Foreign exchange reserves (also called forex reserves or FX reserves) are
cash
In economics, cash is money in the physical form of currency, such as banknotes and coins.
In bookkeeping and financial accounting, cash is current assets comprising currency or currency equivalents that can be accessed immediately or near-imm ...
and other reserve assets such as
gold
Gold is a chemical element with the symbol Au (from la, aurum) and atomic number 79. This makes it one of the higher atomic number elements that occur naturally. It is a bright, slightly orange-yellow, dense, soft, malleable, and ductile met ...
held by a
central bank
A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union,
and oversees their commercial banking system. In contrast to a commercial bank, a central ba ...
or other
monetary authority
In finance and economics, a monetary authority is the entity that manages a country’s currency and money supply, often with the objective of controlling inflation, interest rates, real GDP or unemployment rate. With its monetary tools, a moneta ...
that are primarily available to
balance payments of the country, influence the foreign exchange rate of its currency, and to maintain confidence in financial markets. Reserves are held in one or more
reserve currencies, nowadays mostly the
United States dollar
The United States dollar ( symbol: $; code: USD; also abbreviated US$ or U.S. Dollar, to distinguish it from other dollar-denominated currencies; referred to as the dollar, U.S. dollar, American dollar, or colloquially buck) is the officia ...
and to a lesser extent the
euro
The euro ( symbol: €; code: EUR) is the official currency of 19 out of the member states of the European Union (EU). This group of states is known as the eurozone or, officially, the euro area, and includes about 340 million citizens . ...
.
Foreign exchange reserves assets can comprise
banknotes
A banknote—also called a bill (North American English), paper money, or simply a note—is a type of negotiable instrument, negotiable promissory note, made by a bank or other licensed authority, payable to the bearer on demand.
Banknotes w ...
,
bank deposits
A deposit account is a bank account maintained by a financial institution in which a customer can deposit and withdraw money. Deposit accounts can be savings accounts, current accounts or any of several other types of accounts explained below.
...
, and
government securities
A country's gross government debt (also called public debt, or sovereign debt) is the financial liabilities of the government sector. Changes in government debt over time reflect primarily borrowing due to past government deficits. A deficit oc ...
of the reserve currency, such as
bonds and
treasury bill
United States Treasury securities, also called Treasuries or Treasurys, are government debt instruments issued by the United States Department of the Treasury to finance government spending as an alternative to taxation. Since 2012, U.S. gov ...
s. Some countries hold a part of their reserves in
gold
Gold is a chemical element with the symbol Au (from la, aurum) and atomic number 79. This makes it one of the higher atomic number elements that occur naturally. It is a bright, slightly orange-yellow, dense, soft, malleable, and ductile met ...
, and
special drawing rights
Special drawing rights (SDRs, code ) are supplementary foreign exchange reserve assets defined and maintained by the International Monetary Fund (IMF). SDRs are units of account for the IMF, and not a currency ''per se''. They represent a claim ...
are also considered reserve assets. Often, for convenience, the cash or securities are retained by the central bank of the reserve or other currency and the "holdings" of the foreign country are tagged or otherwise identified as belonging to the other country without them actually leaving the vault of that central bank. From time to time they may be physically moved to the home or another country.
Normally, interest is not paid on foreign cash reserves, nor on gold holdings, but the central bank usually earns interest on government securities. The central bank may, however, profit from a depreciation of the foreign currency or incur a loss on its appreciation. The central bank also incurs opportunity costs from holding the reserve assets (especially cash holdings) and from their storage, security costs, etc.
Definition
![Country foreign exchange reserves minus external debt](https://upload.wikimedia.org/wikipedia/commons/1/19/Country_foreign_exchange_reserves_minus_external_debt.png)
Foreign exchange reserves are also known as reserve assets and include foreign
banknote
A banknote—also called a bill (North American English), paper money, or simply a note—is a type of negotiable instrument, negotiable promissory note, made by a bank or other licensed authority, payable to the bearer on demand.
Banknotes w ...
s, foreign bank deposits, foreign
treasury bill
United States Treasury securities, also called Treasuries or Treasurys, are government debt instruments issued by the United States Department of the Treasury to finance government spending as an alternative to taxation. Since 2012, U.S. gov ...
s, and short and long-term foreign government securities, as well as
gold reserve
A gold reserve is the gold held by a national central bank, intended mainly as a guarantee to redeem promises to pay depositors, note holders (e.g. paper money), or trading peers, during the eras of the gold standard, and also as a store of v ...
s,
special drawing rights
Special drawing rights (SDRs, code ) are supplementary foreign exchange reserve assets defined and maintained by the International Monetary Fund (IMF). SDRs are units of account for the IMF, and not a currency ''per se''. They represent a claim ...
(SDRs), and
International Monetary Fund
The International Monetary Fund (IMF) is a major financial agency of the United Nations, and an international financial institution, headquartered in Washington, D.C., consisting of 190 countries. Its stated mission is "working to foster globa ...
(IMF) reserve positions.
