Foreign Currency Reserves

Readers Question: What is the main purpose of foreign reserves? Who decides what amount to be kept as reserve and how this reserve is financed? Could be please explain in detail?

Definition of: Foreign Currency Reserves (Forex Reserves). This is the amount of foreign currency reserves that are held by the Central Bank of a country.

In general use, foreign currency reserves also include gold and IMF reserves. Also, people may take into account liquid assets that can easily be converted into foreign currency.

For example, Japan has just under $1,000 trillion dollars of foreign currency reserves, mostly in the form of dollars, Euros and Gold.

The most common currency for holding foreign currency is the dollar with 64%, the Euro is increasing its share and now accounts for 26% (see: Will Euro replace Dollar as global reserve currency)

Reasons for Holding Foreign Currency Reserves

• Influence the exchange rate. With large foreign exchange reserves, a country can target a certain exchange rate. For example, suppose China wanted to increase the value of its currency the Yuan. China could sell it’s dollar reserves to buy Yuan on the foreign exchange markets. The increased demand for Yuan would appreciate the Yuan. Actually, the Chinese have been trying to keep the Yuan undervalued by selling Yuan and buying Dollars. This is why China has so many Dollar reserves.  In a fixed exchange rate, foreign currency reserves can play an important role in trying to keep a target exchange rate.
• Act as a Guarantor for Liabilities such as External Debt. If a country holds substantial foreign debt, holding foreign currency reserves can help to give more confidence in the country’s ability to pay. If countries have dwindling foreign currency reserves, there is likely to be a deterioration in a country’s creditworthiness.

Who decides the quantity of foreign currency reserves?

1. The number of foreign currency reserves will be decided by the Central Bank / Government depending on current exchange rate / monetary policy?
2. For example, in the Bretton Woods system, countries tried to maintain a certain level of foreign currencies to be able to protect the value of a currency. In a floating exchange rate, there is less need to hold foreign currency for protecting against speculative attacks.
3. Often an increase in foreign currency reserves may simply reflect a large current account surplus and a desire to prevent the currency appreciating too much. By buying foreign currency the domestic currency is kept lower than it would otherwise have done.

Problems of Foreign Currency Reserves

1. Foreign Currency Reserves are rarely sufficient to target a certain exchange rate. If speculators sell heavily, then a currency will fall despite the best efforts of a Central bank. e.g. the UK lost billions trying to protect the value of Pound when it was in the Exchange Rate Mechanism in 1992. Eventually, the UK authorities had to admit defeat and devalue the pound.
2. Inflation Erodes Value. The problem with holding foreign currency reserves is that they can lose their value. Inflation erodes the value of currencies not fixed against gold (fiat exchange rates). Therefore, a Central Bank will need to keep buying foreign reserves to maintain the same purchasing power in markets. Also, there may have been many better (higher yielding uses of the capital).
3. Lose Money on Currency Changes. In theory, a Central bank can make money through the appreciation of other currencies it holds. However, many Central Banks have been losing money through the long-term decline in the value of the dollar. This particularly applies to China who has over $1900 billion of foreign reserves, mostly held in dollars.

Top 10 Countries foreign exchange reserves

1      China                                              $3,098,000,000,000                                
2      Japan                                              $1,217,000,000,000                                
3      European Union                                     $740,900,000,000                                  
4      Switzerland                                        $679,300,000,000                                  
5      Saudi Arabia                                       $535,800,000,000                                  
6      Taiwan                                             $439,000,000,000                                  
7      Hong Kong                                          $386,300,000,000                                  
8      Russia                                             $377,700,000,000                                  
9      Korea, South                                       $371,100,000,000                                  
10     Brazil                                             $365,000,000,000                                  
11     India                                              $359,700,000,000                                  
12     Singapore                                          $246,600,000,000                                  
13     Germany                                            $185,300,000,000                                  
14     Mexico                                             $178,400,000,000                                  
15     Thailand                                           $171,900,000,000                                  
16     France                                             $146,800,000,000                                  
17     Italy                                              $136,000,000,000                                  
18     United Kingdom                                     $135,000,000,000                                  
19     Iran                                               $133,700,000,000                                  
20     United States                                      $117,300,000,000

Source: CIA Factbook

Further Reading

• Costs and Benefits of Fixed Exchange Rates
• Factors Influencing exchange Rates