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Emerging Market Economies and the Next Reserve Currencies

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Abstract

It is most likely that the current reserve currencies will retain their status in the near future, given the persistence in the composition of reserve holdings. However, since we do not have complete data on the switchovers in lead reserve currencies, a great deal of uncertainty attends any forecasts. Hence, it is possible that new reserve currencies might appear with greater rapidity than anticipated. Of the candidates for new reserve currencies among the major emerging economies, the renminbi (RMB) is the most plausible. However, even under optimistic assumptions regarding economic growth and financial development, RMB status as a major reserve currency is some time off. A role for regional reserve currency status in the near future is much more likely. The advent of a multi-reserve currency world is unlikely to have negative consequences for global financial stability (and might be stability-enhancing). However, achieving the prerequisites for reserve currency status will force sacrifices in terms of policy autonomy. In addition, reserve currency status might reduce international competitiveness for individual countries, as higher currency demand appreciates their currencies.

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Notes

  1. For recent discussions of the dollar’s role and other international currencies, see Prasad (2014).

  2. Eichengreen and Flandreau (2008) report that in 1929, central bank reserve holdings of dollars and sterling were approximately equal.

  3. As of June 30, 2014, 47.4 % of total reserves are unallocated. Most of the unallocated reserves are reported by the non-advanced economy central banks; while the unallocated share for advanced economy reserves is 10.9 %, it is 65.1 % for non-advanced economy reserves (IMF, Currency Composition of Official Foreign Exchange Reserves (COFER) data, September 30, 2014).

  4. In Fig. 2, 60 % of unallocated reserves are assumed to be denominated in USD, and 25 % in euros.

  5. For some measures of international currency use—how often a vehicle currency is used in the invoicing and financing of international trade—other aspects of the pattern of trade may also be relevant. The fact that much of Japan’s imports are oil and other raw materials and that much of its exports go to the Western Hemisphere, for example, helps explain why a disproportionately small share of trade is invoiced in yen as opposed to dollars. Raw materials still tend heavily to be priced in dollars.

  6. Chinn and Frankel (2007) assessed an alternative proxy for the size of financial centers, namely the size of the countries’ stock markets.

  7. E.g., Tavlas and Ozeki (1992).

  8. In Chinn and Frankel (2007), a measure of the popularity of the major currencies for smaller currencies to peg to was added to the regressions as a robustness check. An Asian country that is pegged to the dollar, for example, is likely to hold a larger share of its reserves in the form of the dollar. However, no significant effect of this nature was detected.

  9. Chinn and Frankel focus on results using nominal GDP at market exchange rates, rather than PPP valuations.

  10. The financial crisis of 2008–09 demonstrated that as long as so much international finance is undertaken in dollars, dollar reserves will be particularly important in times of financial stress. See Engel (2012: 22–23). This aspect of reserve determination is difficult to incorporate into the Chinn-Frankel specification.

  11. Some other candidate reserve currencies would include Australian and Canadian dollars. While both countries are relatively small in terms of GDP, by some metrics their currencies are closer to meeting the requirements. 2.7 % of foreign exchange trading takes place in Australia, while turnover in the Australian dollar exceeds that of the Swiss franc (8.6 vs. 5.2 % out of 200 %). In 2014Q1, each of these currencies accounted for about 1 % of total reserves. The Singapore dollar and Swedish and Norwegian currencies are also currently well represented in central bank reserve holdings, under the category of “Other currencies” (Szalay 2012). As of March 2014, “Other currencies” represented 1.5 % of total reserves, and including the Canadian and Australian dollars accounts for 3.4 % (IMF 2014).

  12. See Chinn and Ito (2006) for a more extensive discussion of what exactly constitutes financial development. Ito and Chinn (2009) assess financial development using other financial indicators, including stock market and bond market value and turnover.

  13. The indices displayed are the LEGAL variable used in Chinn and Ito (2008a). The measure is calculated as the first principal component of bureaucratic quality, law and order, and corruption.

  14. See Chinn and Ito (2008b) for details. Data available at: http://web.pdx.edu/~ito/Chinn-Ito_website.htm

  15. Other skeptical analyses include Wu et al. (2010), Ranjan and Prakash (2010) and ECB (2013). Chen and Cheung (2011) assess the internationalization of the RMB. Ito and Chinn (forthcoming) assess the prospects for RMB invoicing of trade.

  16. See Cohen (2012) for additional discussion of costs and benefits.

  17. The empirical evidence regarding choice of anchor currencies is limited. Meissner and Oomes (2009) point to trade flows, and denomination of liabilities. Fratzscher and Mehl (2014) provide evidence that East Asian currencies are pegging against the RMB.

