WORKING PAPER SERIES NO 694 / NOVEMBER 2006 OPTIMAL CURRENCY SHARES IN INTERNATIONAL RESERVES THE IMPACT OF THE EURO AND THE PROSPECTS FOR THE DOLLAR ISSN 1561081-0 by Elias Papaioannou, Richard Portes 9 771561 081005 and Gregorios Siourounis WORKING PAPER SERIES NO 694 / NOVEMBER 2006 OPTIMAL CURRENCY SHARES IN INTERNATIONAL RESERVES THE IMPACT OF THE EURO AND THE PROSPECTS FOR THE DOLLAR 1 by Elias Papaioannou 2, Richard Portes 3 and Gregorios Siourounis 4 In 2006 all ECB publications feature a This paper can be downloaded without charge from motif taken http://www.ecb.int or from the Social Science Research Network from the €5 banknote. electronic library at http://ssrn.com/abstract_id=942731 1 We thank Takatoshi Ito, Takeo Hoshi, Shin-ichi Fukuda, Andrew Rose, Philip Hartmann, J. Onno de Beaufort Wijnholds, Hélène Rey, Harris Dellas, participants in the TRIO (NBER-TCER-CEPR) conference and seminars at the European Central Bank, the Hong Kong Institute for Monetary Research, Bilkent University, Eurobank, the Bank of Japan, and the Bank of Spain for useful comments and suggestions. We also benefited from detailed suggestions and feedback from three anonymous referees. All errors are ours. The views expressed are the authors’ and do not reflect those of the European Central Bank or the Eurosystem. 2 European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany; e-mail: [email protected] 3 Professor of Economics, London Business School, Sussex Place, Regent's Park, London NW1 4SA, United Kingdom; e-mail: [email protected] 4 Economics Department, London Business School, Sussex Place, Regent's Park, London NW1 4SA, United Kingdom; e-mail: [email protected] © European Central Bank, 2006 Address Kaiserstrasse 29 60311 Frankfurt am Main, Germany Postal address Postfach 16 03 19 60066 Frankfurt am Main, Germany Telephone +49 69 1344 0 Internet http://www.ecb.int Fax +49 69 1344 6000 Telex 411 144 ecb d All rights reserved. Any reproduction, publication and reprint in the form of a different publication, whether printed or produced electronically, in whole or in part, is permitted only with the explicit written authorisation of the ECB or the author(s). The views expressed in this paper do not necessarily reflect those of the European Central Bank. The statement of purpose for the ECB Working Paper Series is available from the ECB website, http://www.ecb.int. ISSN 1561-0810 (print) ISSN 1725-2806 (online) CONTENTS Abstract 4 Executive summary 5 1 Introduction 7 2 Related literature on the currency composition of foreign reserves 13 2.1 History 13 2.2 Regression evidence 14 2.3 Case study and survey evidence 16 2.4 Key findings on reserve composition 17 3 Methodology 18 3.1 Expected currency returns 19 3.2 Variance-covariance matrix 20 3.3 Transaction costs (bid-ask spreads) 21 4 Results for the representative central bank 23 4.1 Random walk of the exchange rate 23 4.2 Perfect foresight 24 4.3 Minimum variance 24 4.4 Interest parity with transaction rebalancing costs 25 4.5 Alternative assumptions and robustness tests 26 4.5.1 Risk profile 26 4.5.2 Fat tails 27 4.5.3 The importance of the reference currency 27 5 Simulated results for the BRICs with constraints 28 5.1 Currency composition of external debt 29 5.2 Direction of international trade 30 5.3 The minimum variance portfolio with all returns expressed relative to the domestic currency 32 6 Conclusion 32 References 35 Figures and tables 43 European Central Bank Working Paper Series 60 ECB Working Paper Series No 694 November 2006 3 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)Growthinissuance 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. JEL Classification Nos.: F02, F30, G11, G15. Keywords: Currency optimizer, euro, foreign reserves, international currencies ECB Working Paper Series No 694 4 November 2006 Executive Summary There has been a remarkable accumulation of foreign exchange reserves in recent years. The introduction of the euro, greater liquidity in other major currencies, and the rising current account and fiscal deficits of the United States have increased the pressure on central banks to diversify away from the US dollar. There is concern that portfolio shifts from dollar- denominated assets to those denominated in the euro and other main currencies by central banks, in particular, could result in sharp dollar depreciation. A major portfolio shift would significantly affect exchange rates and the status of the dollar as the dominant international currency. This could have major consequences in the international financial system. For example, if the dollar loses part of its reserve status, this may reduce the "exorbitant privilege" of the United States, which is able to finance large and prolonged current account deficits in its own currency. Around two-thirds of global central bank foreign exchange reserves are in US assets. Many argue that central banks face an increasing “concentration risk” and should thus diversify away from the dollar to other currencies. Others, however, argue that diversification away from the dollar is unlikely and if anything will be moderate and slow. They contend that most central banks with large reserve holdings, especially those in East Asia, collaborate with their governments in pursuing an export-led growth strategy targeting mainly the US market, so they will maintain exchange-rate stability relative to the dollar. In this paper we build a dynamic mean-variance optimization framework with portfolio rebalancing costs to estimate optimal portfolio weights among the main international currencies in a before-after event study approach surrounding the introduction of the euro (the period 1995-2005). The currency optimizer allows for dynamic correlations and serial dependence in the variance-covariance matrix of returns; portfolio rebalancing costs, captured by bid-ask spreads in the FOREX market; and other constraints capturing central bank’s special needs. We study the five main international currencies, namely the U.S. dollar (USD), the euro (EUR), the Swiss franc (CHF), the British pound sterling (GBP), and the Japanese yen (JPY), to assess how the "optimal" share of the euro altered after 1999, compared to the optimal pre-1999 allocation to the three main euro predecessor currencies, the French franc (FFR), the Deutsche mark (DEM) and Dutch guilder (NLG). First we perform this analysis for a global "representative central bank". This enables us to compare the estimated optimal currency shares with the reported aggregate shares, making various assumptions about the central bank’s risk profile, liquidity needs and ECB Working Paper Series No 694 November 2006 5 exchange-rate returns. Second, we perform simulations for optimal currency allocations of four large emerging market countries, Brazil, China, India and Russia, incorporating into the optimization framework constraints that capture central banks’ desire to hold a sizable portion of their portfolio in the currencies of the peg, the foreign debt and international trade. Our results can be summarized as follows. First, we find that due to high interest rates and especially exchange rate volatility, the mean-variance optimizer yields very unstable results. We believe that this result may explain the high inertia in reserve composition and rationalize why central banks proceed slowly when diversifying. Second, our optimizer can match the high allocation of the dollar in reserve holdings (about 60-65%) when we use the US currency as the base-reference currency (risk-free asset). Thus the high share of the dollar should not come as a surprise, since most central banks (even in industrial currencies) express their returns in dollar terms. Third, the optimizer yields allocations that differ from actual (reported) reserve holdings in the other main currencies. The optimization yields roughly equal allocations to the four main currencies (around 8%-12%). This suggests that the actual-reported share of the euro in international reserves (approximately 25%) is much higher than the “optimal” allocation. We believe that this offers tentative evidence of an increasing international role of the euro. So far, however, this increased internationalization comes primarily at the expense of the yen, the pound sterling and the Swiss franc rather than against the dollar. Fourth, the evidence suggests that the narrowing of spreads and the enhanced liquidity of the euro, the increased share of the euro area in international trade, and the increasing number of non-EU governments issuing euro-denominated assets all add pressure on the dollar.