African Reserves

Dollar dominance and the rise of non-traditional reserve currencies

Source: Adobe/William W. Potter

Serkan Arslanalp is Deputy Head of Division in the Balance of Payments Division of the International Monetary Fund Department of Statistics of the (IMF); Barry Eichengreen, George C. Pardee and Helen N. Pardee Professor of Economics and Political Science, University of California; Chima Simpson Bell is an Economist in the African Department of the IMF.

The US dollar has long played an outsized role in global markets. It continues to do so even though the US economy has produced a declining share of global output over the past two decades.

But although the currency’s presence in global trade, international debt and non-bank borrowing still far exceeds the United States’ share of trade, bond issuance and international borrowing and lending, banks centrals do not hold the greenback in their reserves to the extent that they once did.

As the week’s chart shows, the dollar’s share of global foreign exchange reserves fell below 59% in the final quarter of last year, extending a two-decade decline, according to IMF composition data. in foreign currency from official foreign exchange reserves.

In an example of the broader change in the composition of foreign exchange reserves, the Bank of Israel recently unveiled a new strategy for its more than $200 billion in reserves. Starting this year, it will reduce the US dollar share and increase portfolio allocations to the Australian dollar, Canadian dollar, Chinese renminbi and Japanese yen.

As we document in a recent IMF working paper, the reduced role of the US dollar has not been matched by increases in the shares of the other traditional reserve currencies: the euro, the yen and the pound. Moreover, although there has been some increase in the share of reserves held in renminbi, this represents only a quarter of the abandonment of the dollar in recent years, partly due to the relatively closed capital account of China. Moreover, an update of data referenced in the working paper shows that at the end of last year, a single country, Russia, held almost a third of the world’s renminbi reserves.

By contrast, currencies of smaller economies that have not traditionally featured prominently 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 lower volatility. This is increasingly attracting central bank reserve managers as currency stocks grow, raising the stakes for portfolio allocation.
  • New financial technologies, such as automatic market making and automated liquidity management systems, are making it cheaper and easier to trade currencies in smaller economies.

In some cases, the issuers of these currencies also have bilateral swap lines with Federal Reserve (Fed). This, it can be said, creates confidence that their currencies will hold their value against the dollar.

At the same time, the importance of this factor can be questioned. Non-traditional currencies tend to float. In practice, they fluctuate widely against the dollar. And their issuers have rarely, if ever, drawn on their bilateral swap lines with the Fed. Regression analysis shows that having a Fed swap line is associated with a decline of 9 percentage points increase in the dollar share of the recipient’s reserves. This may 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. Important attributes of reserve currency issuers include not only economic weight and financial depth, but also transparent and predictable policies. In other words, economic stability and political decisions are important for international acceptance.

A regression analysis of global reserve currency shares confirms that a higher economic risk premium, as measured by the cost of using credit derivatives to insure against default, reduces a currency’s share of world reserves. Clearly, holders favor currencies from countries known for their good governance, economic stability, and sound finances.

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