In a central bank's accounts, foreign exchange reserves are called
reserve assets in the
capital account
In macroeconomics and international finance, the capital account, also known as the capital and financial account records the net flow of investment transaction into an economy. It is one of the two primary components of the balance of payments, ...
of the
balance of payments
In international economics, the balance of payments (also known as balance of international payments and abbreviated BOP or BoP) of a country is the difference between all money flowing into the country in a particular period of time (e.g., a ...
, and may be labeled as reserve assets under assets by functional category. In terms of financial assets classifications, reserve assets can be classified as
gold bullion
A gold bar, also called gold bullion or gold ingot, is a quantity of refined metallic gold of any shape that is made by a bar producer meeting standard conditions of manufacture, labeling, and record keeping. Larger gold bars that are produced ...
, unallocated gold accounts, special drawing rights, currency, reserve position in the IMF, interbank position, other transferable deposits, other deposits,
debt securities
A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...
,
loan
In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that d ...
s,
stock
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
s (listed and unlisted), investment fund shares and financial
derivative
In mathematics, the derivative of a function of a real variable measures the sensitivity to change of the function value (output value) with respect to a change in its argument (input value). Derivatives are a fundamental tool of calculus. F ...
s, such as
forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on at the time of conclusion of the contract, making it a type of deriva ...
s and
options. There is no counterpart for reserve assets in liabilities of the International Investment Position. Usually, when the monetary authority of a country has some kind of liability, this will be included in other categories, such as Other Investments. On a central bank's
Balance sheet
In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a business ...
, foreign exchange reserves are assets, along with domestic credit.
Purpose
![COFER 2000-2019](https://upload.wikimedia.org/wikipedia/commons/b/bb/COFER_2000-2019.svg)
Typically, one of the critical functions of a country's central bank is reserve management, to ensure that the central bank has control over adequate foreign assets to meet national objectives. These objectives may include:
* supporting and maintaining confidence in the national monetary and exchange rate management policies,
* limiting external vulnerability to shocks during times of crisis or when access to borrowing is curtailed, and in doing so -
** providing a level of confidence to markets,
** demonstrating backing for the domestic currency,
** assisting the government to meet its foreign exchange needs and external debt obligations, and
** maintaining a reserve for potential national disasters or emergencies.
Reserves assets allow a central bank to purchase the domestic currency, which is considered a liability for the central bank (since it prints the money or
fiat currency
Fiat money (from la, fiat, "let it be done") is a type of currency that is not backed by any commodity such as gold or silver. It is typically designated by the issuing government to be legal tender. Throughout history, fiat money was sometime ...
as
IOUs). Thus, the quantity of foreign exchange reserves can change as a central bank implements
monetary policy
Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often a ...
, but this dynamic should be analyzed generally in the context of the level of capital mobility, the
exchange rate
In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of ...
regime and other factors. This is known as
trilemma
A trilemma is a difficult choice from three options, each of which is (or appears) unacceptable or unfavourable. There are two logically equivalent ways in which to express a trilemma: it can be expressed as a choice among three unfavourable option ...
or
impossible trinity. Hence, in a world of perfect capital mobility, a country with
fixed exchange rate
A fixed exchange rate, often called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another m ...
would not be able to execute an independent monetary policy.
A central bank which chooses to implement a fixed exchange rate policy may face a situation where
supply
Supply may refer to:
*The amount of a resource that is available
**Supply (economics), the amount of a product which is available to customers
**Materiel, the goods and equipment for a military unit to fulfill its mission
*Supply, as in confidenc ...
and
demand
In economics, demand is the quantity of a good that consumers are willing and able to purchase at various prices during a given time. The relationship between price and quantity demand is also called the demand curve. Demand for a specific item ...
would tend to push the value of the currency lower or higher (an increase in demand for the currency would tend to push its value higher, and a decrease lower) and thus the central bank would have to use reserves to maintain its fixed exchange rate. Under perfect capital mobility, the change in reserves is a temporary measure, since the fixed exchange rate attaches the domestic monetary policy to that of the country of the
base currency
A currency pair is the dyadic quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. The currency that is used as the reference is called the counter currency, quote currency, o ...
. Hence, in the long term, the monetary policy has to be adjusted in order to be compatible with that of the country of the base currency. Without that, the country will experience outflows or inflows of capital.
Fixed pegs were usually used as a form of monetary policy, since attaching the domestic currency to a currency of a country with lower levels of inflation should usually assure convergence of prices.
In a pure flexible exchange rate regime or
floating exchange rate
In macroeconomics and economic policy, a floating exchange rate (also known as a fluctuating or flexible exchange rate) is a type of exchange rate regime in which a currency's value is allowed to fluctuate in response to foreign exchange mar ...
regime, the central bank does not intervene in the exchange rate dynamics; hence the exchange rate is determined by the market. Theoretically, in this case reserves are not necessary. Other instruments of monetary policy are generally used, such as interest rates in the context of an
inflation targeting
In macroeconomics, inflation targeting is a monetary policy where a central bank follows an explicit target for the inflation rate for the medium-term and announces this inflation target to the public. The assumption is that the best that moneta ...
regime.
