The dollar, the euro, and Euro Area bond portfolios
Kristy A.E. Jansen, Hyun Song Shin, and Goetz von Peter, in this paper, explore how exchange rates influence the asset allocation decisions of bond portfolio investors based in the euro area. The authors use a Value-at-Risk (VaR) portfolio choice model which incorporates the roles of local, foreign, and reference currencies, enabling the assessment of how currency mismatches influence investment decisions. The data used are from the Securities Holdings Statistics by Sector provided by the Eurosystem, which records security-level holdings for each country and sector in the euro area. The dataset spans from the fourth quarter of 2013 to the fourth quarter of 2021. Their main findings are:
- Role of the Dollar and Euro: The study confirms that the US dollar acts as a global risk factor, influencing euro area investors to reduce their holdings of sovereign bonds when the dollar strengthens. This effect is seen across all types of bonds, indicating tighter global financial conditions. Conversely, when the euro strengthens, investors tend to sell local currency bonds due to valuation losses in terms of their reference currency.
- Currency Mismatch: The paper highlights the significance of currency mismatches on investors’ balance sheets. Euro area investors are more likely to sell local currency bonds of sovereigns whose currencies depreciate against the euro. This reaction is attributed to the currency mismatch they face, as their returns are evaluated in euros.
- Distinct Exchange Rate Effects: The analysis shows that different exchange rates affect portfolio allocation at various levels. A rise in the broad dollar index leads to a broad sell-off, while a rise in the broad euro index triggers a sell-off of local currency bonds. Investors also sell more local currency bonds of individual sovereigns that depreciate against the euro.
- Hedging Practices: The study finds that institutional investors, such as Dutch pension funds, hedge a small fraction of their currency exposures outside major currencies, which contributes to the observed currency mismatch effects.
Which Exchange Rate Matters to Global Investors?
Authors: Kristy A.E. Jansen, Hyun Song Shin, Goetz von Peter
From: University of Southern California, BIS
The dollar, the yuan, and global trade fragmentation
In this paper, Ryan Chahrour and Rosen Valchev explore the potential impact of emerging global trade patterns on the dominance of the US dollar in international trade. The model is based on the framework by Chahrour and Valchev (2021) and includes the following key components: a) households which allocate their income from domestic endowments among goods from four regions and bonds issued by the US and China; b) trading firms which choose the currency for trade financing, influenced by the availability of currency-specific assets; c) governments which issue bonds in fixed supply and set taxes to maintain constant debt levels.
Chahrour and Valchev analyze different scenarios:
- Unilateral Tariffs: US tariffs on Chinese imports might increase dollar usage slightly, but reciprocal tariffs by China would negate this effect.
- Bloc Coordination: Coordinated protectionist policies within trading blocs could lead to a bifurcated equilibrium where each bloc uses a different dominant currency.
- Direct Support for Yuan: If China provides substantial support for the yuan’s use in trade, a transition to a yuan-dominant equilibrium is possible.
They conclude that the current dollar-dominant status quo could withstand significant trade retrenchment and fragmentation. However, if any of the above scenarios were to materialize they could lead to substantial changes in currency roles.
The Dollar in an Era of International Retrenchment
Authors: Ryan Chahrour, Rosen Valchev
From: Cornell University, Boston College
