Foreign Reserve Diversification: Should Pakistan Diversify into Euros?

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.