Milton Friedman
Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the ...
was a strong advocate of flexible exchange rates, since he considered that independent monetary (and in some cases fiscal) policy and openness of the capital account are more valuable than a fixed exchange rate. Also, he valued the role of exchange rate as a price. As a matter of fact, he believed that sometimes it could be less painful and thus desirable to adjust only one price (the exchange rate) than the whole set of prices of
goods
In economics, goods are items that satisfy human wants
and provide utility, for example, to a consumer making a purchase of a satisfying product. A common distinction is made between goods which are transferable, and services, which are not tran ...
and
wage
A wage is payment made by an employer to an employee for work done in a specific period of time. Some examples of wage payments include compensatory payments such as ''minimum wage'', ''prevailing wage'', and ''yearly bonuses,'' and remuner ...
s of the economy, that are less flexible.
Mixed exchange rate regimes (
'dirty floats', target bands or similar variations) may require the use of foreign exchange operations to maintain the targeted exchange rate within the prescribed limits, such as fixed exchange rate regimes.
As seen above, there is an intimate relation between exchange rate policy (and hence reserves accumulation) and monetary policy. Foreign exchange operations can be
sterilized (have their effect on the money supply negated via other financial transactions) or unsterilized.
Non-sterilization will cause an expansion or contraction in the amount of domestic currency in circulation, and hence directly affect
inflation
In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...
and monetary policy. For example, to maintain the same exchange rate if there is increased demand, the central bank can issue more of the domestic currency and purchase foreign currency, which will increase the sum of foreign reserves. Since (if there is no sterilization) the domestic money supply is increasing (money is being 'printed'), this may provoke domestic inflation. Also, some central banks may let the exchange rate appreciate to control inflation, usually by the channel of cheapening
tradable
Tradability is the property of a good or service that can be sold in another location distant from where it was produced. A good that is not tradable is called non-tradable. Different goods have differing levels of tradability: the higher the co ...
goods.
Since the amount of foreign reserves available to defend a weak currency (a currency in low demand) is limited, a
currency crisis
A currency crisis is a type of financial crisis, and is often associated with a real economic crisis. A currency crisis raises the probability of a banking crisis or a default crisis. During a currency crisis the value of foreign denominated deb ...
or
devaluation
In macroeconomics and modern monetary policy, a devaluation is an official lowering of the value of a country's currency within a fixed exchange-rate system, in which a monetary authority formally sets a lower exchange rate of the national curren ...
could be the end result. For a currency in very high and rising demand, foreign exchange reserves can theoretically be continuously accumulated, if the intervention is sterilized through
open market operation
In macroeconomics, an open market operation (OMO) is an activity by a central bank to give (or take) liquidity in its currency to (or from) a bank or a group of banks. The central bank can either buy or sell government bonds (or other financial as ...
s to prevent inflation from rising. On the other hand, this is costly, since the sterilization is usually done by
public debt
A country's gross government debt (also called public debt, or sovereign debt) is the financial liabilities of the government sector. Changes in government debt over time reflect primarily borrowing due to past government deficits. A deficit oc ...
instruments (in some countries Central Banks are not allowed to emit debt by themselves).
In practice, few central banks or currency regimes operate on such a simplistic level, and numerous other factors (domestic demand, production and
productivity
Productivity is the efficiency of production of goods or services expressed by some measure. Measurements of productivity are often expressed as a ratio of an aggregate output to a single input or an aggregate input used in a production proces ...
, imports and exports, relative prices of goods and services, etc.) will affect the eventual outcome. Besides that, the hypothesis that the world economy operates under perfect capital mobility is clearly flawed.
As a consequence, even those central banks that strictly limit foreign exchange interventions often recognize that currency markets can be volatile and may intervene to counter disruptive short-term movements (that may include
speculative attack In economics, a speculative attack is a precipitous selling of untrustworthy assets by previously inactive speculators and the corresponding acquisition of some valuable assets ( currencies, gold). The first model of a speculative attack was contai ...
s). Thus, intervention does not mean that they are defending a specific exchange rate level. Hence, the higher the reserves, the higher is the capacity of the central bank to smooth the
volatility of the Balance of Payments and assure
consumption smoothing Consumption smoothing is an economic concept for the practice of optimizing a person's standard of living through an appropriate balance between savings and consumption over time. An optimal consumption rate should be relatively similar at each stag ...
in the long term.
Reserve accumulation
After the end of the
Bretton Woods system
The Bretton Woods system of monetary management established the rules for commercial and financial relations among the United States, Canada, Western European countries, Australia, and Japan after the 1944 Bretton Woods Agreement. The Bretto ...
in the early 1970s, many countries adopted flexible exchange rates. In theory reserves are not needed under this type of exchange rate arrangement; thus the expected trend should be a decline in foreign exchange reserves. However, the opposite happened and foreign reserves present a strong upward trend. Reserves grew more than
gross domestic product
Gross domestic product (GDP) is a money, monetary Measurement in economics, measure of the market value of all the final goods and services produced and sold (not resold) in a specific time period by countries. Due to its complex and subjec ...
(GDP) and imports in many countries. The only ratio that is relatively stable is foreign reserves over
M2.
[Rodrik, Dani. "The social cost of foreign exchange reserves." ''International Economic Journal'' 20.3 (2006): 253-266.] Below are some theories that can explain this trend.
