who should be on a diversification watch? India is on my watch (already diversified, but might want to do more), as is Russia (same issue) and Korea …

I think SAMA should diversify, but i haven’t heard rumors …

PBoC is stuck it seems to me — as it effectively has a currency that is managed v the $ with a slow rate of crawl (it isn’t technically a peg, but it doesn’t move like a true basket peg currency either)

I see what you mean. Basically, if a country pegs to a particular currency, I think it cannot diversify without accumulating more reserves than it needs to maintain the peg only. Right?

This is something that Brad could mention. As I have said before, I do not think that China’s foreign exchange investment corporation means that they will be diversifying out of the dollar; in fact, it makes the existing currency peg more sustainable. What it does mean is that they will diversify into different instruments, including equities, property etc.

Suppose country A pegs to the dollar, but wants to diversify its growing dollar reserves.

Diversification (selling $ against Euro, £, Yen) increases the dollars circulating, hence the downward pressure of the dollar exrate against all currencies, including country A currency. This obliges country A to more intervention hence to more sterilisation.

I am puzzled by your constraint 1 on large reserves. Sterilisation attempts to absorb the additional domestic liquidity created by selling domestic currency. What currency you buy as you intervene, or later to diversify, is almost irrelevant, isn’t it? I would be interested if you would expand your argument.

because

WHEN RESERVES ARE NOT LARGE, they serve the purpose of CB intervention so must be kept in both US$ and in the currency of intervention, and must be invested in liquid asssets.
The crucial topic here is:

2) are EU short term bonds as deep and liquid as US, or national segmentation limits their liquidity? Yen etc.

WHEN RESERVES BECOME “LARGE”… -

3) What is “large”?

When reserves get “large”… CBs can think of diversifying, but what are the constraints to diversification?

4) CONSTRAINT1 Relationship between diversification and sterilization (div. makes ster. difficult)

but not CONSTRAINT2 “avoid div to keep the overall US$ value high”, no CB does that and since you tent to use this argument I would be careful to present some evidence or I would not use it. (“CBs in the world are many, each is smll and they don’t coordinate” is the conventional wisdom, burden of proof on you)

CRITERIA FOR CHOOSING THE CURRENCIES IN WHICH TO DIVERSIFY:

risk and reward.

Reward:
5) can CB beat mkts? I would focus on: “do CBs have some infOrmation advantage over mkts?”, try to adjourn and renew this old theme.

But “more important for a CB must be managing risk”.

6) Define risk as not just the CB balance sheet but the risk of the whole country’s Balance of Payments from external shocks.

The Currency denomination of foreign debts and assets matters. + interest rate risk + commodity prices risk + [expo & impo currency denomination AND price pass-through].

The correct diversification is the one seeking a portfolio that offsets as much as possible external shocks. For ex. if you have many US$ debts you should have Res in $ etc. The difficult problem is how stable are correlations of prices of G&S with exrates…

So CBs should use modern portfolio theory but in a higly competent and original way.

Should hire Gheorghius.

Also, the letter about Japan you describe seems to bolster my case: More retirees, a smaller workforce, and large government debts could be countered with more welcoming migration policies. We can dream, no?

—
Everyone–here’s a fine, detailed article on the political dilemmas caused by a strong Euro that I found at Mark Thoma’s blog: New Euro Record Prompts Quiet Grumbles.