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Optimal reserve composition in the presence of sudden stops - the euro and the dollar as safe haven currencies

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Author Info
Roland Beck () (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
Ebrahim Rahbari () (London Business School, Economics Department, Regent’s Park, London, NW1 4SA, United Kingdom.)

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Abstract

We analytically derive optimal central bank portfolios in a minimum variance framework with two assets and "transaction demands" caused by sudden stops in capital inflows. In this model, the transaction demands become less important relative to traditional portfolio objectives as debt to reserve ratios decrease. We empirically estimate optimal dollar and euro shares for 24 emerging market countries and find that optimal reserve portfolios are dominated by anchor currencies and, at current debt to reserve ratios, introducing transactions demand has a relatively modest effect. We also find that euro and dollar bonds act as "safe haven currencies" during sudden stops. Dollars are better hedges for global sudden stops and for regional sudden stops in Asia and Latin America, while the euro is a better hedge for sudden stops in Emerging Europe. We reproduce qualitatively the recent decline in the share of the dollar in emerging market reserves and find that the denomination of foreign currency debt has very little importance for optimal reserve portfolios. JEL Classification: F31, F32, F33, G11.

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Paper provided by European Central Bank in its series Working Paper Series with number 916.

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Length: 46 pages
Date of creation: Jul 2008
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Handle: RePEc:ecb:ecbwps:20080916

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Related research
Keywords: Foreign exchange reserves; currency composition; sudden stops.;

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  2. Elias Papaioannou & Richard Portes & Gregorios Siourounis, 2006. "Optimal Currency Shares in International Reserves: The Impact of the Euro and the Prospects for the Dollar," NBER Working Papers 12333, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  3. Philip Lane & Jay C. Shambaugh, 2007. "Financial Exchange Rates and International Currency Exposures," NBER Working Papers 13433, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  4. Dani Rodrik, 2006. "The social cost of foreign exchange reserves," International Economic Journal, Korean International Economic Association, vol. 20(3), pages 253-266, September. [Downloadable!] (restricted)
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  5. 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!]
  6. Guillermo A. Calvo & Alejandro Izquierdo & Luis-Fernando Mejia, 2004. "On the Empirics of Sudden Stops: The Relevance of Balance-Sheet Effects," NBER Working Papers 10520, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  7. Fidora, Michael & Fratzscher, Marcel & Thimann, Christian, 2007. "Home bias in global bond and equity markets: The role of real exchange rate volatility," Journal of International Money and Finance, Elsevier, vol. 26(4), pages 631-655, June. [Downloadable!] (restricted)
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  8. Menzie Chinn & Jeffrey Frankel, 2005. "Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?," NBER Working Papers 11510, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  9. Donald J. Mathieson & Barry J. Eichengreen, 2000. "The Currency Composition of Foreign Exchange Reserves - Retrospect and Prospect," IMF Working Papers 00/131, International Monetary Fund.
  10. Ben-Bassat, Avraham, 1980. "The optimal composition of foreign exchange reserves," Journal of International Economics, Elsevier, vol. 10(2), pages 285-295, May. [Downloadable!] (restricted)
  11. Romain Ranciere & Olivier Jeanne, 2006. "The Optimal Level of International Reserves for Emerging Market Countries: Formulas and Applications," IMF Working Papers 06/229, International Monetary Fund. [Downloadable!]
  12. Olivier Jeanne, 2007. "International Reserves in Emerging Market Countries: Too Much of a Good Thing?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 38(2007-1), pages 1-80. [Downloadable!]
  13. Francis E. Warnock & Veronica Cacdac Warnock, 2006. "International Capital Flows and U.S. Interest Rates," NBER Working Papers 12560, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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