Theories
Signaling or vulnerability indicator
Credit risk
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
agencies and international organizations use ratios of reserves to other external sector variables to assess a country's external vulnerability. For example, Article IV of 2013 uses total
external debt
A country's gross external debt (or foreign debt) is the liabilities that are owed to nonresidents by residents. The debtors can be governments, corporations or citizens. External debt may be denominated in domestic or foreign currency. It incl ...
to gross international reserves, gross international reserves in months of prospective goods and nonfactor services imports to
broad money
In economics, broad money is a measure of the amount of money, or money supply, in a national economy including both highly liquid "narrow money" and less liquid forms. The European Central Bank, the OECD and the Bank of England all have their own ...
, broad money to short-term external debt, and short-term external debt to short-term external debt on residual maturity basis plus current account deficit. Therefore, countries with similar characteristics accumulate reserves to avoid negative assessment by the financial market, especially when compared to members of a
peer group
In sociology, a peer group is both a social group and a Primary and secondary groups, primary group of people who have similar interests (homophily), age, background, or social status. The members of this group are likely to influence the person's ...
.
Precautionary aspect
Reserves are used as
savings
Wealth is the abundance of valuable financial assets or physical possessions which can be converted into a form that can be used for transactions. This includes the core meaning as held in the originating Old English word , which is from an I ...
for potential times of crises, especially balance of payments crises. Original fears were related to the current account, but this gradually changed to also include financial account needs. Furthermore, the creation of the IMF was viewed as a response to the need of countries to accumulate reserves. If a specific country is suffering from a balance of payments crisis, it would be able to borrow from the IMF. However, the process of obtaining resources from the Fund is not automatic, which can cause problematic delays especially when markets are stressed. Therefore, the fund only serves as a provider of resources for longer term adjustments. Also, when the crisis is generalized, the resources of the IMF could prove insufficient. After the 2008 crisis, the members of the Fund had to approve a capital increase, since its resources were strained. Moreover, after the 1997 Asian crisis, reserves in Asian countries increased because of doubt in the IMF reserves. Also, during the 2008 crisis, the
Federal Reserve
The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
instituted
currency swap
In finance, a currency swap (more typically termed a cross-currency swap, XCS) is an interest rate derivative (IRD). In particular it is a linear IRD, and one of the most liquid benchmark products spanning multiple currencies simultaneously. I ...
lines with several countries, alleviating liquidity pressures in dollars, thus reducing the need to use reserves.
=External trade
=
Countries engaging in
international trade
International trade is the exchange of capital, goods, and services across international borders or territories because there is a need or want of goods or services. (see: World economy)
In most countries, such trade represents a significant ...
, maintain reserves to ensure no interruption. A rule usually followed by central banks is to hold in reserve at least three months of imports. Also, an increase in reserves occurred when commercial openness increased (part of the process known as
globalization
Globalization, or globalisation (Commonwealth English; see spelling differences), is the process of interaction and integration among people, companies, and governments worldwide. The term ''globalization'' first appeared in the early 20t ...
). Reserve accumulation was faster than that which would be explained by trade, since the ratio has increased to several months of imports. Furthermore, the ratio of reserves to foreign trade is closely watched by credit risk agencies in months of imports.
=Financial openness
=
The opening of a financial account of the
balance of payments
In international economics, the balance of payments (also known as balance of international payments and abbreviated BOP or BoP) of a country is the difference between all money flowing into the country in a particular period of time (e.g., a ...
has been important during the last decade. Hence, financial flows such as
direct investment and
portfolio investment
Portfolio investments are investments in the form of a group (portfolio) of assets, including transactions in equity, securities, such as common stock, and debt securities, such as banknotes, bonds, and debentures.
Portfolio investments are p ...
became more important. Usually financial flows are more volatile that enforce the necessity of higher reserves. Moreover, holding reserves, as a consequence of the increasing of financial flows, is known as
Guidotti–Greenspan rule that states a country should hold liquid reserves equal to their foreign liabilities coming due within a year. For example, international wholesale financing relied more on Korean banks in the aftermath of the 2008 crisis, when the Korean Won depreciated strongly, because the Korean banks' ratio of short-term external debt to reserves was close to 100%, which exacerbated the perception of vulnerability.
Exchange rate policy
Reserve accumulation can be an instrument to interfere with the exchange rate. Since the first
General Agreement on Tariffs and Trade
The General Agreement on Tariffs and Trade (GATT) is a legal agreement between many countries, whose overall purpose was to promote international trade by reducing or eliminating trade barriers such as tariffs or quotas. According to its pre ...
(GATT) of 1948 to the foundation of the
World Trade Organization
The World Trade Organization (WTO) is an intergovernmental organization that regulates and facilitates international trade. With effective cooperation
in the United Nations System, governments use the organization to establish, revise, and e ...
