Foreign Exchange Reserves

Forex exchange reserve are the assets that are held on reserve by the central banks or other monetary authorities in foreign currencies, the assets can be banknotes, deposits bonds, treasury, and other government security. Most foreign exchange reserves are hold in US Dollars. This is because economists say that reserves of a country should be saved in a currency that is not of that country. The assets serve many purposes but the main purpose of holding the assets is to ensure that the central bank has backup funds in case the national currency devalues rapidly or becomes altogether insolvent. The forex reserves influence the exchange rate of the country’s currency in the market and maintain its confidence in the financial markets. China is the largest foreign reserve holder in the world in US Dollars.

Purpose Of Foreign Exchange Reserves

• The reserved assets allow the central bank to purchase the domestic currency.
• The reserves of a state acts as a backup funds in case the state faces devalue in the national currency
• The central banks that choose to implement a fixed exchange rate policy might face a situation
• where supply and demand are pushing the exchange rate of the country. In such a condition,
• the reserves will be used to maintain the exchange rate of the country.
• Foreign exchange reserves are not only a backup for liabilities but, they can also influence the monetary policy of a country.
• Countries hold a foreign reserve to keep the value of their local currency.
• The countries who have a floating exchange rate system use these reserves to keep their currency value lower than the US Dollars.
• In case of an economic crisis, the reserves are used to maintain liquidity in the country.
• Foreign reserves make sure that a country will meet its foreign obligations.

How Does a Foreign Exchange Reserve Work

Foreign exchange reserves can comprise of banknotes, treasury bills, deposits, and government securities. The foreign exchange reserve is usually in a foreign currency, the US Dollar is the most traded currency in the world, which is the reason that the reserves are held in US Dollars. Whereas, the reserves can be held in other foreign currencies like EURO, pound, JPY (Japanese Yen) as well as CHY (Chinese Yen).

The reason that the economists recommend that reserves should be held in a currency that is not directly connected to the country’s own currency is to make a barrier in case there is a market shock.

The working of the reserve process can be explained as the exporters deposit foreign currency into their local banks which is paid to them by their trading partners, they transfer the currency into the central bank. Then these exporters exchange the foreign currency into local currency to carry out the business locally.

Theories Regarding Reserve Accumulation

In the early 1970’s many countries implemented flexible foreign exchange market rates, theoretically, reserves are not required for such type of exchange rate arrangements, and thus there should be a decline in the reserve rate. Rather there was on increase seen in the reserves, even more than the GDP (GROSS DOMESTIC PRODUCT). Below are some theories that can support this trend.

Signaling OR Vulnerability Indicator

The countries who don’t want the international organizations to assess their reserves as minimum tend to accumulate reserves to avoid negative assessment by the financial market.

External Trade

Countries that are engaged in external trade tend to accumulate reserves in order to avoid any interruption. A usual rule followed by the central banks is to hold the reserves for at least three months of import.

Financial Openness

Since the last decade, the opening of a balance of payments financial accounts has gained a lot of importance. That made the financial flows like portfolio investment and direct investment important. According to the Guidotti Greenspan Rule “A country should hold liquid reserves which is equal to their liquid liabilities coming due in a year.

Intergenerational Savings

Reserve accumulations can also be seen as a way of forced saving. By closing the financial Account, the government can force the private sector to buy domestic debt.