Optimal Reserve Composition in the Presence of Sudden Stops: The Euro and the Dollar as Safe Haven Currencies

48 Pages Posted: 11 Aug 2008 Last revised: 18 Aug 2008

See all articles by Roland Beck

Roland Beck

European Central Bank (ECB)

Ebrahim Rahbari

London Business School - Department of Economics

Date Written: July 10, 2008

Abstract

We analytically derive optimal central bank portfolios in a minimum variance framework with two assets and "transaction demands" caused by sudden stops in capital inflows. In this model, the transaction demands become less important relative to traditional portfolio objectives as debt to reserve ratios decrease. We empirically estimate optimal dollar and euro shares for 24 emerging market countries and find that optimal reserve portfolios are dominated by anchor currencies and, at current debt to reserve ratios, introducing transactions demand has a elatively modest effect. We also find that euro and dollar bonds act as "safe haven currencies" during sudden stops. Dollars are better hedges for global sudden stops and for regional sudden stops in Asia and Latin America, while the euro is a better hedge for sudden stops in Emerging Europe. We reproduce qualitatively the recent decline in the share of the dollar in emerging market reserves and find that the denomination of foreign currency debt has very little importance for optimal reserve portfolios.

Keywords: Foreign exchange reserves, currency composition, sudden stops

JEL Classification: F31, F32, F33, G11

Suggested Citation

Beck, Roland and Rahbari, Ebrahim, Optimal Reserve Composition in the Presence of Sudden Stops: The Euro and the Dollar as Safe Haven Currencies (July 10, 2008). ECB Working Paper No. 916, Available at SSRN: https://ssrn.com/abstract=1157770

Roland Beck (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Ebrahim Rahbari

London Business School - Department of Economics ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

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