What it means
Most countries cannot price oil, grain or loans in their own currency and expect the world to accept it. They use a key currency instead, because buyers and sellers on both sides know its value and can convert it easily.
Over time the habit becomes self-reinforcing, since the more people use it the more useful it is. Several qualities make a currency a key currency.
The issuing country needs a large and stable economy, open capital markets with plenty of safe assets to buy, and legal systems that people trust. Political stability and a low risk of sudden controls on moving money also matter a great deal.
For businesses, the practical effect is that many contracts are written in a key currency even when neither party is from that country. A Brazilian exporter selling to an Indian buyer may invoice in US dollars, and a Gulf producer may price crude oil the same way.
Companies outside the issuing country therefore carry foreign exchange risk on trade that has nothing to do with the issuing nation. Central banks also hold key currencies in their reserves, which are the stockpiles of foreign assets used to defend their own currency and pay for imports.
The mix of currencies in those reserves changes slowly over time. A key currency is often called a reserve currency, although the two terms are not always identical in meaning.
The status brings benefits and costs for the issuing country. It enjoys easy borrowing and lower financing costs because of strong demand, but it can also face a stronger exchange rate that hurts its exporters.
For everyone else, the important point is that a key currency's interest rate decisions spread through the global economy.
In practice
Real-world examples.
Example
A South African fruit exporter sells to a supermarket group in the Middle East. Both sides agree to invoice in US dollars because that currency is easy to hedge and widely accepted. The exporter then converts the dollars into its own currency to pay growers.
Example
A central bank in a small economy builds its reserves by buying key currency assets. When its domestic currency comes under pressure, it can sell some reserves to support the exchange rate. The size and mix of the reserves are watched by lenders and rating agencies.
Example
A software company in Poland agrees a long-term customer contract in euros. Most of its costs are in zloty, so the finance director reviews the currency exposure and arranges forward contracts. The key currency status makes hedging inexpensive.
Formula
Calculation
Local-currency cost = invoice amount in key currency x exchange rate.
Suppose a manufacturer in Thailand buys machinery invoiced at $400,000 in US dollars. When the exchange rate is 35 Thai baht per dollar, the cost is 400,000 x 35 = 14,000,000 baht. If the baht weakens to 38 per dollar by the payment date, the cost rises to 400,000 x 38 = 15,200,000 baht. The extra cost is 15,200,000 - 14,000,000 = 1,200,000 baht, even though the machine's dollar price did not change.Case study
Seen in the real world.
Marigold Trading is an illustrative, fictional exporter of coffee based in a country with a small, little-traded currency. Its buyers preferred to pay in a key currency, because they could not easily buy or sell the local one.
The finance director invoiced a shipment at $2,500,000, expecting to convert it to local currency when it arrived. Between the invoice date and payment, the local currency strengthened by 4%, which cut the local value of the proceeds by about 4%.
The illustrative lesson is that using a key currency solves the trading problem but creates a conversion problem. After this experience, the company began hedging its expected dollar receipts with forward contracts, which fixed the rate in advance.
Watch out
Common mistakes.
- Assuming that invoicing in a key currency removes currency risk, when the risk simply moves to whichever party has costs or revenues in another currency.
- Believing that a key currency status is permanent, when the balance of currencies in trade and reserves shifts slowly over decades.
- Using key currency and reserve currency as perfect synonyms, when the first stresses everyday use in trade and finance and the second stresses what central banks hold.
Questions
People also ask.
Which currencies are key currencies?
The US dollar is the most widely used, with the euro next in importance, and others such as the Japanese yen, the pound sterling and the Swiss franc play significant roles.
Why do countries not just trade in their own currencies?
A currency has to be easy to trade, stable and accepted by many parties, and smaller or less liquid currencies often fail on one or more of those tests.
Does the issuing country benefit from key currency status?
It usually gains cheaper borrowing and wider market influence, though a persistently strong currency can make its exports less competitive.
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