Foreign Dollar Reserves and Financial Stability

Countries have accumulated massive foreign reserve portfolios, but the reasons for doing so remain debated. I document a new empirical fact on the compositions of foreign reserve portfolios, and argue that the prevalence of the dollar supports an explanation in which foreign reserves hedge liquidity shocks to dollarized financial systems. First, I fit a Bayesian dynamic linear model to extract currency shares for the foreign reserves of seventy-seven developed and emerging countries, and show that foreign reserves are poorly-diversified and overwhelmingly consist of dollar assets. Second, I show that the dollar shares of foreign reserves are explained by the dollarization of their financial systems’ liabilities across countries, particularly for countries that cannot easily borrow dollars from the Federal Reserve directly. Third, I build a model in which central banks build up dollar reserves to mitigate liquidity shocks for financial systems with currency mismatches, particularly in the presence of foreign exchange transaction costs.