The Currency Composition of Foreign Exchange Reserves
The US dollar continues to dominate the international monetary and financial system, but it plays an outsized role that puzzles many scholars. In fact, the US share of both world gross domestic product (GDP) and global trade has declined post-war. However, some recent work on the dollar has looked beyond the US economy to the global use of key currencies. When researchers seek to understand the dollar’s prominence in foreign exchange (FX) reserves, they quickly encounter severe data limitations that impede empirical analysis.
A working paper by Hiro Ito and Robert N. McCauley analyzes the factors that govern the choice of the currency composition of official foreign exchange reserves. The authors introduce a new panel dataset on the key currencies in foreign exchange reserves of about 60 economies from 1999 to 2017. The paper shows that the currency composition of reserves relates strongly to the co-movement of the domestic currency with key currencies and the currency invoicing of trade.
The authors find that the greater the co-movement of the domestic currency with the dollar, the higher its dollar share of FX reserves. If a currency varies less against the dollar than against other key currencies, then an FX reserve portfolio with a large dollar share poses less risk when returns are measured in domestic currency.Read the Working Paper