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A parsimonious model of trade, finance and endogenous currency choices in international reserves

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  • Lu, Dong
  • Mu, Yuhao

Abstract

We provide a parsimonious model with two international currencies (dollar and quasi-dollar) to examine the endogenous linkage among trade invoicing, bank funding and optimal currency choices in central banks’ international reserves. We find that (1) when the exchange rate volatility is high, an increase in dollar debt share would lead central banks to hold a larger dollar share in international reserves; (2) when exchange rates of dollar and quasi-dollar move in the same direction, they tend to cut dollar share in reserve holdings. We test these predictions using a newly-available foreign exchange reserve currency composition dataset and find considerable support.

Suggested Citation

  • Lu, Dong & Mu, Yuhao, 2023. "A parsimonious model of trade, finance and endogenous currency choices in international reserves," Economics Letters, Elsevier, vol. 225(C).
    • Handle: RePEc:eee:ecolet:v:225:y:2023:i:c:s0165176523000885
    DOI: 10.1016/j.econlet.2023.111063
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    References listed on IDEAS

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    1. Papaioannou, Elias & Portes, Richard & Siourounis, Gregorios, 2006. "Optimal currency shares in international reserves: The impact of the euro and the prospects for the dollar," Journal of the Japanese and International Economies, Elsevier, vol. 20(4), pages 508-547, December.
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    5. Gita Gopinath & Jeremy C Stein, 2021. "Banking, Trade, and the Making of a Dominant Currency," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 136(2), pages 783-830.
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    11. Liu, Tao & Lu, Dong, 2019. "Trade, finance and endogenous invoicing currency: Theory and firm-level evidence," Pacific-Basin Finance Journal, Elsevier, vol. 56(C), pages 21-44.
    12. Ito, Hiro & McCauley, Robert N., 2020. "Currency composition of foreign exchange reserves," Journal of International Money and Finance, Elsevier, vol. 102(C).
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    14. Aizenman, Joshua & Cheung, Yin-Wong & Qian, XingWang, 2020. "The currency composition of international reserves, demand for international reserves, and global safe assets," Journal of International Money and Finance, Elsevier, vol. 102(C).
    15. Arslanalp, Serkan & Eichengreen, Barry & Simpson-Bell, Chima, 2022. "The stealth erosion of dollar dominance and the rise of nontraditional reserve currencies," Journal of International Economics, Elsevier, vol. 138(C).
    16. Mr. Serkan Arslanalp & Mr. Barry J. Eichengreen & Chima Simpson-Bell, 2022. "The Stealth Erosion of Dollar Dominance: Active Diversifiers and the Rise of Nontraditional Reserve Currencies," IMF Working Papers 2022/058, International Monetary Fund.
    17. Gita Gopinath & Jeremy C. Stein, 2018. "Trade Invoicing, Bank Funding, and Central Bank Reserve Holdings," AEA Papers and Proceedings, American Economic Association, vol. 108, pages 542-546, May.
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    Cited by:

    1. Mateane, Lebogang, 2023. "Risk preferences, global market conditions and foreign debt: Is there any role for the currency composition of FX reserves?," Research in Economics, Elsevier, vol. 77(3), pages 402-418.

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    More about this item

    Keywords

    Currency choices; International reserves; Foreign debt; Exchange rate volatility; Exchange rate comovement;
    All these keywords.

    JEL classification:

    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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