(WTO) in 1995, the regulation of trade is a major concern for most countries throughout the world. Hence, commercial distortions such as subsidies and taxes are strongly discouraged. However, there is no global framework to regulate financial flows. As an example of regional framework, members of the
European Union
The European Union (EU) is a supranational political and economic union of member states that are located primarily in Europe. The union has a total area of and an estimated total population of about 447million. The EU has often been des ...
are prohibited from introducing
capital control
Capital controls are residency-based measures such as transaction taxes, other limits, or outright prohibitions that a nation's government can use to regulate flows from capital markets into and out of the country's capital account. These measure ...
s, except in an extraordinary situation. The dynamics of
China's
China, officially the People's Republic of China (PRC), is a country in East Asia. It is the world's most populous country, with a population exceeding 1.4 billion, slightly ahead of India. China spans the equivalent of five time zones and ...
trade balance and reserve accumulation during the first decade of the 2000 was one of the main reasons for the interest in this topic.
Some economists are trying to explain this behavior. Usually, the explanation is based on a sophisticated variation of
mercantilism
Mercantilism is an economic policy that is designed to maximize the exports and minimize the imports for an economy. It promotes imperialism, colonialism, tariffs and subsidies on traded goods to achieve that goal. The policy aims to reduce a ...
, such as to protect the take-off in the
tradable
Tradability is the property of a good or service that can be sold in another location distant from where it was produced. A good that is not tradable is called non-tradable. Different goods have differing levels of tradability: the higher the co ...
sector of an economy, by avoiding the real exchange rate appreciation that would naturally arise from this process. One attempt uses a standard model of open economy
intertemporal consumption
Economic theories of intertemporal consumption seek to explain people's preferences in relation to consumption and saving over the course of their lives. The earliest work on the subject was by Irving Fisher and Roy Harrod, who described 'hump sav ...
to show that it is possible to replicate a tariff on imports or a subsidy on exports by closing the capital account and accumulating reserves. Another is more related to the
economic growth
Economic growth can be defined as the increase or improvement in the inflation-adjusted market value of the goods and services produced by an economy in a financial year. Statisticians conventionally measure such growth as the percent rate of ...
literature. The argument is that the tradable sector of an economy is more capital intense than the non-tradable sector. The private sector invests too little in capital, since it fails to understand the social gains of a higher capital ratio given by
externalities
In economics, an externality or external cost is an indirect cost or benefit to an uninvolved third party that arises as an effect of another party's (or parties') activity. Externalities can be considered as unpriced goods involved in either co ...
(like improvements in human capital, higher competition, technological spillovers and increasing returns to scale). The government could improve the equilibrium by imposing
subsidies
A subsidy or government incentive is a form of financial aid or support extended to an economic sector (business, or individual) generally with the aim of promoting economic and social policy. Although commonly extended from the government, the ter ...
and
tariff
A tariff is a tax imposed by the government of a country or by a supranational union on imports or exports of goods. Besides being a source of revenue for the government, import duties can also be a form of regulation of foreign trade and poli ...
s, but the hypothesis is that the government is unable to distinguish between good investment opportunities and
rent-seeking
Rent-seeking is the act of growing one's existing wealth without creating new wealth by manipulating the social or political environment.
Rent-seeking activities have negative effects on the rest of society. They result in reduced economic effi ...
schemes. Thus, reserves accumulation would correspond to a loan to foreigners to purchase a quantity of tradable goods from the economy. In this case, the real exchange rate would depreciate and the growth rate would increase. In some cases, this could improve welfare, since the higher growth rate would compensate the loss of the tradable goods that could be consumed or invested. In this context, foreigners have the role to choose only the useful tradable goods sectors.
Intergenerational savings
Reserve accumulation can be seen as a way of "forced savings". The government, by closing the financial account, would force the private sector to buy
domestic debt
In public finance, internal debt or domestic debt is the component of the total government debt in a country that is owed to lenders within the country. Internal government debt is complement is external government debt. The main sources of fun ...
for lack of better alternatives. With these resources, the government buys foreign assets. Thus, the government coordinates the savings accumulation in the form of reserves.
Sovereign wealth fund
A sovereign wealth fund (SWF), sovereign investment fund, or social wealth fund is a state-owned investment fund that invests in real and financial assets such as stocks, bonds, real estate, precious metals, or in alternative investments such ...
s are examples of governments that try to save the windfall of booming exports as long-term assets to be used when the source of the windfall is extinguished.
Costs
There are costs in maintaining large currency reserves. Fluctuations in
exchange rate
In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of ...
s result in gains and losses in the value of reserves. In addition, the purchasing power of
fiat money
Fiat money (from la, fiat, "let it be done") is a type of currency that is not backed by any commodity such as gold or silver. It is typically designated by the issuing government to be legal tender. Throughout history, fiat money was sometime ...
decreases constantly due to devaluation through inflation. Therefore, a central bank must continually increase the amount of its reserves to maintain the same power to manage exchange rates. Reserves of foreign currency may provide a small return in
interest
In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distinct ...
. However, this may be less than the reduction in purchasing power of that currency over the same period of time due to inflation, effectively resulting in a negative return known as the "quasi-fiscal cost". In addition, large currency reserves could have been invested in higher yielding assets.
