Working Paper: NBER ID: w12333
Authors: Elias Papaioannou; Richard Portes; Gregorios Siourounis
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.
Keywords: Euro; Dollar; International Reserves; Central Banks; Currency Composition
JEL Codes: F02; F30; G11; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| The introduction of the euro (F36) | significant changes in the allocation of foreign exchange reserves (F31) |
| increased issuance of euro-denominated securities (G15) | increase in optimal share of the euro for certain countries (F36) |
| The euro zone as a major trading partner (F10) | increase in optimal share of the euro for certain countries (F36) |
| optimal portfolios (G11) | lower weight for the euro compared to its actual observed share (F31) |
| The reference currency (F31) | determining optimal reserve compositions (Q31) |
| dollar's dominance (F31) | influenced by currency pegs and external debt obligations (F31) |