How The USD Became The World’s Most Powerful And Dominant Reserve Currency

Currently, around 180 different currencies are being used in 197 countries of the world. There are also some currencies that are used in more than one country as the Euro is used as the primary currency in more than 24 countries of the European Union. Similarly, the US dollar is currently the primary currency of about 14 countries. All the countries of the world have foreign currency reserves in addition to their own currency which are called foreign exchange reserves. The main purpose of holding foreign exchange reserves is to make international payments for trade or other financial transactions. But is is also facts that about 59% of the world’s foreign currency reserves are in the form of US dollars. America is currently the superpower of the world and undoubtedly the American economy is considered to be the most powerful economy in the world and the American dollar is considered to be the most powerful currency of the world.

This journey of development of American economy is very interesting and why most of the world’s trade is being done in dollars and how the US dollar became the world’s most powerful global currency?

Different systems have been used in different eras for trade and financial transactions in the world. At the end of the 19th century and the beginning of the 20th century, the financial system of the world was converting into the use of different types of paper currency. In this situation, there was an urgent need to create a common system for commercial and financial transactions among countries. Because each country had its own currency and there was no clear rule for printing and circulation of currency, each country used to print and used currency as per its own needs. As a result there were serious difficulties In using the currency for trade among different countries. To solve this problem, most countries agreed that each currency should be valued at a certain amount of gold and that the government should have enough gold to print more of any currency. For instance, in 1873, the value of one US dollar was set at 1.504 grams of gold, so in order to print 1000 US dollars, the US government must have 1504 grams of gold. In simple words, each country can print its currency as per the availability of gold, not more than that. This was decided and agreed by all at that time, But after the start of the First World War, this system was collapsed.

The countries involved in the First World War needed a lot money for war expenses and to meet this need, many countries once again started printing their own currency notes blindly. As a result, the inflation in some countries increased too much and the value of their currency became very low. Britain was the superpower of the era and its colonies were spread all over the world. Although they tried to keep their currency pegged to gold in order to maintain the value of their currency and maintain their position in the world. Eventually in 1931, they too abandoned the gold standard behind the currency. This led to a sharp drop in the value of the pound and the bank accounts of international traders who traded in pounds at the time were severely effected. Moreover, even superpower like Great Britain had to borrow money to meet the war expenses. After the First World War, in 1920 their national deficit had reached 7.8 billion pounds, which was just 600 million pounds in 1913 before the war. After the Second World War, this deficit increased to about 21 billion pounds, which at the time was almost three times of their Gross Domestics Product (GDP). Similarly, other countries like Russia, France and Germany also suffered severe financial deficits.

It is to be noted that the economic and diplomatic policy of the United States in both these wars was excellent. The United States participated in both these wars first as a war merchant and later as a war participant. That is, while the whole world was engaged in these wars, the US was engaged in the production of cotton, wheat, rubber, machinery, precious metals and arms will all its capital and manpower. When the other nations were busy in wars, the United States utilised its full resources to maximise its metals, machinery, weapons and food exports. As a result, America saw the world’s greatest economic boom in a short period of time and emerged as the world’s largest exporter. Between 1913 to 1917, in just four years, total US exports rose from 2.4 billion US dollars to almost three times, that is 6.2 billion US dollars, while the superpower Britains’s exports were about 2.5 billion US dollars. Similarly, at the beginning of World War II, America was not officially a war participant, So they used all their resources to increase their exports. By 1945, US exports had grown to over 10 billion US dollars, most of which went to Great Britain and Russia. In comparison, Britain’s exports were only around around 3 billion US dollars.

The interesting and notable things is that there was a condition on the part of the US that it would sell all the goods during war only in exchange for its own currency, that is USD or in gold. At that time, obviously all other countries don’t have US dollars to trade. So America collected major gold reserves of other countries. That is, the United States created such business opportunities for itself from these two great wars that when the economies of the world’s superpowers were being effected by war, the United States had successfully accumulated about three-fourth of the world’s gold through trade. America’s gold reserves increased from 2,000 tons in 1910 to 20,000 tons in 1945.

