Working Paper
The Currency composition of Foreign Exchange Reserves

Retrospect and Prospect

The management of international reserves remains one of the understudied aspects of the international monetary system. There are now a number of reasons why this should change. On the supply side of the market there is the advent of the euro, creating a full-fledged rival to the dollar for the first time in more than 50 years. The existence of this attractive alternative, it is said, will produce major shifts in the currency composition of international reserves, requiring large movements in the euro-dollar exchange rate to restore equilibrium to international financial markets. On the demand side there is the rush by industrial-country central banks out of gold and changes in the trade relations, capital account restrictions, and exchange rate regimes of developing countries, which may have important repercussions for the composition of their reserves.
A number these issues have been addressed in the recent literature. But one of them-their impact on the currency composition of reserves-has not been systematically addressed. We therefore analyse recent trends in currency composition in this paper, with special attention to emerging markets, where the impact of changes in the international financial environment is especially far-reaching, and with special reference to the euro, perhaps the single most important event on the reserve-currency scene.
Our single most important finding is the striking stability over time not just of the currency composition of reserves but also of the relationship between the demand for reserves denominated in different currencies and its principal determinants: trade flows, financial flows and currency pegs. This is not something that would have been predicted from recent contributions to the literature, which have forecast sharp shifts in the currency composition of central banks' holdings of foreign exchange. The message would seem to be that in this, as in other respects, the international monetary system is in a mode of gradual, continuous evolution, not of rapid, discontinuous change. For the same reasons that, say, the share of countries operating a particular exchange rate arrangement tends to evolve gradually (rather than to shift all at once in response to some grand scheme for a new Bretton Woods or a global system of target zones), the composition of reserves similarly appears to evolve only gradually, despite the existence of quite marked changes in the wider financial environment. If the right metaphor is punctuated equilibrium, then we would appear to be in one of those long periods between punctuation marks.