  18. This concern was one of the primary reasons German policymakers were reluctant to see Deutsche mark internationalization.

  19. Eichengreen and Flandreau (2012) emphasize that achievement of the pre-requisites is insufficient; active policy intervention was necessary in the case of the dollar establishment as a reserve currency.

  20. See Patnaik and Shah (2011). Domestic political concerns are also of importance (Helleiner and Malkin 2012).

  21. A common view is that the first the currency must be moved toward alignment with market perceptions of “fair value”, as the banking sector is strengthened and liberalized (particularly with respect to interest rates). Then as capital outflows are encouraged, domestic securities markets are developed. See for instance Brehon et al. (2012) and also Prasad and Ye (2012).

  22. McKinsey Global Institute (2009) estimates the cost of an appreciated dollar at between $30 and $60 billion. Hence, on net, the US benefits on net from the dollar’s reserve currency status.

  23. If reserve currency status encourages cross border holdings of financial assets, then it is likely that these countries will also be exposed to greater valuation effects due to exchange rate changes. See Lane and Shambaugh (2010).

  24. There is the fear that a multipolar system would be inherently unstable, as central banks re-allocate their holdings in order to gain the highest returns. Eichengreen (2010) argues that this view inappropriately analogizes central bank behavior to that of hedge funds. However, central bank managers have a variety of objectives, typically of a longer term horizon.

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Acknowledgments

This paper is based upon a note written for the International Growth Centre (IGC), India Central Programme. I thank Yin-Wong Cheung, Barry Eichengreen, Charles Engel, Jeff Frankel, Hiro Ito, Eswar Prasad and George Tavlas for very helpful comments, and Dylan Blake for assistance collecting data.

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Authors and Affiliations

  1. Robert M. La Follette School of Public Affairs; and Department of Economics, University of Wisconsin, 1180 Observatory Drive, Madison, WI, 53706, USA

    Menzie D. Chinn

  2. NBER, Cambridge, MA, USA

    Menzie D. Chinn

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Correspondence to Menzie D. Chinn.

Appendix 1

Appendix 1

1.1 Data Description and Sources for Table 2

Table 2 Panel regression for determination of currency shares
Full size table

Share is the proportion of currency holdings. GDPratio is the share of world GDP (evaluated at market exchange rates); Inflationdiff is the difference between a 5 year moving average of CPI inflation and industrialized country inflation; Depreciation is the 20 year average annual depreciation against the SDR; Exratevar is the trade weighted exchange rate volatility (monthly), measured as a 5 year moving average; Fxturnovertatio is daily turnover divided by total 5 center turnover.

  • Reserve currency holdings. Official reserve holdings of member central banks, at end of year. The data used is spliced version of Updated 2003 data obtained July 1, 2004 (for 1980 onward) to an unpublished data for 1965–2001. NA observations set to 0 except for the euro legacy currencies. Then, US dollar series is based on COFER data beginning at end-2004, while Euro series is based on COFER data beginning at end 1999. 70 % of unallocated reserves are categorized as dollar reserves, while 25 % are categorized as euro reserves. Note the 2007 entry is for 2007Q3. In logistic transformations, 0 entries set to 0.000001 (0.0001 %). Sources: IMF Annual Reports, Table I.2, IMF unpublished data, and Currency Composition of Official Foreign Exchange Reserves (COFER) data, September 30, 2014 version. http://www.imf.org/external/np/sta/cofer/eng/index.htm.

  • Ratio of GDP to total World GDP. Ratio of GDP in USD (converted at official exchange rates) to GDP of world aggregate. Sources: IMF, International Financial Statistics and IMF, World Economic Outlook.

  • Inflation. Calculated as log difference of monthly CPI, averaged. Five year moving average is centered. Source: IMF, International Financial Statistics; Euro area inflation for 1980–1998 is ECB data. Industrial country inflation from International Financial Statistics.

  • Exchange rate depreciation. Calculated as the 20 year log difference divided by 20 of the SDR exchange rate. Source: IMF, International Financial Statistics.

  • Exchange rate volatility. Calculated as the standard deviation of the log first difference of the SDR exchange rate. Source: IMF, International Financial Statistics.

  • Forex Turnover. 1989, 1992, 1995, 1998, 2001, 2004, and 2007 from BIS TriannualTriennial Surveys. Billions of dollars of daily turnover, in April. Data from 1977 to 88 from G-30, NY Fed surveys, central bank surveys. Observations in-between survey years log-linearly interpolated. For 1973–1979, interpolation using 1977–79 relationship.

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Chinn, M.D. Emerging Market Economies and the Next Reserve Currencies. Open Econ Rev 26, 155–174 (2015). https://doi.org/10.1007/s11079-014-9336-6

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