An article by Robert N McCauley and Tracy Chan titled “Currency movements drive reserve composition” was published in the Bank for International Settlements December Quarterly Review. The article highlights that currencies whose trading patterns closely mirror the U.S. dollar tend to have large dollar reserves.

McCauley and Chan argue that the reason that the U.S. dollar has remained the preeminent reserve currency despite a long-term decline in and a relatively smaller U.S. economy is the creation of the “dollar zone”. They point out that in countries whose currencies are more stable against the dollar than the euro, a reserve composition that favors the dollar produces more stability in the domestic currency. This interpretation, however, implies that reserve currency shares could change rapidly, and there is historical precedent for this.

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U.S. dollar: Further details on the study

The study data make it clear “that the higher the co-movement of a given currency with the dollar, the higher the economy’s dollar share of official reserves. Two thirds of the variation in the dollar share of foreign exchange reserves is related to the respective currency’s dollar zone weight.”

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The authors point out this association is bolstered by the currency composition of economy-wide balance sheets including the private sector. They note that their sample of official reserves is only 24 economies representing $2.8 trillion or around 28% foreign exchange reserves ex-G3. To confirm the association, McCauley and Chan looked at 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 data from this test provided even stronger confirmation of the association.

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McCauley and Chan note: “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.”

Implications for the currency composition of official reserves

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The findings of this study also have implications for future changes in currency composition of official reserves. The data 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.”

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The authors also point out that this study as implications for the future growth of the renminbi as a reserve currency. It suggests that the continued relatively rapid growth of the Chinese economy, even if accompanied by developing money and bond markets, together with the opening of the capital account and floating of the renminbi, still might not lead to the renminbi surpassing the dollar in global reserve holdings.

On the other hand, if in the future the renminbi showed a significant movement against the major currencies and if its major neighbors’ and trading partners’ currencies started tracking that movement, then it could be said that a “renminbi zone” was developing. If that came to pass, it seems more likely that global central bankers might choose to hold a larger percentage of renminbi, perhaps even close to their currencies’ renminbi zone weights.