Towards greater diversification in central bank reserves
This article compares the performance of various diversification strategies regarding foreign exchange reserves. The aim is to provide central banks with guidelines in portfolio allocation. We pay particular attention to the situation of upward pressures on US interest rates by implementing our analysis over both the whole 1986–2015 period and a rising rate subsample. Relying on geometric tests of mean-variance efficiency, we show that introducing currencies weakly correlated to the USD (AUD and CAD) significantly reduces portfolio risk. Expected return is improved through mortgage-backed securities, corporate bonds and equities.
Keywordsforeign exchange reserves diversification asset allocation
- Banco Centrale de Chile (2012) Management of Foreign Exchange Reserves at the Central Bank of Chile, http://www.bcentral.cl/eng/financial-operations/pdf/reservemanagement2012.pdf, accessed 3 March 2014.
- Bernadell, C., Cardon, P., Coche, J., Diebold, F.X. and Manganelli, S. (2004) Risk Management for Central Bank Foreign Reserves, Frankfurt: European Central Bank.Google Scholar
- Borio, C., Ebbesen, J., Galati, G. and Health, A. (2008a) FX Reserve Management: Elements of a Framework. Basel: Bank for International Settlements. BIS Papers no. 38.Google Scholar
- Borio, C., Galati, G. and Health, A. (2008b) FX Reserve Management: Trends and Challenges. Basel: Bank for International Settlements. BIS Papers no. 40.Google Scholar
- Brière, M., Drut, B., Mignon, V., Oosterlinck, K. and Szafarz, A. (2013) Is the market portfolio efficient? A new test of mean variance efficiency when all assets are risky. Finance 34 (1): 7–41.Google Scholar
- Cova, P., Pagano, P. and Pisani, M. (2015) Foreign exchange reserve diversification and the ‘exorbitant privilege’: Global macroeconomic effects. Journal of International Money and Finance, available online 25 June 2015, http://dx.doi.org/10.1016/j.jimonfin.2015.06.012.
- Eichengreen, B. (2011) Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System, Oxford: Oxford University Press.Google Scholar
- Eichengreen, B. and Flandreau, M. (2014) A Century and a Half of Central Banks, International Reserves and International Currencies. Norges Bank Conference “Of the uses of Central Banks: Lessons from history”, June 5–6, 2014, Oslo, Norway.Google Scholar
- Goldberg, L.S., Hull, C. and Stein, S.K. (2013) Do industrialized countries hold the right foreign exchange reserves? Current Issues in Economics and Finance 19 (1): 1–10.Google Scholar
- Jones, C. (2014) Central banks set to cut debt holdings. Financial Times 23 June.Google Scholar
- Jorion, P. (2007) Value at Risk: The New Benchmark for Managing Financial Risk. 3rd edn. New York: McGraw-Hill.Google Scholar
- Levy, H. and Markowitz, H.M. (1979) Approximating expected utility by a function of mean and variance. American Economic Review 69 (3): 308–317.Google Scholar
- McCauley, R.N. and Fung, B.S. (2003) Choosing instruments in managing dollar foreign exchange reserves. BIS Quarterly Review (March): 39–69.Google Scholar
- McCauley, R.N. and Rigaudy, J.-F. (2011) Managing Foreign Exchange Reserves in the Crisis and After. Basel: Bank for International Settlements. BIS Papers no. 58.Google Scholar
- Medeiros, C. and Nocera, S. (1988) The Potential Role of the SDR in Diversified Currency Portfolios of Central Banks. Washington: International Monetary Fund. IMF Working Paper 88/81.Google Scholar
- Morahan, A. and Mulder, C. (2013) Survey of Reserve Managers: Lessons from the Crisis. Washington: International Monetary Fund. IMF Working Paper 13/99.Google Scholar
- Pan, L. and Junbo, Z. (2008) The Management of China’s Huge Foreign Reserve and its Currency Composition. Berlin: Institute of Management Berlin at the Berlin School of Economics (FHW Berlin), Working Paper no.37.Google Scholar
- Plender, J. (2014) Follow the Swiss for reserve management Success. Financial Times 9 December.Google Scholar
- Ramaswamy, S. (2008) Managing international reserves: How does diversification affect financial costs. BIS Quarterly Review (June): 45–55.Google Scholar
- Wei, L. and Cui, C. (2013) China is seeking US assets. Wall Street Journal 20 May.Google Scholar
- Wooldridge, P.D. (2006) The changing composition of official reserves. BIS Quarterly Review (September): 25–38.Google Scholar