Foreign Exchange Reserves

Foreign exchange reserves are foreign currency funds and various foreign assets held by a country’s central bank, or other monetary authority. The purpose of these reserves is to allow the said authority to pay its liabilities. Such liabilities may arise from the currency issued by the central bank, as well as from the deposits held with it, by the government and various financial institutions.

One of the reasons why central banks hold such reserves in foreign currency is to insulate themselves from potential problems befalling the local financial ecosystem.

In the strictest sense of the concept, foreign exchange reserves include only actual foreign money, foreign government securities, foreign bank deposits and foreign treasury bills. That’s it.

More often than not however, assets such as gold, IMF reserve positions and special drawing rights are also included.

Foreign exchange reserves make up an important part of a country’s international investment position. They are an important weapon the central bank can wield in a number of ways.

How Do Central Banks Use Foreign Exchange Reserves?

Perhaps most importantly, FX reserves allow a central bank to execute a monetary policy.

For a central bank, the currency that it circulates and prints constitutes a liability. In effect, it promises to deliver some sort of value in exchange for the IOUs that are its banknotes.

In the case of a floating exchange rate regime, the market takes care of the valuation of any given currency. Under such conditions, FX reserves are theoretically unnecessary.

Most countries’ central banks push some kind of monetary policy different from the floating rate regime.

Fixed exchange rate policies draw heavily upon the FX reserves. The central bank has to manipulate the value of its issued currency, by influencing supply and demand through its FX reserves.

While such artifices are generally unnatural in pure capital mobility terms, they are useful in regards to defending weak currencies and fending off speculation attacks.

The Overall Trend Ff FX Reserve Accumulation

The end of the Bretton Woods system ushered in floating exchange rates. In theory, this should have led to the gradual diminishing of foreign exchange reserves.

Few central banks in the world thought such a course of action prudent however.

Most of them began accumulating reserves, instead of dissolving them.

Thus, China has accumulated FX reserves in excess of $3 trillion. Other countries that have built up massive reserves are Saudi Arabia and Russia.

This comes to show that some of the world’s biggest economies rely heavily on sturdy FX reserves.

From a precautionary perspective, foreign exchange reserves certainly make sense. The IMF is there to provide funds to countries in trouble, when needed. The process of obtaining these funds is hardly automatic however.

For tiding a central bank through a short term crisis, FX reserves offer the best option. In case of a global economic meltdown, the resources of the IMF will be insufficient to prop up all ailing parties.

Most Foreign Exchange Reserves Are Held In USD

At first glance, it may seem counterintuitive that countries such as China, Saudi Arabia and Russia should hold their FX reserves in USD.

Since most international trade happens in USD, it makes perfect sense for China to build upon the greenback FX reserve-wise. It is after all the biggest player of the international trade scene.

Saudi Arabia aims to cushion the volatility of oil prices through massive USD reserves.

As far as Russia is concerned, besides USD, it also holds massive reserves of gold. Gold as a reserve asset carries some additional risks compared to USD and other currencies such as the EUR.

Looking into the future, new asset classes, such as cryptocurrencies, may step up to fill the shoes of the USD as the world’s top reserve option.