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

  • Beck, Roland
  • Rahbari, Ebrahim

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 0916.

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Date of creation: Jul 2008
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Handle: RePEc:ecb:ecbwps:20080916
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  1. Philip R. Lane & Jay C. Shambaugh, 2010. "Financial Exchange Rates and International Currency Exposures," American Economic Review, American Economic Association, vol. 100(1), pages 518-40, March.
  2. 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.
  3. Ewe-Ghee Lim, 2006. "The Euro's Challenge to the Dollar; Different Views From Economists and Evidence From Cofer (Currency Composition of Foreign Exchange Reserves) and Other Data," IMF Working Papers 06/153, International Monetary Fund.
  4. 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.
  5. Papaioannou, Elias & Portes, Richard & Siourounis, Gregorios, 2006. "Optimal Currency Shares in International Reserves: The Impact of the Euro and the Prospects for the Dollar," CEPR Discussion Papers 5734, C.E.P.R. Discussion Papers.
  6. Dellas, Harris & Bang Yoo, Chin, 1991. "Reserve currency preferences of central banks: the case of Korea," Journal of International Money and Finance, Elsevier, vol. 10(3), pages 406-419, September.
  7. Guillermo A. Calvo & Alejandro Izquierdo & Luis Fernando Mejía, 2004. "On the Empirics of Sudden Stops: The Relevance of Balance-Sheet Effects," IDB Publications (Working Papers) 6516, Inter-American Development Bank.
  8. Dani Rodrik, 2006. "The Social Cost of Foreign Exchange Reserves," NBER Working Papers 11952, National Bureau of Economic Research, Inc.
  9. 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.
  10. 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(1), pages 1-80.
  11. 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.
  12. 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.
  13. Anna Wong, 2007. "Measurement and Inference in International Reserve Diversification," Working Paper Series WP07-6, Peterson Institute for International Economics.
  14. Ben-Bassat, Avraham, 1980. "The optimal composition of foreign exchange reserves," Journal of International Economics, Elsevier, vol. 10(2), pages 285-295, May.
  15. Michael P. Dooley & J. Saul Lizondo & Donald J. Mathieson, 1989. "The Currency Composition of Foreign Exchange Reserves," IMF Staff Papers, Palgrave Macmillan, vol. 36(2), pages 385-434, June.
  16. Barry J. Eichengreen & Donald J. Mathieson, 2000. "The Currency Composition of Foreign Exchange Reserves; Retrospect and Prospect," IMF Working Papers 00/131, International Monetary Fund.
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