Even the enemies of the US hold dollar reserves

Every once in a while, the demise of the US dollar as the world’s reserve currency is announced in the media. I have written about the premature reports of the death of the US Dollar as an international trading currency before, but now there is a different take by some doomsters that claims that central banks are systematically reducing their reserve currency exposure to the Dollar.

Menzie Chinn, Jeffrey Frankel, and Hiro Ito have put this thesis to the test and – as you might have guessed – find little evidence that central banks are actively divesting from the US Dollar.

On the face of it, it does indeed look like the dollar as a reserve currency is on a structural decline. Over the last 25 years, the Dollar share of global central bank reserve holdings has declined from 71% to 59%. Meanwhile, allocations to Euro and Japanese Yen have remained largely the same at 20% and 6%, respectively.

Global central bank reserve currency allocation

Source: IMF

So, where did the money move to? I can hear you say ‘Chinese Renminbi’ as I write this and that is true to some extent, global reserve allocation to the Renminbi has increased from zero to a whopping 2.1%! Not what I would call a barnstorming ascent. Indeed, allocations to Pound Sterling have risen by the same share (from 2.7% to 4.8%). Other beneficiaries have been the Australian and Canadian Dollar and a bunch of emerging market currencies as emerging market central banks managed to accumulate more reserves.

In their study, Chinn et al. tested a whole battery of factors that could drive the change in currency allocation and crucially, they found no evidence that international sanctions or other geopolitical variables had any significant influence on currency holdings. The only geopolitical factor that had a small influence was voting behaviour in the UN, but only for the euro and Sterling, not for the US Dollar. Countries that are politically more closely aligned with the UK and the Eurozone countries tend to hold more of their currencies.

The true drivers of currency holdings today are the same as they always were: trade relationships and the need for the US Dollar as the global safe haven currency. The more trade a country has with the UK, the Eurozone, or the US, the more Sterling, Euro, and Dollars the central bank will hold. Hence, countries with larger GDP tend to occupy a larger share of the reserve portfolio.

This effect is however mediated by the size of the capital market and any capital flow restrictions that may exist. This is why the Renminbi has not captured a lot of the global reserve portfolio. The local financial market is simply too illiquid and capital flow restrictions make it impossible for foreign central banks to hold any meaningful quantities of Renminbi.

Even if China fully liberates its financial market tomorrow (which would have disastrous consequences for the Chinese economy as much of the money invested locally would immediately flee the country) central banks are a conservative bunch. They would only gradually and slowly build more Renminbi positions. This is why I constantly remind people that they shouldn’t worry about the decline of the US Dollar in the next 20 to 30 years. We all probably will be retired before that even becomes a remote possibility and it may very well not happen in our lifetime.