Due to this stunning economic development of the United States during the wars, it became the last option to lend to many countries. During the World War II, the US began providing major military equipment and other aid to the Allies under “The Lend-Lease Act”.
Under The Land-Lease Act of 1941, the US government, instead of selling could lend , lease or grant war equipments to any country. The purpose of this loan or aid was to provide defence assistance to countries whose security was considered critical to the security of the United States. By this time, the United States itself was not officially a party to the war and was officially neutral in the conflicts, So much of this aid went to Britain and other countries that were already at war with Germany and Japan, And were not capable to buy more weapons. It was the land-lease act that enabled a superpower like Great Britain to practically continue war against Germany. After the incident of Pearl Harbour, in December 1941, when the United States became a war participant. But still, under the lend-lease act, aid continued and by the end of the war, the US had provided nearly 50 billion US dollars in aid to more than 30 countries.

Due to these factors, the US dollar started to emerge as a strong and global currency and the big superpowers of that time also became
indebted to the US. It was on this occasion that in 1944, the United States gathered representatives of 44 countries and signed an agreement that formed the basis of making the US dollar a world currency.

Delegates from the 44 allied nations met in Bretton Woods, New Hampshire in 1944, to devise a system for managing foreign exchange that would not harm any country. The delegation decided that world currencies would longer be pegged to gold but to the US dollar and it means, all other currencies will be backed by US dollar and the US dollar will eventually pegged to gold. The price of one ounce that is 28.35 grams of gold was then set at 35 US dollar. This arrangement became known as the Bretton Woods Agreement.

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Now the question arises, what could these 44 countries have benefitted from this agreement?

At that time, America had the largest gold reserves and most of the countries in the world had depleted their gold reserves due to war, So they don’t have gold to issue more currencies. So they accepted to peg their currencies with US dollar rather than gold. However, under this act, it was the responsibility of the US to print only as much of money as there are gold reserves available equivalent to that value of currency. In this way , the currencies of these countries, although not directly, but were indirectly linked with gold. Under this system, the authority of central banks was established which would maintain fixed exchange rates between their currencies and the US dollar, while the return of gold to a country at a fixed price in exchange for US dollars, was part of this agreement. In this agreement, US dollar was accepted as international trade currency. Because of this agreement, the two countries could trade easily without even trusting each other. For instance, If Great Britain exports one million USD worth goods to France. it was sure, that it can buy a specific amount of gold from the US for one million USD it receives from France. On the other hand, if it receives this money in French currency “Francs”, then if today, one million Francs can be exchanged for 1 kilogram of gold, it is possible that after a month France will print more currency which will depreciate the French currency, francs and with this one million francs, Britain can exchange may be 700 grams of gold instead of one kg. Thus, all the value of this trade will be practically lost. Moreover, if Britain wants to use these francs for trade with another country, and that country itself does not trust francs, then that money will be of no use to Britain. But if all this trade is done in US dollars, which became most powerful country at that time. The US guarantees that a specific amount of gold can be withdrawn at any time in exchange for US dollars. So any country can trade anything with any other country in USD, because they know for sure that they can exchange the gold anytime, in exchange of these USD.

The Bretton Wood Agreement importantly resulted in the establishment of two major financial institutions. One is the World Bank and the other is the International Monetary Fund (IMF). As most of the countries were suffering from economic collapse after the two world wars, So all these countries needed loans to restore their infrastructure and economy. With US funding, the World Bank gave massive loans to thees countries for their recovery. In addition, the IMF monitored the world economy as a whole and provided loans to small countries to ease their balance of payments difficulties. Thus, the Bretton Woods Agreement gave America a prominent position over other countries of the world. And this was the first stage where the US dollar gained precedence over all other countries and it emerged as a global currency.

