The Case for an International Reserve Diversification Standard

Abstract

1 7 5 0 M a s s a c h u s e t t s a v e n u e , n W | W a s h i n g t o n , D c 2 0 0 3 6 -1 9 0 3 t e l : ( 2 0 2 ) 3 2 8 -9 0 0 0 | F a x : ( 2 0 2 ) 6 5 9 -3 2 2 5 | W W W . i i e . c o MThe Case for an International Reserve Diversification Standard Edwin M. Truman and Anna WongAbstract: Rumors about the actual or potential currency diversification of countries' foreign exchange holdings out of dollars are not a new phenomenon. This working paper argues that such concerns about reserve diversification are exaggerated. We present evidence that the extent of actual diversification has been modest to date. Nevertheless, the potential for reserve diversification adds volatility to foreign exchange markets and can catalyze abrupt exchange rate movements. We argue that policymakers acting in their own national interests can do something constructive to reduce the volatility introduced into foreign exchange and financial markets by rumors of large-scale international foreign exchange reserve diversification. We propose the voluntary adoption by major foreign exchange reserve holders in particular of an International Reserve Diversification Standard consisting of two elements: (1) routine disclosure of the currency composition of official foreign exchange holdings and (2) a commitment by each adherent to adjust gradually the actual currency composition of its reserves to any new benchmark for those holdings.

Stability or Upheaval? The Currency Composition of International Reserves in the Long Run

“…However, since we do not have information on the distinction prior to 1994, we do not analyse the "other currencies" category prior or subsequent to this. 9 See Truman and Wong (2006) and Ouyang and Li (2013), for example. See also Dominguez, Hashimoto and Ito (2012) for an attempt to estimate valuation effects as determinants of changes in reserve composition in emerging markets in early stages of the global financial crisis.…”

Measurement and Inference in International Reserve Diversification

“…Truman and Wong (2006) put forth a hypothesis regarding the connection between changes in the dollar's global share in reserves to its exchange rate value: In the short run, the share of a depreciating reserve currency that is also an intervention currency may increase because countries increase their holdings of the currency to suppress appreciation of their own currencies against it, resulting in a pattern of stabilizing diversification in this depreciating currency. But the global share of this reserve currency may also eventually decrease (increase) due to the decreased (increased) attractiveness of its external purchasing power, thus resulting in a pattern of active diversification over the medium term.…”

“…In an examination of five episodes of sustained dollar depreciation and four episodes of dollar appreciation from 1973 to 2005, chosen based on end-period exchange rates, Truman and Wong (2006) observe a pattern of stabilizing diversification in all five depreciation episodes and two of the appreciation episodes. One could also make the case for using average exchange rates to identify these episodes on account of exchange rate changes and interventions throughout the year.…”

“…Reserve diversification, as noted by Truman and Wong (2006), can be differentiated between that which does not exert or relieve pressure on foreign exchange markets-passive diversification-and that which exerts pressure on foreign exchange markets-active and stabilizing diversification. Under passive diversification, monetary authorities do not take actions but allow exchange rate changes to alter the allocation of their reserve portfolio.…”

“…3 Discussion of reserve diversification based on aggregate data shows only the share of reserves held in the currency by all countries as a group but does not reveal the dominant trend defined as the direction of changes by the largest 1. See Truman and Wong (2006) for further details on the three types of diversification. .…”