Definition: 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 credit worthiness.

Who Decides Foreign Currency Reserves?

1. The amount 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 have over $1900 billion of foreign reserves, mostly held in dollars.

Further Reading

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

List of Foreign Exchange Reserves – Top 10

Both, the Australian and UK economy faces a year of uncertainty and sluggish growth. It is really a question of which will be weakest. However, I think the Australian economy and currency will be hit harder than many in Australia would like to believe. I think this could drag the Aus $ lower, even against the weak £ sterling.

In past years, the Australian economy has been outperforming many others such as UK, US and Eurozone. However, I think this masks underlying problems.

• There has been a shrinking in the manufacturing base.
• Strong economy has been based on the demand for commodities. Increasingly, Australia’s strength is dependent upon demand from China and Asia.
• The growth in demand for commodities has squeezed other areas of the economy as resources have been funelled into mining. This however, makes the Aus economy more vulnerable to swings in the price of commodities and fortunes of China / Asia.

There is a good article here about the vulnerability of an unbalanced Australian economy.

I also feel that the Australian housing market is vulnerable. Like many other countries, house prices have risen faster than incomes, but, unlike the UK, Australian house prices have not yet fallen. When they do, it will slowdown the Australian economy.

In 2009,   the Australian economy will slowdown. This will lead to lower interest rates and lower demand for the currency. Commodity inflation is also slowing as global demand slows down. This will push the Aus $ lower

So in 2009, you have 2 weak economies – the UK and Australia so it is hard to say which will be the strongest. However, the Pound has already weakened in anticipation of a recession and lower rates. The Australian dollar could become weaker in 2009.

• Graph of Aus $ to GB $
• Factors influencing exchange rates

The Euro’s strength is mainly a reflection of the dollars weakness.

US interest rates have fallen due to the threat of a recession in the US. This fall in interest rates, relative to the EU means the Euro has become more attractive as a place to deposit ‘hot money flows’

Also, unlike the US, the Euroarea has broadly equilibrium on its current account. Quite an achievement given the strength of the Euro.

In 2008, US interest rates have continued to fall, to try and negate the effects of the housing crisis. This could maintain the weakness of the Euro. However, the EU economy is showing signs of strain under the decline in export competitiveness. If growth in the EU slows, the ECB may follow the example of US and cut Euro interest rates. This would change the market dynamics significantly. The short term strength of the Euro may decline (much to the delight of EU manufacturers)

Long Term Forecast for Euro

The EU economy has been doing better in the past couple of years. But, there are real problems lurking in the shadows.

The Alternative to the Dollar.

Some people, who would like to see America go down in the world, have been taking great delight in the free falling currency. If the dollar continues to slide investors and holders of foreign currency may feel inclined to switch out of investing in dollars, but prefer the more stable Euro. This may also encourage people to hold reserves in Euros rather than dollars. If the Dollar does lose its position as most trusted currency, it will be harder for America to borrow at cheap interest rates.

Ageing Population

Europe has an ageing population and inverted population pyramid. Furthermore European governments are tied to generous welfare benefits for the retired. European governments face a real crunch – How to finance its growing pension bill from a diminishing workforce. The problem is more acute in Europe than America. It could cause slower long term growth in Europe.

• Will Dollar be Replaced by Euro as main Global Currency?
• Predictions for Euro Dollar 2008

Interest rates.

Interest rates have a powerful influence on the exchange rate because of hot money flows.

Suppose you have £100,000 to save in a bank. If both Australia and UK have same interest rates (5%) it doesn’t matter where you save your money. However, if Australian interest rates increase (6%) and UK interest rates fall(4%). There is a clear incentive for investors to save in Australia and benefit from higher interest rates. Therefore, people need to buy Aus Dollars to save in Australian banks. British investors wills sell pounds to buy Aus Dollars This causes the value of Aus Dollar to rise against the British Pound.

• Note Australian interest rates are likely to be higher if the Australian economy has a higher rate of economic growth

Inflation.

If one country has a lower inflation rate, then its goods will become increasingly competitive and this will lead to increased demand for the currency.

Commodities

Another reason for the appreciating dollar is the increased demand for commodities that Australia is producing. In recent months the price of many commodities such as precious metals has increased, this has increased demand for Aus dollars to pay for Australian exports

See: Australian economy 2008

Predictions for Australian Dollar

Part A ii)
On 1 July, AUD1 = NZD 1.10. On 1 August, AUD1 = NZD 1.15.