The second reason which proved decisive in making the USD a global currency. As we look back at the time of the Second World War where one side Britain, France, Russia, America, Germany, Italy and Japan are at war and on the other side the Arab countries are relaxing in the desert, oblivious to these was disasters. They probably didn’t even know they were sitting on world’s largest oil reserves. At that time, the United States and Great Britain were the only countries that had the ability and technology to extract oil from the ground, process and trade it. Meanwhile, in 1938, an American company discovered a large oil deposit in Saudi Arabia and began extracting oil from it. At that time , Saudi Arabia was not prosperous economically, because oil had just started to be extracted from their land. During the war, Italy bombed several times on the US installations on the land of Saudi Arabia. And Saudi Arabia was in a dire need to protect their land and these oil facilities. It was at this time that the then President of the United States, Franklin Roosevelt, realised that oil will be the most important thing today and in future for development. So, after a long meeting with the Saudi ruler, King Abdulaziz, He made a historic deal in 1945 that permanently changed the fate of the dollar. According to this deal, the US will help Saudi Arabia to avoid any possible attack in the future. For this purpose, they will provide Saudi Arabia all kinds of advanced weapons and in return, Saudi Arabia will sell its oil against US dollars. Thus, Oil was sold in dollars and from here the rise of Middle East countries started.

After the establishment of the Organisation of the Petroleum Exporting Countries (OPEC) IN 1960, all oil trade in the world started to be done in dollars.

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The question arises, how did the dollar become the strongest currency in the world by trading oil for dollars?

According to the Britton Woods Agreement, any country could receive a fixed amount of gold from the US in exchange for dollars. As a result, in 1970, the gold reserves of the United States decreased to only ten thousand tons. This was the time when it became almost impossible for the US to exchange gold for dollars. At this point, the then US President Richard Nixon temporarily cancelled the gold exchange rate against the dollars and now, the Bretton Woods Agreement and the convertibility of US dollars into gold effectively terminated. Now every country in the world was free to set the exchange rate of its currency but no currency was now linked to gold, because all the currencies were linked to US dollar and US dollar was directly linked to gold. So, now the measure of value of any currency was not the gold attached to it, but the use of that currency or its demand in the international market determine its value. That is, it became important to know where your currency could be used and what it could buy. In this context, the US dollar was the currency with which one could buy the most important commodity of the century, which is oil. Therefore, most countries still kept their foreign exchange reserves in dollars to buy oil from the Arab world.

Another important reason is that, prosperous countries have huge foreign exchange reserves, while they use only a certain amount of it for trade. For instance, if a prosperous country has reserves of 100 billion US dollars, he could be utilising only 20 billion US dollars of that for trade. It will have remaining 80 billion US dollars in reserves, just as, instead of holding, we prefer to invest our savings in stocks, savings certificates or bonds, mutual funds, public provident fund (PPF) etc. In the same way, these countries invest their excess foreign exchange reserves in US treasury bonds. These US treasury bonds are issued by the US government and various countries invest in them with the aim of getting reasonable returns in the future. According to the Federal Reserve and the US Department of the Treasury, foreign countries held a total of eight billion US dollars in US Treasury Securities as of January 2024. This huge amount is more than the combined GDP of France, India and Russia. With this vast amount of money, the US has the added advantage of funding economic growth, defence spending , industrial production and even large financial institutions such as the World Bank and the IMF. And with these vast economic resources, the US gains an unfair control over other countries. Not only this, if a country tries to go against the will of the USA, the dollar reserves of that country in the USA can be frozen. An example of this is the sanctions imposed on Russia recently. So, American currency is the strongest currency in the world and America controls it and there is no restrictions to back that currency with gold.

Based on all these reasons, the status of America is a superpower and the US dollar is considered as a strong global currency. By the way, now a few countries of the world have started suing their local currency for trade among themselves, but the need for the dollar in global trade and its importance in the world’s economic system is still the highest today.