The Composition of International Reserves

Abstract

This dissertation analyzes the composition of central bank reserves using a combination of financial econometrics, forensic techniques, and economic theory. Chapter 1 shows that central banks may shift their international reserve holdings by accumulating gold in order to protect themselves ex-ante against the risk of financial sanctions by fiat reserve currency issuers. I explore the potential for Bitcoin to serve as an alternative hedging asset. I describe a dynamic Bayesian copula model to simulate the joint returns of Bitcoin and other reserve assets under a wide range of plausible sanctions probabilities, quantifying the extent to which varying levels of sanctions risk increases optimal gold and Bitcoin allocations. I conclude that sanctions risk may diminish the appeal of US Treasuries, propel broader diversification in central bank reserves, and bolster the long-run fundamental value of both cryptocurrency and gold. Chapter 2 proposes an econometric technique to impute missing data. Some of the largest holders of reserves report minimal information about their currency composition, hindering empirical analysis. I describe a Hidden Markov Model to estimate the composition of a central bank's reserves by relating the fluctuation in the portfolio's valuation to the exchange rates of major reserve currencies. I apply the model to China and Singapore, two countries that collectively hold about $3.4 trillion in reserves and conceal their composition. I find that both China's reserve composition likely resembles the global average, while Singapore probably holds fewer US dollars. Finally, Chapter 3 describes a theoretical model of central bank reserve holdings in which US sanctions can benefit pro-US countries by facilitating a separating equilibrium. If foreign investors are uncertain about the future behavior of political leaders, and the risk of US sanctions is correlated with policy decisions that result in poor outcomes for investors, then the central bank’s reserve currency composition can convey a credible signal of the country’s commitment to prudent economic policymaking. In this setting, US sanctions can act as a public good by facilitating a more efficient allocation of capital across countries.