The Bank for International Settlements (BIS) has issued its quarterly review, concentrating on a period of time during which FX volatility increased dramatically compared with the first nine months of 2014 which were stagnant and indeed worrysome for many companies.
This quarter’s review features a detailed focus on FX currency reserves in US dollars, and the dollar’s role as reference for other countries’ exchange rates ranges from dollar pegs, at one end, to largely market-driven co-movements under free-floating regimes as influenced by interest rate policies, at the other.
By examining the degree of co-movements, and predefining the set of key currencies, we derive a measure of each such currency’s zone of influence using simple regression techniques. The BIS uses the euro (before 1999, the Deutsche mark) and yen as the other candidate reference currencies, consistent with their status as the second and third most transacted currencies in the Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity.
The review does not define a tightly linked dollar bloc, but rather a fuzzier dollar zone. A given country’s GDP contributes to this zone in proportion to its currency’s dollar weight. So defined, the dollar zone accounts for more than half of global GDP.
By this measure, the US dollar’s pre-eminent influence as a reference currency lines up with its relative role as store of value for official reserves. The dollar zone has been close to 60% of global GDP and has shown little trend since 1990. This 60% is much closer to the dollar share of reserves than the global share of the US economy. The euro zone share of global GDP is now around 25%, just above the euro’s (reduced) share of reserves. The yen trails.
A stable dollar zone share of global GDP is at first puzzling, given that the euro’s influence has extended east in Europe, to commodity currencies and even as far as emerging Asia. However, Asia’s fast growth has offset the euro’s wider influence, given the diminished yet still strong dollar linkage of Asian currencies.
In sum, the dollar’s share in global forex reserves tracks over time the share of the dollar zone in global output. Together with the cross-sectional evidence which is presented here, this evidence suggests the importance of portfolio considerations and the domestic currency denomination.
Cross-sectional evidence
The insight that the way a currency trades against the major currencies guides the choice of the currency denomination of reserves has found only limited use in previous cross-sectional studies. IMF studies of confidential data, whether Heller and Knight (1978), Dooley et al (1989) or Eichengreen and Mathieson (2000), use dummies for pegs. They thus restrict to only extreme cases a test of the connection between currency anchoring and reserve composition.
The less restrictive approach sketched above provides quite a different picture. Most economies outside the United States, the euro area and Japan are intermediate cases, with dollar zone weights of less than 95% and above 5%.
Intermediate status derives from explicit management or from a combination of policy and market responses. For example, the Central Bank of the Russian Federation has managed the Russian rouble against a basket of €0.45 and $0.55. Its weight on the dollar is calculated at 0.55. Another intermediate case, the free-floating pound sterling, has a dollar weight of 0.45, as Haldane and Hall (1991) find for the late 1970s.
The report questions the widespread view that western hemisphere currencies are all firmly attached to the dollar. Other than the currencies of highly dollarised Peru and Uruguay, the co-movement with the euro of the Chilean, Colombian and Mexican pesos, or especially the Brazilian real, contradicts the long-standing notion of a solid dollar zone in the western hemisphere. Similarly, the co-movement of the Australian, New Zealand and, to a lesser extent, Canadian dollars with the euro against the dollar suggests that the “dollar bloc” label, still used by many asset managers, has outlasted its sell-by date.6
Does a currency’s dollar weight influence the share of the US dollar in the corresponding country’s official reserves? Yes, the limited cross-sectional evidence strongly suggests. Broadly, central banks in the Americas heavily weight the dollar, which remains the most important influence on their currencies despite the rising importance of the euro. Most European central banks do not hold such a high share of dollars, and Russia, Turkey, the United Kingdom, Australia and New Zealand are in between. Two thirds of the cross-sectional variation in the dollar share in foreign exchange reserves can be accounted for by the currencies’ average dollar zone weight in 2010-13.
In conclusion, BIS finds that there is a correlation between composition of broader economy-wide balance sheets including the private sector. After all, the BIS sample of official reserves is limited to only 24 economies representing $2.8 trillion or 28% of official foreign exchange reserves outside the G3. As a sort of robustness check, the BIS assesses the same relationship between currency movements and portfolio choices for $6 trillion, $6 trillion and $7 trillion in bank deposits, bank loans and international bonds outstanding, respectively.
The logic underlying both private and official behaviour is straightforward. The dollar looks less risky as an investment or a borrowing currency the more closely the domestic currency moves with the dollar.
Looking forward, findings by the BIS also have implications for the possible evolution of the currency composition of official reserves. They suggest that changes in the co-movement of currencies could result in more rapid than commonly thought shifts in the composition of reserves, potentially eroding the weight of the dollar. By the same token, they indicate that country size alone may be less relevant.
If correct, these findings have implications for the future of the renminbi. The continued relatively rapid growth of the Chinese economy, even if accompanied by developing money and bond markets, opening of the capital account and floating of the renminbi, might not be sufficient for the currency to eclipse the dollar in official reserve holdings. By contrast, if the renminbi at some point showed substantial independent movement against the major currencies and if its neighbours’ and trading partners’ currencies shared that movement, then it might be said that the renminbi bloc is here. In that case, official reserve managers might hold a substantial share of renminbi, perhaps not too far from their currencies’ renminbi zone weights.
For the full BIS report, click here.