FRBSF Economic Letter
2005-17; July 29, 2005
What If Foreign Governments Diversified Their Reserves?
Pacific Basin Notes. This series appears
on an occasional basis. It is prepared under the auspices of
the Center for Pacific
Basin Studies within the FRBSF's Economic Research Department.
World financial markets paid close
attention when officials from both South Korea and Japan
said that their governments
were considering diversifying their holdings of foreign
reserves (Dougherty 2005 and Koizumi 2005). Many analysts
thought these announcements were partly in response to
the past depreciation of the dollar; if true, then it seemed
likely that those two governments would sell some of their
dollar-denominated assets, putting further downward pressure
on the dollar.
Since then, officials in both countries
have insisted that they were not considering any major
changes to the policy
of reserve holdings. Nonetheless, the potential for a
sell-off of dollar-denominated assets by foreign governments
has
raised some questions about the consequences of such
a move. This Economic Letter attempts to put these issues
into perspective. It begins with a review of recent trends
in the holdings of such assets by foreign governments
and
a description of how these governments use them. Then
it explores some of the risks the U.S. economy might face
if foreign governments sold off large quantities of their
dollar-denominated reserves. It concludes with a discussion
of some of the costs such a sell-off would pose to foreign
countries themselves.
Recent trends in holdings of foreign
exchange reserves and how they are used
 Foreign exchange
reserves are holdings of foreign-denominated securities
by foreign governments. One of the major
uses of foreign exchange reserves is to intervene in
the foreign
exchange market in order to influence the value of
the domestic currency and to serve as collateral for
foreign
borrowing. Suppose, for example, that a country wants
to see the value of its currency depreciate, so that
the cost
of its exports will be relatively lower and therefore
more attractive to foreign buyers. The government
would then
buy foreign-denominated securities and pay for them
with domestic currency, thus leading the domestic currency
to depreciate. Governments may also intervene in
the foreign
exchange market to keep the local currency stable
relative to another currency in order to reduce the risk
of
exchange
rate fluctuations. By reducing exchange rate risk,
foreign governments may promote greater foreign trade
and financial
flows. A more dramatic use of foreign reserves may
occur when the domestic currency is under a speculative "attack." Reserves
can be used as a "war chest" to defend
the local currency and, by extension, the domestic
financial
systems,
in case of future runs on their currency. Following
the 1997-1998 Asian financial crises, many East Asian
governments
moved to accumulate large amounts of reserves to
serve as collateral for their domestic financial
systems
and prevent future currency crises (Figure 1). At
the end of
2004, South Korea held over $200 billion in reserves,
more than twice the level it held in 2000.
Total
worldwide foreign reserves holdings reached $3 trillion
at the end of 2004, up from $2.4 trillion
in 2003, with
the largest holders being Japan, at $834 billion,
and
China, at $615 billion. Most foreign exchange reserves
are held
in the form of dollar-denominated securities; one
reason for this is that foreign governments like
the highly
liquid market for U.S. Treasury securities. As of
December 2003,
dollar-denominated securities accounted for roughly
70% of total reserves, while euro-denominated reserves
accounted
for about 20% (BIS 2004). At the end of 2004, foreign
governments held $1.2 trillion of U.S. Treasury securities,
almost
double the $609 billion held in 2000.
 Governments
keep the composition of their reserves a well-guarded
secret. Therefore, there are no data
on
the amount of dollars
that individual foreign governments hold in their
reserves. However, the U.S. Treasury does have
estimates of total
holdings—that is, official plus private—by country.
According to those estimates, at the end of 2004,
Japan held $712
billion, China $193 billion, and South Korea $69
billion (Figure 2). Most of these securities are
believed to
be held by the central bank of each country.
Effects
of a sale of dollar-denominated reserves on the U.S.
economy
The sale of dollar-denominated reserves could have
negative effects along several dimensions of
the U.S. economy.
First, it would tend to depress the value of
the dollar vis-à-vis
other currencies. A depreciation of the dollar
in turn would tend to raise import prices, which could
feed through
to higher consumer price inflation. Since 2002,
the dollar has depreciated by 25.7%, and import prices
have increased
by 6.6%. If the sale of dollar-denominated reserves
took the form of a sale of U.S. Treasury securities,
then the
price of these securities would decrease, causing
an increase in interest rates, which may also be harmful
to the economy.
Furthermore, U.S. consumers have benefited
from cheap imports from abroad, and many U.S. producers
depend
on imported
raw materials and intermediate inputs for their
production plans. Thus, both consumers and
producers would be
hurt by an increase in the price of intermediate
inputs. Exporters,
however, would benefit from a dollar depreciation,
as it would make their goods cheaper in terms
of other currencies.
