Central Bank Diversification Strategies: Rebalancing from the Dollar and Euro

by Ashish Bhatia, Natalie Dempster

Central banks have begun to reduce reserve portfolio allocations to US dollars and euros in favor of alternative reserve assets. A portfolio optimization analysis concludes that gold, with its lack of credit risk and deep and liquid market, is one of the most attractive alternatives in this diversification process.

Despite limited availability and convertibility of its currency, China’s rise in the global economy has forced central banks to seriously consider renminbi denominated assets. Meanwhile, in the World of deteriorating credit, countries like Canada, Australia and Switzerland, all with AAA credit ratings, stand out as potential reserve investment alternatives.

Against this backdrop, this paper examines the trend of diversification in reserve asset management away from the US dollar and euro in order to better understand how central banks should approach allocation decision at the margin.

Purely through portfolio optimization analysis of assets, renminbi, gold and Australian dollar assets emerge as the most important for diversification. However, given the limited size of Chinese and Australian sovereign debt markets, gold emerges as the dominant asset for diversification.

Accordingly, building gold reserves in tandem with new alternatives is an optimal strategy as these markets need time to develop and allocations to gold remain largely below optimal levels.

In 2010 central banks became net buyers of gold for the first time in 2 decades.  In 2012, the trend in fact accelerated, in part attributable to an active rebalancing of central bank portfolios away from dollars and euros.

Central Bank Diversification Strategies – Rebalancing from the Dollar and Euro