# The rise of non-SDR currency reserves

New Cofer data release may show an overall fall in FX reserves, writes Gary Smith

The International Monetary Fund’s currency composition of official foreign exchange reserve (Cofer) data for the third quarter will be released at the end of this month. There is an expectation it will reveal a further substantial decline in the value of global foreign exchange reserve assets.

The run-down of holdings associated with FX interventions will form part of the explanation, but negative currency valuation effects (as non-dollar holdings are converted to a US dollar value) and weaker asset prices will also subtract from the total reserves number. Behind the headline figure, it will be interesting to learn how currency shares continue to evolve, and if the use of smaller currencies has continued to grow despite the dollar valuation effects.

### A truly historic year

In 2022, the FX reserves of Russia were placed under a freeze order – something that has never occurred to the central bank assets of a major sovereign nation outside of declarations of war. The concept of a ‘weaponised’ US dollar is nothing new. It was also discussed by FX reserves managers when European banks were fined in 2015 for extraterritorial breaches of US sanctions that were backdated many years. However, the move this year was accompanied by a newly weaponised euro, sterling, yen and Canadian dollar. Welcome to a broader era of ‘weaponised finance’!

### Dollar weight may decline

The dollar weight in FX reserves has fallen from 71% at the turn of the century to a 59% share today. The expectation is that the gradual decline in the importance of the dollar in the global FX reserves data will continue in coming years. But the weaponisation of the dollar will probably not be the key driver. More influential will be the lagged consequences of the smaller role that the US economy has on the world stage (which now stands at around 25% of global GDP, although this share is higher if one includes economies with a peg to the dollar).

Network effects and the power of incumbency have slowed the speed of the US dollar’s decline and will continue to provide a parachute effect. However, a further move towards a 50% share over the next decade for the US dollar is possible.

### Which currencies will grow?

The long-term decline in the share of the US dollar is not a result of a move by a small number of very large reserve holders with a preference for non-dollar currencies. It appears that the change reflects portfolio diversification decisions by a wide range of central banks.

IMF data highlights the shift away from the dollar in recent years has mostly mirrored an increase in holdings of non-traditional reserve currencies. In the past, these non-traditional currencies were considered to have insufficient scale and liquidity to qualify as candidates for international reserves. Yet this shift into new and smaller reserve currencies has been substantial and broad based. A study published earlier this year identified 46 countries with a share of official reserves in non-traditional currencies of at least 5%.

The Australian and Canadian dollars have led this surge, and both currencies have continued to grow. They are not far behind the Chinese renminbi in terms of global reserve currency share. Other currencies to have grown include the Swedish, Norwegian and Danish currencies, the Singapore dollar, Korean won and New Zealand dollar. Sterling appears to have survived the Brexit vote and has also grown in importance in a modest way. The Swiss franc maintains a small but stable presence.

Historically, the international dominance of the dollar (and to a lesser extent the euro, sterling and yen) was supported by the fact that smaller currencies could not be traded directly with each other – ie, other currency pairs often had to use the dollar as an intermediary currency requiring the investor to pay an additional transaction cost.

Direct markets in a larger number of currency pairs are now established and bid/ask spreads on FX transactions in smaller currencies have narrowed. A good example is the south Korean won versus the Australian dollar. The two nations have a growing trade relationship. Reflecting these stronger ties, they first announced a bilateral currency swap agreement in 2014, an agreement that was extended and expanded in recent months. Completing the virtuous circle of engagement, the Reserve Bank of Australia announced in 2016 that it formally would add won to its FX reserves, and media reports suggest the Korean central bank has held Aussie dollars for over a decade.

In the last 10 years, the won and the Aussie dollar have both offered attractive yields compared to similar dollar assets, in common with many other non-traditional currencies. Higher yields may have an impact at two levels. Firstly, they may encourage an asset allocation shift. Secondly, if interest income is higher in non-traditional currencies, and is reinvested in assets of the same currency, the weight of that currency will grow. Thus, the fall in the share of the traditional reserve currencies has been nudged by interest rate and bond yield differentials in favour of non-traditional currencies.

### Is the renminbi a challenger?

The modest pace of development in domestic Chinese capital markets, the continued use of capital controls, and the deterioration in the political relationship between China and the US have all been blamed for slowing the wider use of the renminbi as a reserve currency.

Ironically, the sanctions placed on Russia may trigger a pivot in perceptions about which currencies are safe havens. The renminbi may have benefitted from an anti-dollar vote in recent years, but the sanctions placed on Russia may also prompt careful consideration of what a further deterioration in China/US relations might entail for the holders of renminbi assets.

### Diversification amid growth

Before the decline in reserves in 2022, there had been a multi-decade period of growth in FX reserves. Unsurprisingly, this growth led to a reassessment of the appropriate asset allocation. A key development has been a distinction between the liquidity tranche and the investment tranche, and a recognition that as reserves grew, the investment tranche was getting bigger at a quicker rate.

Many central banks have adopted the view that the investment tranche can be invested more flexibly both in terms of asset class and in terms of currency, because it is less likely to be required to be liquidated at short notice. The well-chronicled diversification into equities and non-traditional currencies are two similar sides of the same coin.

### Demand for more reserve currencies

Nations that issue most non-traditional currencies outside of the special drawing right all enjoy a degree of political alignment with the US. When this shift into smaller currencies began two decades ago, this was not a reason for the flow. However, in the current challenging political environment, this might help to encourage additional flows.

Although the decline in global FX reserves in 2022 might slow diversification trades, the shrinkage has been modest in the context of growth over the previous 20 years. If there is a correction in the value of the dollar in 2023, one could expect quick growth in the share of FX reserves, not least as valuation effects reverse. The trend towards a multi-polar, international monetary system remains in place. The world clearly has a latent demand for more reserve currencies.

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