Key currency is a currency that does not fluctuate too broadly, helps in setting exchange rates, and supports global transactions. The term “key currency” can also be used to define prominent currencies in the world.
Since a key currency is recognized globally, it can set the value of other currencies. Key currencies are the currencies of countries that are economically stable, financially strong, developed, and are participants of the global market.
A key currency acts as a reference value in global financial transactions. In the foreign exchange market, it provides stable exchange rates for other currencies. Hence, small countries relying heavily on export may implement key currencies to reduce the currency risks involved in international trade.
Key currency is a major currency that does not vary much, helps in international transactions, and sets the exchange rates.
Smaller and developing countries hold reserves of key currencies to settle global debt obligations and support investments.
Many countries peg their currencies to one or a basket of key currencies to stabilize their economy and ease international transactions.
Significance of a Key Currency
A key currency affects the exchange rate of smaller countries; hence, central banks hold reserves of key currencies. The reserve currencies help complete global transactions, pay foreign debt obligations, and support investments. A reserve currency may or may not be a key currency.
Countries hold key currencies to pay for a lot of internationally-traded commodities, such as oil and gold, which are generally rated at a key currency. Furthermore, when different countries agree upon a deal, they usually use a key currency for transaction purposes to reduce the risk of changes in exchange rates during the time of the deal.
Countries with non-key currencies usually peg their national currencies to key currencies. By doing so, smaller and developing countries hope to ease international transactions and stabilize the economy.
Although the fixing of national currency to key currency reduces the flexibility of monetary policies, it increases the confidence in the economy of the country.
The U.S. Dollar as the International Key Currency
Over the past seven decades, the U.S. dollar has attained a leading position among all other currency units in the world. It has evolved into a global medium of exchange, facilitating global investments and trade in a safer environment.
The global dominance of the U.S. in gross domestic product (GDP), currency stability, world trade, capital flows, and foreign direct investments has led the U.S. dollar to be the key currency of the world. According to the International Monetary Fund (IMF), in Q1 2020, the U.S. dollar accounted for about 62% of the foreign exchange holdings compared to 20% for Euro and 6% for Yen.
Moreover, during times of crisis or panic, the U.S. treasuries or cash in any liquid currency are the most demanded investments. The U.S. dollar is being used extensively in almost everything from foreign-exchange transactions to commodity pricing to international trade. It makes the U.S. dollar an important currency for investors and businesses.
Many countries make investments in U.S. dollar-denominated assets due to its stability and international value. Also, it provides a market with the most liquid bonds.
Furthermore, treasuries are believed to be the best risk-free asset in the world, and the yields of U.S. treasuries are more than the Japanese and European treasuries. Even when the yields of the U.S. treasuries fall to a record low, they are 1% above their counterparts.
Key Currency Pairs
In the foreign exchange market, a currency pair is the estimate of one currency’s value relative to another. The currency used as a reference is called the quote currency, and the other one is called the base currency. The following are some of the key currency pairs:
Euro/U.S. Dollar (EUR/USD)
Also known as the Euro, it is the most popular pair. Economic releases by the U.S. Federal Reserve and the European Central Bank impact the currency pair. The value of EUR/USD falls as the dollar value rises and vice versa.
British Pound Sterling/U.S. Dollar (GBP/USD)
In the 1800s, the exchange between the countries used to be via a cable laid along the Atlantic Ocean’s floor. Hence, trading in GBP/USD is referred to as trading the “Cable.”
U.S. Dollar/Japanese Yen (USD/JPY)
The above key currency pair is referred to as “Gopher.” The Japanese yen is a popular currency for carry trade strategies, which is similar to the buy low and sell high strategy. Traders and investors can benefit from the difference in interest rates of the Japanese yen and USD since the interest rate on the USD/JPY pair remains low.
U.S. Dollar/Canadian Dollar (USD/CAD)
It is a commodity pair commonly called the “Loonie.” While the proximity of Canada to the U.S. enables the sharing of high volumes of trade, tariffs imposed by the governments of both countries have made CAD vulnerable to the volatility of the market.
U.S. Dollar/Swiss Franc (USD/CHF)
Known as the “Swissie,” the interest rate difference between the Swiss National Bank and the U.S. Federal Reserve greatly impacts this key currency pair. Similar to the USD, the Swiss franc is considered a safe haven currency and also appreciates during times of uncertain global markets.
The choice of a currency pair depends on the country where the investor will be trading or looking for investment opportunities.
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