanctions. 

Some experts predict that the U.S. sanctions favor the CHY market by stimulating more targeted countries to use the Chinese yuan as an alternative currency to U.S. dollars.

The oil crisis and the recent Ukrainian war encouraged Russia and Middle Eastern countries to adopt CHY to avoid U.S. economic and policy sanctions. Most recently, Saudi Arabia is said to finalize a deal with China to settle oil transactions in the Chinese yuan.  

So, the political line is drawn between China and the U.S. and their alignments. Therefore, the greenback and the redback are against each other.

However, the instability of Chinese politics, such as the harsh zero-covid policy, discourages most Westerners from trusting the CCP government. Moreover, their fear of capital control and doubt of transparency further baffle them from recognizing CHY as a key currency. 

Conclusion

Key currencies play a pivotal role in the global economy, serving as benchmarks for exchange rates and reserves for central banks worldwide.

The U.S. dollar remains the dominant key currency, underpinning the majority of international transactions and serving as a primary reserve currency.

Alongside the dollar, the Euro, British pound, Japanese yen, Canadian dollar, Swiss franc, and Mexican peso constitute the roster of key currencies, each contributing to the stability and functionality of the international monetary system.

Looking ahead, the evolution of key currencies will be shaped by geopolitical dynamics, technological innovations, and economic policies.

While established currencies maintain their dominance, the emergence of new contenders underscores the ever-changing nature of the global financial landscape.

As economies interconnect and diversify, the role of key currencies will continue to evolve, influencing trade, investment, and monetary policies on a global scale.

Free Resources 

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