Several calculations have been attempted to measure the cost of reserves. The traditional one is the spread between government debt and the yield on reserves. The caveat is that higher reserves can decrease the perception of risk and thus the government bond interest rate, so this measures can overstate the cost. Alternatively, another measure compares the yield in reserves with the alternative scenario of the resources being invested in capital stock to the economy, which is hard to measure. One interesting
measure tries to compare the spread between short term foreign borrowing of the private sector and yields on reserves, recognizing that reserves can correspond to a transfer between the private and the public sectors. By this measure, the cost can reach 1% of GDP to developing countries. While this is high, it should be viewed as an insurance against a crisis that could easily cost 10% of GDP to a country. In the context of theoretical economic models it is possible to simulate economies with different policies (accumulate reserves or not) and directly compare the welfare in terms of consumption. Results are mixed, since they depend on specific features of the models.
A case to point out is that of the
Swiss National Bank
The Swiss National Bank (SNB; german: Schweizerische Nationalbank; french: Banque nationale suisse; it, Banca nazionale svizzera; rm, Banca naziunala svizra) is the central bank of Switzerland, responsible for the nation's monetary policy an ...
, the central bank of Switzerland. The Swiss franc is regarded as a
safe haven currency
In macroeconomics, hard currency, safe-haven currency, or strong currency is any Foreign exchange market, globally traded currency that serves as a reliable and stable store of value. Factors contributing to a currency's ''hard'' status might inc ...
, so it usually appreciates during market's stress. In the aftermath of the 2008 crisis and during the initial stages of the
Eurozone crisis
The euro area, commonly called eurozone (EZ), is a currency union of 19 member states of the European Union (EU) that have adopted the euro (€) as their primary currency and sole legal tender, and have thus fully implemented EMU policies ...
, the
Swiss franc
The Swiss franc is the currency and legal tender of Switzerland and Liechtenstein. It is also legal tender in the Italian exclave of Campione d'Italia which is surrounded by Swiss territory. The Swiss National Bank (SNB) issues banknotes and the f ...
(CHF) appreciated sharply. The central bank resisted appreciation by buying reserves. After accumulating reserves during 15 months until June 2010, the SNB let the currency appreciate. As a result, the loss with the devaluation of reserves just in 2010 amounted to CHF 27 Billion or 5% of GDP (part of this was compensated by the profit of almost CHF6 Billion due to the surge in the price of gold). In 2011, after the currency appreciated against the Euro from 1.5 to 1.1, the SNB announced a ceiling at the value of CHF 1.2. In the middle of 2012, reserves reached 71% of GDP.
History
Origins and Gold Standard Era
The modern exchange market as tied to the prices of gold began during 1880. Of this year the countries significant by size of reserves were
Austria-Hungary
Austria-Hungary, often referred to as the Austro-Hungarian Empire,, the Dual Monarchy, or Austria, was a constitutional monarchy and great power in Central Europe between 1867 and 1918. It was formed with the Austro-Hungarian Compromise of ...
, Belgium,
Canadian Confederation
Canadian Confederation (french: Confédération canadienne, link=no) was the process by which three British North American provinces, the Province of Canada, Nova Scotia, and New Brunswick, were united into one federation called the Canada, Dom ...
, Denmark,
Grand Duchy of Finland
The Grand Duchy of Finland ( fi, Suomen suuriruhtinaskunta; sv, Storfurstendömet Finland; russian: Великое княжество Финляндское, , all of which literally translate as Grand Principality of Finland) was the predecessor ...
,
German Empire
The German Empire (),Herbert Tuttle wrote in September 1881 that the term "Reich" does not literally connote an empire as has been commonly assumed by English-speaking people. The term literally denotes an empire – particularly a hereditary ...
and
Sweden-Norway
Sweden and Norway or Sweden–Norway ( sv, Svensk-norska unionen; no, Den svensk-norske union(en)), officially the United Kingdoms of Sweden and Norway, and known as the United Kingdoms, was a personal union of the separate kingdoms of Sweden ...
.
Official international reserves, the means of official international payments, formerly consisted only of gold, and occasionally silver. But under the Bretton Woods system, the US dollar functioned as a reserve currency, so it too became part of a nation's official international reserve assets. From 1944–1968, the US dollar was convertible into gold through the Federal Reserve System, but after 1968 only central banks could convert dollars into gold from official gold reserves, and after 1973 no individual or institution could convert US dollars into gold from official gold reserves. Since 1973, no major currencies have been convertible into gold from official gold reserves. Individuals and institutions must now buy gold in private markets, just like other commodities. Even though US dollars and other currencies are no longer convertible into gold from official gold reserves, they still can function as official international reserves.
Central banks throughout the world have sometimes cooperated in buying and selling official international reserves to attempt to influence exchange rates and avert financial crisis. For example, in the
Baring crisis
The Baring crisis or the Panic of 1890 was an acute recession. Although less serious than other panics of the era, it is the nineteenth century’s most famous sovereign debt crisis, and the 17th largest decline in U.S. stock market history.
Bac ...
(the "Panic of 1890"), the
Bank of England
The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694 to act as the English Government's banker, and still one of the bankers for the Government of ...
borrowed GBP 2 million from the
Banque de France
The Bank of France ( French: ''Banque de France''), headquartered in Paris, is the central bank of France. Founded in 1800, it began as a private institution for managing state debts and issuing notes. It is responsible for the accounts of the F ...