A depreciation of the
dollar would eventually lead to an improvement in the
current account
deficit—which
reached
a record 6.3% of GDP in the fourth quarter
of 2004—through its negative impact on imports
and positive impact
on
exports. An improvement in the current account
would reduce the
amount of additional external borrowing needed
to finance this deficit. However, a rapid
reversal of
the current
account may be disruptive to the U.S. economy,
as either investment or consumption, or both,
would need to contract
to close the current account gap (for the
argument, see Setser and Roubini 2005).
Diversifying reserves
without selling dollar-denominated assets
One source of
information on whether there are any instances of diversifying
reserves
without
selling
dollar-denominated
assets comes from the Bank for International
Settlements (BIS). The BIS (2005) reports
data on the currency
composition of deposits of BIS-reporting
banks. These deposits include
some foreign exchange reserves held outside
the home country.
Figure 3 shows that
banks in South Korea, Taiwan, and particularly China,
have increased the
amount of dollar
deposits they
hold, including holdings of reserves
between 2000 and 2004. This is consistent
with
the data presented
previously
on
the increase of reserves by foreign
central banks and the predominance of the dollar
as a currency
of reserve.
Figure
4 shows that while the fraction of
dollar-denominated deposits in South Korea and Taiwan has
remained mostly stable between
2000 and 2004, China has slowly diversified
its holdings away from the dollar during
this period.
The fact
that China increased its total holdings
indicates that a
diversification away from the dollar
does not necessarily imply that
central banks will sell their dollar-denominated
assets. Foreign
governments may be able to achieve
diversification
by purchasing larger amounts of securities
denominated in
other currencies
in the future instead of by selling
current holdings of dollar-denominated assets.
For example, it
is possible that the euro will grow
in importance as an international
reserve currency as the European Central
Bank cements
its
low-inflation performance and as the
euro financial market develops.
A sale
of dollar-denominated reserves may
be costly to foreign economies
In many
Asian countries, economic growth has been led by the
export sector,
which would
be hurt by
an appreciation
of the local currency vis-à-vis
the dollar. In fact, the economies
of Japan and South Korea would grow
more
slowly were it not for their dynamic
export sectors. Thus, a significant
move away from dollar-denominated
reserves would entail significant
costs to foreign
economies.
A sale of dollar-denominated
assets that leads to a large depreciation
of the
dollar would
generate large
capital
losses for foreign governments, as
the value of their
assets would drop with respect to
their domestic currency. On
the other hand, since the United
States borrows internationally mostly
in terms
of dollars
and since most of its
foreign assets are denominated in
foreign currencies, it would
receive most of the capital gains,
as the value of its liabilities would
drop
relative
to the
value of its assets.
Tille (2005) estimates that a 10%
depreciation of
the dollar leads to a valuation loss
for foreign economies
equivalent
to about 4% of U.S. GDP.
Conclusions
This Economic Letter posed the question:
What if foreign central banks diversified
their
reserves? The answer
has several dimensions. A sale
of dollar-denominated reserves
would depress the value of the
dollar vis-à-vis
other currencies, thus raising
import prices for U.S. consumers and feeding into higher
consumer price inflation. If the
depreciation is sudden and leads
to a rapid reversal of the current account, it may
depress investment and consumption.
However, a sale of dollar-denominated
securities would also be costly to foreign economies.
Foreign governments
would be exposed to large capital
losses, and an appreciation of their currencies would
make their exports less competitive.
Finally, the case of China makes
it clear that if foreign governments want to diversify
their holdings of reserves,
they can do so not only by selling
dollar-denominated securities but also by buying into
securities denominated in other
currencies.
Diego Valderrama
Economist References
[URLs accessed July 2005.]
Bank for International Settlements.
2004. Annual
Report.
http://www.bis.org/publ/ar2004e.htm
Bank for International
Settlements. 2005. BIS Quarterly Review (March).
http://www.bis.org/publ/r_qt0503.htm
Dougherty,
Carter. 2005. "Dollar Plunges on Proposal
by Korea Bank to Diversify." New York Times (February
23, 2005) sec. C, p. 12, col. 5, national edition.
Koizumi, Junichiro. 2005. Remarks before Japanese Parliament,
March 10, 2005. Setser, Brad, and Nouriel Roubini. 2005. "How
Scary Is the Deficit?" Foreign Affairs. (July/August)
pp. 194-200.
Tille, Cédric. 2005. "Financial Integration
and the Wealth Effect of Exchange Rate Fluctuations." Mimeo.
FRB New York.
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do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
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