New international reserve currency

Abstract

There has been a remarkable accumulation of foreign exchange reserves in recent years by a number of emerging & developed countries. The introduction of the Euro, enhanced liquidity in other major currencies, and the rising current account and fiscal deficits of the United States have increased the pressure on central banks to diversify away from the US dollar. There is concern that portfolio shifts from Dollar-denominated assets to those denominated in the Euro and other main currencies by Central Banks, in particular, could result in sharp dollar depreciation. A major portfolio shift would significantly affect exchange rates and the status of the dollar as the dominant international currency. Currently, around two-thirds of global central bank foreign exchange reserves are in the form of USD denominated assets. Many argue that central banks face an increasing “concentration risk” and should thus diversify away from the dollar to other currencies. Others, however, argue that diversification away from the dollar is unlikely and if anything will be moderate and slow. They contend that most central banks with large reserve holdings, especially those in East Asia, collaborate with their governments in pursuing an export-led growth strategy targeting mainly the US market, so will maintain exchange-rate stability relative to the dollar. With the increasing importance of emerging nations (China, India and Brazil) in the international financial system and huge amount of dollar denominated reserves accumulated by these countries, it is imperative to study the dynamics and factors influencing the currency composition of foreign exchange reserves, especially in light of current economic scenario.