. The same was true for the
Louvre Accord
The Louvre Accord (formally, the Statement of the G6 Finance Ministers and Central Bank Governors) was an agreement, signed on February 22, 1987, in Paris, that aimed to stabilize international currency markets and halt the continued decline of t ...
and the
Plaza Accord
The Plaza Accord was a joint–agreement signed on September 22, 1985, at the Plaza Hotel in New York City, between France, West Germany, Japan, the United Kingdom, and the United States, to depreciate the U.S. dollar in relation to the French ...
in the post gold-standard era.
Post Gold Standard Era
Historically, especially before the
1997 Asian financial crisis
The Asian financial crisis was a period of financial crisis that gripped much of East Asia and Southeast Asia beginning in July 1997 and raised fears of a worldwide economic meltdown due to financial contagion. However, the recovery in 1998–1 ...
, central banks had rather meager reserves (by today's standards) and were therefore subject to the whims of the market, of which there was accusations of
hot money In economics, hot money is the flow of funds (or capital) from one country to another in order to earn a short-term profit on interest rate differences and/or anticipated exchange rate shifts. These speculative capital flows are called "hot money" b ...
manipulation, however Japan was the exception. In the case of Japan, forex reserves began their ascent a decade earlier, shortly after the
Plaza Accord
The Plaza Accord was a joint–agreement signed on September 22, 1985, at the Plaza Hotel in New York City, between France, West Germany, Japan, the United Kingdom, and the United States, to depreciate the U.S. dollar in relation to the French ...
in 1985, and were primarily used as a tool to weaken the surging
yen
The is the official currency of Japan. It is the third-most traded currency in the foreign exchange market, after the United States dollar (US$) and the euro. It is also widely used as a third reserve currency after the US dollar and the e ...
.
This effectively granted the United States a massive loan as they were almost exclusively invested in
US Treasuries, which assisted the US to engage the
Soviet Union
The Soviet Union,. officially the Union of Soviet Socialist Republics. (USSR),. was a transcontinental country that spanned much of Eurasia from 1922 to 1991. A flagship communist state, it was nominally a federal union of fifteen national ...
in an arms race which ended with the latter's bankruptcy, and at the same time, turned Japan into the world's largest creditor and the US the largest debtor, as well as swelled Japan's domestic debt (Japan sold its own currency to fund the buildup of dollar based assets). By end of 1980, foreign assets of Japan were about 13% of GDP but by the end of 1989 had reached an unprecedented 62%.
After 1997, nations in East and Southeast Asia began their massive build-up of forex reserves, as their levels were deemed too low and susceptible to the whims of the market credit bubbles and busts. This build-up has major implications for today's developed world economy, by setting aside so much cash that was piled into US and European debt, investment had been
crowded out, the developed world economy had effectively slowed to a crawl, giving birth to contemporary
negative interest rates
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
.
By 2007, the world had experienced yet another financial crisis, this time the US Federal Reserve organized
central bank liquidity swap Central bank liquidity swap is a type of currency swap used by a country's central bank to provide liquidity of its currency to another country's central bank. In a liquidity swap, the lending central bank uses its currency to buy the currency of an ...
s with other institutions. Developed countries authorities adopted extra expansionary monetary and fiscal policies, which led to the appreciation of currencies of some
emerging markets
An emerging market (or an emerging country or an emerging economy) is a market that has some characteristics of a developed market, but does not fully meet its standards. This includes markets that may become developed markets in the future or were ...
. The resistance to appreciation and the fear of lost
competitiveness
In economics, competition is a scenario where different economic firmsThis article follows the general economic convention of referring to all actors as firms; examples in include individuals and brands or divisions within the same (legal) firm ...
led to policies aiming to prevent inflows of capital and more accumulation of reserves. This pattern was called
currency war
Currency war, also known as competitive devaluations, is a condition in international affairs where countries seek to gain a trade advantage over other countries by causing the exchange rate of their currency to fall in relation to other currenc ...
by an exasperated Brazilian authority, and again in 2016 followed the
commodities collapse, Mexico had warned China of triggering currency wars.
Adequacy and excess reserves
The IMF proposed a new metric to assess reserves adequacy in 2011. The metric was based on the careful analysis of sources of outflow during crisis. Those liquidity needs are calculated taking in consideration the
correlation
In statistics, correlation or dependence is any statistical relationship, whether causal or not, between two random variables or bivariate data. Although in the broadest sense, "correlation" may indicate any type of association, in statistics ...
between various components of the balance of payments and the probability of tail events. The higher the ratio of reserves to the developed metric, the lower is the risk of a crisis and the drop in consumption during a crisis. Besides that, the Fund does
econometric analysis
Econometrics is the application of statistical methods to economic data in order to give empirical content to economic relationships. M. Hashem Pesaran (1987). "Econometrics," '' The New Palgrave: A Dictionary of Economics'', v. 2, p. 8 p. 8 ...
of several factors listed above and finds those reserves ratios are generally adequate among emerging markets.
