Determinants of Currency Composition of Reserves: a Portfolio Theory Approach with an Application to RMB
IMF Working Papers, March 8, 2019
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- Determinants of Currency Composition of Reserves: a Portfolio Theory Approach with an Application to RMB
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Bibliographic details
- Authors: Miss Yinqiu Lu, Yilin Wang
- Published: March 8, 2019
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781498302562.001
Overview
- Authors: Yinqiu Lu, Yilin Wang
- Publication date: March 8, 2019
- Document type: IMF Working Paper
- Central premise: Central banks increasingly manage foreign reserves in two or more tranches—liquidity tranche and investment tranche—and a reserve portfolio choice model that incorporates tranching can analyze determinants of currency composition of reserves.
Methodology
- Investment tranche modeled with the classical mean-variance framework.
- Liquidity tranche modeled with an asset-liability framework.
- Structural model integrates roles of:
- Currency compositions in imports invoicing.
- Short-term external debt.
- Risk and returns of reserve currencies.
- Contribution: Provides a structural model to quantify the determinants of currency shares in reserves, addressing an absence of structural models in the literature.
Key findings and analytical insights
- Reserve tranching is a major trend in central bank reserve management, especially for those with adequate reserves.
- The structural model quantifies how:
- Imports invoicing in different currencies affects currency holdings.
- Short-term external debt currency composition affects liquidity needs and reserve currency choice.
- Risk and returns of candidate reserve currencies influence the investment-tranche allocation under mean-variance optimization.
- The paper estimates potential paths for the share of RMB in global reserves under alternative scenarios to assess its international currency status.
Application to RMB — scenarios and projections
- The paper estimates potential paths of the share of RMB in reserves under different scenarios (scenarios not enumerated on this page).
- Purpose of scenarios: to shed light on RMB's status as an international currency.
Policy implications and relevance
- Reserve managers should consider tranching (liquidity vs. investment) when choosing currency composition.
- Currency composition decisions depend on both liability-side considerations (imports invoicing, short-term external debt) and asset-side tradeoffs (risk-return characteristics).
- Structural, portfolio-theory–based approaches can inform reserve currency allocation and projections of emerging reserve currencies such as the RMB.
Content in this bundle
- Working Paper