The currency composition of foreign exchange reserves

Focus

Since 1945, the US dollar has dominated the international monetary and financial system. The dollar plays a particularly outsized role in official foreign exchange (FX) reserves. Scholars find it puzzling that its share has persisted at about two thirds of the total. After all, the US share of both world GDP and global trade has declined post-war. However, when researchers seek to understand the dollar's predominance in FX reserves, they quickly encounter severe data limitations that greatly impede empirical analysis.

Contribution

We attempt to remove this impediment. To do so, we compile a data set from annual reports, financial statements and other relevant sources for 58 central banks across the world in 1999-2017. This data set makes a big contribution. The IMF's Currency Composition of Official Foreign Exchange Reserves (COFER) data generally disclose only aggregates for the entire world, advanced economies and emerging market economies, not data on individual economies. Previous efforts to collect publicly available country data, including our own, came up with a mere two dozen cases. 

Conceptually, we add to recent work on the dollar's role that emphasises the global uses of the dollar rather than the US economy. We innovate in assessing the influence of the dollar's anchor role for not only pegged currencies but also floating ones. We do so in a multivariate setting that includes the much-discussed influence of the dollar as an invoicing currency for exports.

Findings

Using this data set, we find that the greater the co-movement of the domestic currency with the dollar (euro), the higher its dollar (euro) share of FX reserves. This finding holds in both the cross section and the panel. This makes sense. If a currency varies less against the dollar than against other key currencies, then an FX reserve portfolio with a large dollar share poses less risk when returns are measured in domestic currency. We also find in smaller samples that the higher the dollar-denominated (euro-denominated) share of exports, the higher the dollar (euro) share in FX reserves. The effect of currency anchoring appears to be on a par with that of the unit of account in trade as determinants of reserve composition.

Abstract

This paper analyses the factors that govern the choice of the currency composition of official foreign exchange reserves. First, we introduce a new panel dataset on the key currencies in foreign exchange reserves of about 60 economies in the 1999-2017 period. Second, we show that the currency composition of reserves relates strongly to the co-movement of the domestic currency with key currencies and the currency invoicing of trade. These factors represent attributes of the dollar or the euro rather than of the United States or the euro area. They exert about equal effects on the currency composition of foreign exchange reserves. We demonstrate that these findings are robust to a host of other possible factors.

JEL codes: E44, E58, F14, F31

Keywords: foreign exchange reserves, international currency, key currency, currency zones, invoicing of trade, currency of international debt, foreign exchange reserve management