Serkan Arslanalp is Deputy Head of the Balance of Payments Department of the Department of Statistics in International Monetary Fund (IMF); Barry EichengreenGeorge C. Pardee and Helen N. Pardee Professor of Economics and Political Science, University of California ; Chima Simpson Bell is an economist in the IMF’s African branch.
The US dollar has long played a major role in global markets. It continues to do so even though the U.S. economy has seen its share of global production shrink over the past two decades.
But even though the currency’s presence in global trade, international debt and non-bank borrowing still far exceeds the US share of trade, bond issues and international borrowing and lending, banks’ power plants no longer hold the dollar in their reserves to the same extent as before.
As this week’s chart shows, the dollar’s share of global foreign exchange reserves fell below 59% in the last quarter of last year, continuing a decline that has lasted for two decades, according to IMF data on the currency composition of official foreign exchange reserves.
To illustrate the general development in the composition of foreign exchange reserves, Israel Bank recently unveiled a new strategy for its over 200 billion. USD in reserves. Starting this year, it will reduce the share of the US dollar and increase the portfolio’s allocations to the Australian dollar, Canadian dollar, Chinese renminbi and Japanese yen.
As we explain in a recent IMF working paper, the decline in the role of the US dollar has not been accompanied by an increase in shares of the other traditional reserve currencies: the euro, the yen and the pound. Moreover, while the share of renminbi reserves has risen somewhat, it represents only a quarter of the dollar’s abandonment in recent years, in part due to China’s relatively closed capital account. An update of data mentioned in the working paper shows that at the end of last year, a single country – Russia – had almost a third of the world’s renminbi reserves.
In contrast, currencies from smaller economies, which do not traditionally have a prominent place in reserve portfolios such as the Australian and Canadian dollars, the Swedish krona and the South Korean won, account for three-quarters of the dollar’s abandonment.
Two factors can help explain the movement towards this set of currencies:
- These currencies combine higher returns with relatively low volatility, which is of increasing interest to central bank reserve managers as currency stocks grow, increasing efforts in portfolio allocation.
- New financial technologies – such as automatic market making and automated liquidity management systems – make trading currencies in small economies cheaper and easier.
In some cases, the issuers of these currencies also include bilateral swap lines Federal Reserve (EDF). This creates a degree of confidence that their currencies will hold their value against the dollar.
At the same time, the significance of this factor can be questioned. Non-traditional currencies tend to float. In practice, they fluctuate a lot against the dollar. And their issuers rarely or never used their bilateral swap lines with the Fed. A regression analysis shows that having a swap line with the Fed is associated with a 9 percentage point increase in the dollar share of the recipient’s reserves. This could indicate that swap lines are an imperfect substitute for real reserves.
A more plausible explanation is that these non-traditional reserve currencies are issued by countries with open capital accounts and a track record of sound and stable policies. Key features for reserve currency issuers include not only economic weight and financial depth, but also transparent and predictable policies. In other words, stability in the economy and in political decisions is important for international acceptance.
A regression analysis of global reserve currency ratios confirms that a higher economic risk premium, measured by the cost of using credit derivatives to hedge, reduces a currency’s share of world reserves. It is clear that holders prefer currencies from countries known for their good governance, economic stability and sound finances.
This article was first published on blogs.imf.org.
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