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Optimal Currency Shares in International Reserves: The Impact of the Euro and the Prospects for the Dollar

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Author Info
Elias Papaioannou
Richard Portes
Gregorios Siourounis

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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%u2019s 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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12333.

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Date of creation: Jun 2006
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Handle: RePEc:nbr:nberwo:12333

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Find related papers by JEL classification:
F02 - International Economics - - General - - - International Economic Order; Noneconomic International Organizations;; Economic Integration and Globalization: General
F30 - International Economics - - International Finance - - - General
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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Cited by:
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  1. Rasmus Rüffer & Marcelo Sánchez & Jian-Guang Shen, 2007. "Emerging Asia’s growth and integration - how autonomous are business cycles?," Working Paper Series 715, European Central Bank. [Downloadable!]
  2. Gabriele Galati & Philip Wooldridge, 2009. "The euro as a reserve currency: a challenge to the pre-eminence of the US dollar?," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 14(1), pages 1-23. [Downloadable!]
    Other versions:
  3. 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. [Downloadable!]
  4. Matteo Bobba & Andrew Powell & Giuseppe Della Corte, 2007. "Sobre los determinantes de la elección de moneda internacional: Dominará el Euro en el Mundo?," RES Working Papers 4531, Inter-American Development Bank, Research Department. [Downloadable!]
  5. Roland Beck & Ebrahim Rahbari, 2008. "Optimal reserve composition in the presence of sudden stops - the euro and the dollar as safe haven currencies," Working Paper Series 916, European Central Bank. [Downloadable!]
  6. Matteo Bobba & Andrew Powell & Giuseppe Della Corte, 2007. "On the Determinants of International Currency Choice: Will the Euro Dominate the World?," RES Working Papers 4530, Inter-American Development Bank, Research Department. [Downloadable!]
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