External Debt Currency Denomination and the Currency Composition of Foreign Exchange Reserves

This paper studies the effects of external debt currency denomination on the currency composition of foreign exchange reserves (FXR). We 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 when macroprudential policies are less strict. Supportive empirical evidence is obtained by analyzing the country-level data of FXR currency composition 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. Finally, we find that the dollar FXR share is less responsive to the dollar-denominated debt share in the presence of macroprudential policies