On 1 July, your aunt in New Zealand booked the accommodation your families will stay in when you have a family reunion in Melbourne in August. She expects this to cost NZD 5400 when she pays the bill on August 1. You agreed to cover the costs she might incur if any exchange rate fluctuations took place between these dates. Will you have to help out? How much will you have to pay?

Again the important thing to note is that the Australian Dollar has appreciated in value. In August the Australian dollar now gains more NZD. It has appreciated by 4.5%. Therefore the cost of buying Australian goods will be higher for people paying with NZD.

Example of Exchange Rate Calculations

To find the cost of 100 NZD. You divide 100 / 1.1 – 90.9. Therefore the cost of 100 NZD is 90.9 Australian Dollar

If the exchange rate appreciates, then the new cost in Aus dollars will be 100 / 1.15 = 86.9. Therefore you need more New Zealand Dollars to buy the same amount of Australian Dollars.

To find the cost of 100 Aus Dollars you multiply 100 * 1.1 = 110

there are more steps, but this is the basics of exchange rate calculations

On 1July the Australian Dollar has appreciated against the British Pound. 1 Australian dollar now gets 0.45 GBP rather than 0.42. This means British companies will have to pay more in Pounds to get the same amount of Australian goods.

For example, in March, the price of buying a tonne of Australian flowers is 385* 0.42 = GBP 161

In July the price of buying the same tonne is 385 * 0.45 = £173

Therefore, the appreciation in the Australian Dollar makes the Australian flowers more expensive for British importers. In this situation Australian exporters may do two things

1. Keep the same price in Australian Dollars, this may lead to a fall in demand by British importers.
2. Try and keep the price for British importers. This means they would have to reduce their profit margins and accept a lower amount of Australian Dollars. If they kept the price £161 then with the new exchange rate the Australian exporters would only receive 161 / 0.45 = 364 Aus Dollars.

For example, if you agree to buy a house for Euros 20,000 an appreciation in the Euro, could increase the Pound Sterling value by a considerable amount.

The way forward exchange rates work.

On a particular day, there will be a spot price for future contracts between the Euro and Pound. If you buy this contract then you are able to exchange money at a specified day for this particular price.

It means that you can have certainty that you will be able to buy foreign exchange at a certain price. It enables you to have insulation against rapid fluctuations.

This is an example of a bank offering forward exchange contracts

Some are predicting we might see parity between the Euro and Pound in the next few months. That would be bad news for UK tourists travelling to America. However, I think it is unlikely the pound will fall that low – unless the housing price falls turns into a housing slump.

Apologies for getting behind with readers questions

Prospects of growth in 2008, look reasonably good; buoyed by consumer spending growth is forecast to be 2%. With inflation under control the Japanese Monetary authorities are unlikely to change interest rates.  (interest rates are currently close to 0%)

Forecast Yen against the Dollar

The US economy appears to have more structural weaknesses than Japan. With US house prices still falling and further fallouts from the sub prime crises the American economy faces the prospect of recession. It is likely that the Fed will lower interest rates in the US, despite this further undermining the dollar. Therefore, the long term trend of Yen appreciation against the dollar is likely to continue

Graph of Yen against US $

Forecast of Yen against Euro

The Euro and the Yen have been quite volatile in 2007. This is because the Yen is often used to finance carry trades. When the stock market is rising investors sell their Yen assets and invest in shares. When they want to borrow money they use the Japanese Yen, because it offers the cheapest interest rates .

In the past 6 years, the yen has fallen 37 percent against the euro. However, this prolonged decline may well becoming to an end. There is only so far that the Euro can keep rising without causing pain to the EU economy. In the near future, the markets may seek to correct the 6 year trend and revalue the Yen at 120 per Euro.

Readers Question: Explain why a fall in the exchange rate of the pound sterling is ‘needed for an improved balance of payments on current account, as well as for growth and jobs’

A fall in the value of the pound will reduce the foreign price of UK exports, this makes UK goods more competitive abroad, increasing quantity demanded. This will lead to a boost for the exporting sector (often manufacturing) With more demand and output, firms will take on extra workers helping to reduce unemployment.

A falling pound will also make imports more expensive. Therefore, there will be expenditure switching, from imports to domestic goods. With rising exports and falling imports, the UK should experience an improvement in the current account deficit. (i.e reduction in the record trade deficit)

However, it assumes demand for exports and imports is relatively elastic (Marshall Lerner condition)

Related

• The effects of a devaluation in the dollar
• Effects of a devalution