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Optimal currency shares in international reserves - the impact of the euro and the prospects for the dollar

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Author Info
Elias Papaioannou () (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany)
Richard Portes () (London Business School, Sussex Place, Regent's Park, London NW1 4SA, United Kingdom)
Gregorios Siourounis () (London Business School, Sussex Place, Regent's Park, London NW1 4SA, United Kingdom)

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Abstract

Foreign exchange reserve accumulation has risen dramatically in recent years. The introduction of the euro, greater liquidity in other major currencies, and the rising current account deficits and external debt of the United States have increased the pressure on central banks to diversify away from the US dollar. A major portfolio shift would significantly affect exchange rates and the status of the dollar as the dominant international currency. We develop a dynamic mean-variance optimization framework with portfolio rebalancing costs to estimate optimal portfolio weights among the main international currencies. Making various assumptions on expected currency returns and the variance-covariance structure, we assess how the euro has changed this allocation. We then perform simulations for the optimal currency allocations of four large emerging market countries (Brazil, Russia, India and China), adding constraints that reflect a central bank’s desire to hold a sizable portion of its portfolio in the currencies of its peg, its foreign debt and its international trade. Our main results are: (i) The optimizer can match the large share of the US dollar in reserves, when the dollar is the reference (risk-free) currency. (ii) The optimum portfolios show a much lower weight for the euro than is observed. This suggests that the euro may already enjoy an enhanced role as an international reserve currency ("punching above its weight"). (iii) Growth in issuance of euro-denominated securities, a rise in euro zone trade with key emerging markets, and increased use of the euro as a currency peg, would all work towards raising the optimal euro shares, with the last factor being quantitatively the most important. JEL Classification: F02, F30, G11, G15.

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Paper provided by European Central Bank in its series Working Paper Series with number 694.

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Length: 61 pages
Date of creation: Nov 2006
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Handle: RePEc:ecb:ecbwps:20060694

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Keywords: Currency optimizer; euro; foreign reserves; international currencies.;

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This paper has been announced in the following NEP Reports: References listed on IDEAS
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Roland Beck & Ebrahim Rahbari, 2008. "Optimal reserve composition in the presence of sudden stops - the euro and the dollar as safe haven currencies," Working Paper Series 916, European Central Bank. [Downloadable!]
  2. Aristovnik, Aleksander & Čeč, Tanja, 2009. "Compositional Analysis of Foreign Currency Reserves in the 1999-2007 Period : The Euro vs. The Dollar as Leading Reserve Currency," MPRA Paper 14350, University Library of Munich, Germany. [Downloadable!]
  3. Rasmus Rüffer & Marcelo Sánchez & Jian-Guang Shen, 2007. "Emerging Asia’s growth and integration - how autonomous are business cycles?," Working Paper Series 715, European Central Bank. [Downloadable!]
  4. Gabriele Galati & Philip Wooldridge, 2009. "The euro as a reserve currency: a challenge to the pre-eminence of the US dollar?," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 14(1), pages 1-23. [Downloadable!]
    Other versions:
  5. Matteo Bobba & Andrew Powell & Giuseppe Della Corte, 2007. "On the Determinants of International Currency Choice: Will the Euro Dominate the World?," RES Working Papers 4530, Inter-American Development Bank, Research Department. [Downloadable!]
  6. Ewe-Ghee Lim, 2007. "Do Reserve Portfolios Respond to Exchange Rate Changes Using a Portfolio Rebalancing Strategy? An Econometric Study Using COFER Data," IMF Working Papers 07/293, International Monetary Fund. [Downloadable!]
  7. Matteo Bobba & Andrew Powell & Giuseppe Della Corte, 2007. "Sobre los determinantes de la elección de moneda internacional: Dominará el Euro en el Mundo?," RES Working Papers 4531, Inter-American Development Bank, Research Department. [Downloadable!]
  8. Bank for International Settlements, 2008. "FX reserve management: trends and challenges," BIS Papers, Bank for International Settlements, number 40, 11. [Downloadable!]
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