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.
How Are Foreign Exchange Reserves Acquired?
Foreign exchange reserves are accumulated the same way an individual acquires savings – by taking in more than it spends.
This can mean exporting more than it imports to maintain a positive trade balance. This can be raw materials (oil, gold, coal, etc.), or secondary goods (e.g., importing lumber and exporting wooden furniture).
Or by selling more services to the rest of the world than it takes in – e.g., tourism, attracting foreign businesses, receipt of foreign aid, remittances from workers abroad.
They can also increase reserves by borrowing from the rest of the world through loans or by issuing their debt to foreigners.
If a country lacks resources to export, then it must build reserves through productivity. They can do this by selling services or importing materials to create value additive products to export back out.
Exporters and other companies that earn foreign currency can exchange that for domestic currency with a commercial bank (which is under the purview of the central bank) or directly with the central bank itself.
Central banks typically like to keep their reserve accounts steady. So, if they don’t wish to allocate any more to US dollars, for example, they probably won’t be a big buyer of US Treasuries if their accounts are already “topped off” with USD. This can be informative in figuring out where Treasuries are likely to go price-wise.
So, reserve growth is a function of the balance of payments, which influences the supply and demand for different currencies.
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.
The Impact Of Depleting Reserves
On the flip side, when a country depletes its reserves, the confidence in the national currency can rapidly deteriorate. While this is more common in emerging and frontier markets, this does occasionally occur in developed markets as well.
Example: United Kingdom, 1992
The UK’s reserve situation in 1992 is perhaps the most famous example of how a currency can move in response to the situation involving its foreign reserves.
During the early part of the 1990s, the British pound had kept in line with the German mark. The pegging system was in place to enhance monetary and economic cooperation throughout the euro area as a precursor to the euro.
However, the Bank of England didn’t have the reserves available to keep the pound indefinitely within the European Exchange Rate Mechanism (ERM) – the antecedent to the European Monetary Union (and the adoption of the euro). The rate was kept at 2.7 German marks per pound.
To that point, because of the purported merit of having greater monetary and economic cooperation between European countries, the UK was forced to keep its interest rates artificially low. However, it was not a sustainable set of conditions. The UK needed higher interest rates to slow down its inflation rate from 8 percent, a rate at which creates unnecessary price pressures and inefficiencies within the economy.
To keep the pound pegged to the mark, the Bank of England had to buy its own currency with its foreign reserves to keep the pound within the desired band. Many market participants had sniffed out that the Bank of England couldn’t indefinitely fight market forces with its economic situation and would eventually have to float the currency.
The Bank of England wanted to avoid having to restrict capital flows, which can be very difficult. So, it was left with no other option but to relinquish its ability to have an independent monetary policy.
Inflation eventually got out of control under these conditions. Traders speculated that the BoE would need to take the pound out of the ERM to rectify the situation. Accordingly, they decided to short the currency.
The BoE countered speculative pressure by hiking interest rates to attract inflows into the pound (rather than having to use its own reserves). First from 10 percent to 12 percent, then up to 15 percent. This made the currency more expensive to borrow and more attractive to lend.
But the market wasn’t swayed and knew an interest rate defense wouldn’t be effective and that the BoE would eventually deplete its reserves entirely.
The British government eventually relented and let the pound fall out of the ERM – just two years after it had joined.
The pound fell roughly 15 percent against the German mark over the following few weeks. For traders short the pound, this provided a spectacular windfall. For the UK Treasury, and by extension UK taxpayers, the losses were in excess of £3 billion.