Reserves that are above the adequacy ratio can be used in other government funds invested in more risky assets such as sovereign wealth funds or as insurance to time of crisis, such as
stabilization funds. If those were included,
Norway
Norway, officially the Kingdom of Norway, is a Nordic country in Northern Europe, the mainland territory of which comprises the western and northernmost portion of the Scandinavian Peninsula. The remote Arctic island of Jan Mayen and t ...
,
Singapore
Singapore (), officially the Republic of Singapore, is a sovereign island country and city-state in maritime Southeast Asia. It lies about one degree of latitude () north of the equator, off the southern tip of the Malay Peninsula, borde ...
and
Persian Gulf States
The Arab states of the Persian Gulf refers to a group of Arab states which border the Persian Gulf. There are seven member states of the Arab League in the region: Bahrain, Kuwait, Iraq, Oman, Qatar, Saudi Arabia, and the United Arab Emirates. ...
would rank higher on these lists, and
United Arab Emirates
The United Arab Emirates (UAE; ar, اَلْإِمَارَات الْعَرَبِيَة الْمُتَحِدَة ), or simply the Emirates ( ar, الِْإمَارَات ), is a country in Western Asia (The Middle East). It is located at th ...
' estimated $627 billion
Abu Dhabi Investment Authority
The Abu Dhabi Investment Authority ( ar, جهاز أبوظبي للاستثمار, ADIA) is a sovereign wealth fund owned by the Emirate of Abu Dhabi (in the United Arab Emirates) founded for the purpose of investing funds on behalf of the Gover ...
would be second after China. Apart from high foreign exchange reserves, Singapore also has significant government and sovereign wealth funds including
Temasek Holdings
Temasek Holdings (Private) Limited, or simply Temasek, is a Singaporean state holding company owned by the Government of Singapore. Incorporated on 25 June 1974, Temasek owns and manages a total of US$496.59 billion (S$671 billion) in assets u ...
(last valued at US$375 billion) and
GIC Private Limited
GIC Private Limited is a sovereign wealth fund in Singapore that manages its foreign reserves. Established by the Government of Singapore in 1981 as the Government of Singapore Investment Corporation, its mission is to preserve and enhance the ...
(last valued at US$440 billion).
ECN is a unique electronic communication network that links different participants of the Forex market: banks, centralized exchanges, other brokers and companies and private investors.
List of countries by foreign-exchange reserves
List of countries by foreign-exchange reserves (excluding gold)
See also
*
Balance of payments
In international economics, the balance of payments (also known as balance of international payments and abbreviated BOP or BoP) of a country is the difference between all money flowing into the country in a particular period of time (e.g., a ...
*
Endaka
Endaka ( ja, 円高, lit. ''yen expensive'') or ''Endaka Fukyo'' ( ja, 円高不況, lit. ''yen expensive recession'') is a state in which the value of the Japanese yen is high compared to other currencies. Since the economy of Japan is highly ...
*
Foreign-exchange reserves of China
The foreign exchange reserves of China are the state of foreign exchange reserves held by the mainland China, People's Republic of China, comprising cash, deposit account, bank deposits, bond (finance), bonds, and other financial assets denomin ...
*
Foreign-exchange reserves of India
India has large foreign-exchange reserves; holdings of cash, bank deposits, bonds, and other financial assets denominated in currencies other than India's national currency, the Indian rupee. The reserves are managed by the Reserve Bank of In ...
*
International Reserves of the Russian Federation
International Reserves of the Russian Federation are liquid assets held by Central Bank of Russia, the Russian Federation's central bank or other monetary authority in order to implement monetary policies relating to the country's currency exchange ...
*
Foreign exchange market
The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspec ...
*
Global assets under management
Global assets under management consists of assets held by asset management firms, pension funds, sovereign wealth funds, hedge funds
A hedge fund is a pooled investment fund that trades in relatively liquid assets and is able to make extensiv ...
References
External links
Sources
The World Factbook, CIA*
ttp://www.bcb.gov.br/?DAILYRESERVES Central Bank of Brazil – Daily updated foreign exchange reservesBank of Korea's top ten foreign exchange reserves holding countries monthly
Hong Kong Official Reserves Ranking
Articles
Guidelines for foreign exchange reserve managementAccompanying Document 1Document 2Appendix
* "
'" published by th
International Business Times AU
on 11 February 2011
A primer on exchange reserves
An empirical analysis of foreign exchange reserves in emerging Asia – December 2005
Foreign exchange reserves: issues in asia – January 2005
Foreign exchange reserves in east asia: why the high demand? – 25 April 2003
Optimal currency shares in international reserves
Are high foreign exchange reserves in emerging markets a blessing or a burden?
The adequacy of foreign exchange reserves
Are changes in foreign exchange reserves well correlated with official intervention?
Foreign exchange reserves buildup: business as usual
Compositional Analysis Of Foreign Currency Reserves In The 1999–2007 Period. The Euro Vs. The Dollar As Leading Reserve Currency
Speeches
Y V Reddy: India's foreign exchange reserves – policy, status and issues – 10 May 2002Marion Williams: foreign exchange reserves – how much is enough? – 2 November 2005
Books
* Eichengreen, Barry. Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System. Oxford University Press, USA, 2011.
{{DEFAULTSORT:Foreign Exchange Reserves
International macroeconomics
Macroeconomic indicators
Government finances