Understanding Currency Internationalization: Uses, Benefits, and Requirements

What Is Currency Internationalization?

Currency internationalization is the widespread use of a currency outside of the borders of the country that issued it. Demand for such a currency can stem from the need of it for international trade transactions, as a reserve currency or as a safe-haven currency. Currency internationalization may also occur with currency substitution.

How Currency Internationalization Works

An important facet of currency internationalization is that the currency concerned is used not only in transactions by residents of the issuing country but also in transactions between nonresidents; that is, nonresidents use it instead of their own national currencies when transacting in goods, services, or financial assets.

The demand for the use of a currency outside the borders of the issuing country can arise in several ways. Foreign governments and central banks may use the currency as a reserve currency on which to pyramid their own currencies. Foreigners may need to use the currency to settle international trade with partners who want to be paid in that currency. Lastly, foreigners may want to use the currency alongside or in place of their own local currencies to buy and sell goods in their own domestic economies.

Among these uses, use as a bank's reserve currency is the easiest to measure and keep track of as an indicator of currency internationalization. The most dominant reserve currency is the USD, with the euro (EUR) and the Japanese yen a distant second and third. According to the International Monetary Fund, which keeps track of the foreign exchange reserves around the world, as of Q1 2021, 59% of the total foreign exchange reserves are U.S. dollars, 20.5% are held in the euro, 5.89% in the Japanese Yen, and 4.70% in the British pound sterling (GBP).

Essential Requirements for Currency Internationalization

The Bank for International Settlements (BIS) highlights some important characteristics that need to be in place for internationalization.

The most critical is that the government of the issuing country has no restrictions on the purchase or sale of that currency by any entity. Secondly, exporters, whether from the country concerned or others, must be able to invoice some, if not all, of their exports in that currency. Third, a range of entities, including private and official companies and banks as well as individuals, should be able to hold the amounts they desire. If enough is held by foreign central banks, then the currency will become a reserve currency. Finally, both domestic and foreign firms and institutions should be able to issue marketable instruments in that country's currency, irrespective of the place of issue.

For example, a Eurobond may be sold by an emerging market to European investors but be denominated in USD; or an American company may issue a dollar bond in Asia.

Advantages of Adopting Currency Internationalization

There are a number of benefits to a country whose currency is internationalized. Economically, it enlarges the sphere of the market in which they can participate, without the need to exchange currencies and incur the related transaction costs. It provides more certainty to residents, who can denominate foreign transactions in their home currency. They can also borrow in foreign markets without incurring exchange rate risk, potentially enabling them to find cheaper funding.

In general, the underpinned demand for the currency should dampen interest rates and thus help lower the domestic cost of capital. While a potential cost of internationalization could be destabilizing effects if a foreign loss of confidence were to lead to a sell-off in assets denominated in the currency, most major currencies have large domestic debt markets that could act as a shock absorber in such a scenario.

The Bottom Line

Currency internationalization is the extensive use and demand for a currency by countries other than the one that issued it. The advantages of currency internationalization are reduced transaction costs and exchange rate risks for residents. However, a potential risk is the sell-off of assets denominated in the currency should users lose confidence in it.