External debt currency denomination and the currency composition of foreign exchange reserves

Abstract

This study examines how the foreign currency denomination of external debt influences the currency composition of foreign exchange reserves (FXR). We follow the Gopinath and Stein (2018) framework to construct a theoretical model in which central banks consider the buffer-stock role of FXR when managing their currency composition of FXR. The model predicts that countries depending more on dollar-denominated debt tend to hold more dollar FXR, especially those with less macroprudential policies. We verify the theoretical results by using country-level data on the currency composition of FXR in 51 countries from 1999 to 2019. Importantly, we leverage an exogenous shock - the central bank swap lines established during the 2008 global financial crisis - to isolate and quantify the effect of dollar-denominated external debt on dollar FXR. Empirical evidences also suggest that the dollar FXR share is less responsive to the dollar-denominated debt share in the presence of macroprudential policies.

Keywords: Currency composition; foreign exchange reserves; debt currency denomination

JEL Classification: F3; F34; F36