A question that has frustrated even the most experienced economists in the last few decades is how the dollar has remained the most prominent reserve currency in the world despite the global share of U.S. output eroding away.
The Bank for International Settlements (BIS), a Basel-based institution that is known as the central bank of central banks, thinks it has found the answer.
"We argue that the dollar's role may reflect instead the share of global output produced in countries with relatively stable dollar exchange rates – the 'dollar zone'," it said in its new quarterly report released on Sunday.
In 1978, economists Robert Heller and Malcolm Knight were credited as first to draw attention to the fact that countries held an average of 66 percent of their foreign-exchange reserves in dollars. Even today that number hasn't budged much with the latest statistics from the International Monetary Fund showing that just over 60 percent of allocated funds are held in the greenback.
The higher the correlation in price between a given currency and the dollar, the higher the economy's dollar share of that country's official reserves, according to Robert McCauley and Tracy Chan, the two authors of the BIS report. The report adds that the dollar's robustness comes despite an 18 percent decline against major currencies since 1978 and the U.S. economy's share of global GDP (gross domestic product) shrinking 6 percent in those 36 years.
"The 'dollar zone' still accounts for more than half of the global economy. In countries whose currencies are more stable against the dollar than against the euro, reserve composition that favors the dollar produces more stable returns in terms of the domestic currency," they said.
"This alternative interpretation implies that currency shares could shift rapidly, as happened between the world wars."
The survey covers 24 different economies which represent 28 percent of the official foreign exchange reserves from nations outside of the top three biggest economies. it also included samples for the private sector and found a similar correlation in reserve holdings.
"The logic underlying both private and official behavior is straightforward. The dollar looks less risky as an investment or a borrowing currency the more closely the domestic currency moves with the dollar," McCauley and Chan said. "If correct, these findings have implications for the future of the renminbi."
Rapid growth of the Chinese economy might therefore not be sufficient for the renminbi to eclipse the dollar in official reserve holdings, they added. This would only be possible if it showed "substantial independent movement" against the major currencies and if its neighbors, they said, calling it a possible "renminbi bloc."