Abstract:
The foreign exchange reserves serve a pivotal role in a country’s economy for various
reasons. The Central Bank of a country is the major custodian of these reserves. The
monetary value of such reserves will naturally be higher if the currency in which they
are held is appreciating or is at least stable. However, if the reserve currency begins to
show a depreciating trend over a longer period of time, it points out a reason for
concern for that country. The dollar is the major reserve currency throughout the world
till now. A significant proportion of the world reserves are denominated in dollars.
However, due to a consistent downturn in the value of the greenback (dollar) since
quite a few years, one can sense signs of diversification of reserves away from the
dollar and towards more stable and appreciating currencies like the Euro and the
Japanese Yen. Few have even suggested an increase in gold holdings for this purpose.
Thus we see a gradual shift from a paradigm of single currency reserve model to a
multi currency model. This trend is again gaining ground and major reserve holding
countries of the world like China, Korea and other east Asian countries are either
contemplating such moves or have already gone through a diversification. To decide
whether such a diversification will be sustainable this time around and whether it
would benefit these and other reserve holders, is a question that requires an insight into
the dynamics of international trade.
This paper attempts to take a look at the history of dollar’s evolution as a reserve
currency, the need for and implications of a reserve diversification out of dollars into
other currencies, the euro as a potential future reserve currency, and relate to
examples of state banks which have took significant steps in this regard. Finally, it
presents the rationale for the State Bank of Pakistan to diversify its reserves into a
basket of currencies and a model to invest its excess reserves.
