Foreign reserves
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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 book-keeping and financial accounting, cash is current assets comprising currency or currency equivalents that can be accessed immediately or near-i ...
and other reserve assets such as
gold Gold is a chemical element; it has chemical symbol Au (from Latin ) and atomic number 79. In its pure form, it is a brightness, bright, slightly orange-yellow, dense, soft, malleable, and ductile metal. Chemically, gold is a transition metal ...
and
silver Silver is a chemical element; it has Symbol (chemistry), symbol Ag () and atomic number 47. A soft, whitish-gray, lustrous transition metal, it exhibits the highest electrical conductivity, thermal conductivity, and reflectivity of any metal. ...
held by a
central bank A central bank, reserve bank, national bank, or monetary authority is an institution that manages the monetary policy of a country or monetary union. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the mo ...
or other
monetary authority A central bank, reserve bank, national bank, or monetary authority is an institution that manages the monetary policy of a country or monetary union. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the monet ...
that are primarily available to
balance 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 ...
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 (Currency symbol, symbol: Dollar sign, $; ISO 4217, currency code: USD) is the official currency of the United States and International use of the U.S. dollar, several other countries. The Coinage Act of 1792 introdu ...
and to a lesser extent the
euro The euro (currency symbol, symbol: euro sign, €; ISO 4217, currency code: EUR) is the official currency of 20 of the Member state of the European Union, member states of the European Union. This group of states is officially known as the ...
. Foreign exchange reserves assets can comprise
banknotes A banknote or bank notealso called a bill (North American English) or simply a noteis a type of paper money that is made and distributed ("issued") by a bank of issue, payable to the bearer on demand. Banknotes were originally issued by commer ...
,
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 occ ...
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 a supplement to taxation. Since 2012, the U.S. ...
s. Some countries hold a part of their reserves in
gold Gold is a chemical element; it has chemical symbol Au (from Latin ) and atomic number 79. In its pure form, it is a brightness, bright, slightly orange-yellow, dense, soft, malleable, and ductile metal. Chemically, gold is a transition metal ...
, 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 cost In microeconomic theory, the opportunity cost of a choice is the value of the best alternative forgone where, given limited resources, a choice needs to be made between several mutually exclusive alternatives. Assuming the best choice is made, ...
s from holding the reserve assets (especially cash holdings) and from their storage, security costs, etc.


Definition

Foreign exchange reserves are also known as reserve assets and include foreign
banknote A banknote or bank notealso called a bill (North American English) or simply a noteis a type of paper money that is made and distributed ("issued") by a bank of issue, payable to the bearer on demand. Banknotes were originally issued by commerc ...
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 a supplement to taxation. Since 2012, the U.S. ...
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 funded by 191 member countries, with headquarters in Washington, D.C. It is regarded as the global lender of las ...
(IMF) reserve positions. In a central bank's accounts, foreign exchange reserves are called
reserve asset 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 ...
s 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 Foreign direct investment, investment into an economy. It is one of the two primary components of the balan ...
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 known as gold bullion or a gold ingot, is a quantity of refining, refined metallic gold that can be shaped in various forms, produced under standardized conditions of manufacture, labeling, and record-keeping. Larger varietie ...
, 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 tender of money by one party to another with an agreement to pay it back. The recipient, or borrower, incurs a debt and is usually required to pay interest for the use of the money. The document evidencing the deb ...
s,
stock Stocks (also capital stock, or sometimes interchangeably, shares) consist of all the Share (finance), shares by which ownership of a corporation or company is divided. A single share of the stock means fractional ownership of the corporatio ...
s (listed and unlisted), investment fund shares and financial
derivative In mathematics, the derivative is a fundamental tool that quantifies the sensitivity to change of a function's output with respect to its input. The derivative of a function of a single variable at a chosen input value, when it exists, is t ...
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 in the contract, making it a type of derivative instrument.John C Hu ...
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

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 is a type of government-issued currency that is not backed by a precious metal, such as gold or silver, nor by any other tangible asset or commodity. Fiat currency is typically designated by the issuing government to be legal tender, ...
as
IOU An IOU (Abbreviation, abbreviated from the phrase "I owe you") is usually an informal document acknowledging debt. An IOU differs from a promissory note in that an IOU is not a negotiable instrument and does not specify repayment terms such as th ...
s). 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 affect monetary and other financial conditions to accomplish broader objectives like high employment and price stability (normally interpreted as a low and stable rat ...
, 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 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 currency basket, basket of other currenc ...
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 or supplies 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 ...
and
demand In economics, demand is the quantity of a goods, good that consumers are willing and able to purchase at various prices during a given time. In economics "demand" for a commodity is not the same thing as "desire" for it. It refers to both the desi ...
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. 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 market ...
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 ...
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 anything that is good, usually in the sense that it provides welfare or utility to someone. Alan V. Deardorff, 2006. ''Terms Of Trade: Glossary of International Economics'', World Scientific. Online version: Deardorffs ...
and
wage A wage is payment made by an employer to an employee for work (human activity), work done in a specific period of time. Some examples of wage payments include wiktionary:compensatory, compensatory payments such as ''minimum wage'', ''prevailin ...
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 average price of goods and services in terms of money. This increase is measured using a price index, typically a consumer price index (CPI). When the general price level rises, each unit of curre ...
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 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 curre ...
could be the 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 exchange liquidity in its currency with a bank or a group of banks. The central bank can either transact government bonds and other financial assets in the ope ...
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 occu ...
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 proce ...
, 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 conta ...
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 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 relations among 44 countries, including the United States, Canada, Western European countries, and Australia, after the 1944 Bretton Woods Agreement until the ...
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 monetary measure of the total market value of all the final goods and services produced and rendered in a specific time period by a country or countries. GDP is often used to measure the economic performanc ...
(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 Credit risk is the chance that a borrower does not repay a loan In finance, a loan is the tender of money by one party to another with an agreement to pay it back. The recipient, or borrower, incurs a debt and is usually required to pay ...
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 government, governments, corporation, corporations or citizens. External debt may be denominated in domestic or f ...
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 group of people who have similar interests ( homophily), age, background, or social status. Members of peer groups are likely to influence each others' beliefs and behaviour. Durin ...
.


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 ...
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. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of ...
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. It ...
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 significan ...
, 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 is the process of increasing interdependence and integration among the economies, markets, societies, and cultures of different countries worldwide. This is made possible by the reduction of barriers to international trade, th ...
). 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 investment cover ...
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 p ...
(GATT) of 1948 to the foundation of the
World Trade Organization The World Trade Organization (WTO) is an intergovernmental organization headquartered in Geneva, Switzerland that regulates and facilitates international trade. Governments use the organization to establish, revise, and enforce the rules that g ...
(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 union, supranational political union, political and economic union of Member state of the European Union, member states that are Geography of the European Union, located primarily in Europe. The u ...
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 meas ...
s, except in an extraordinary situation. The dynamics of China's 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 a economic nationalism, nationalist economic policy that is designed to maximize the exports and minimize the imports of an economy. It seeks to maximize the accumulation of resources within the country and use those resources ...
, such as to protect the take-off in the tradable 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 (economics), consumption and saving over the course of their lives. The earliest work on the subject was by Irving Fisher and Roy Harrod ...
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 In economics, economic growth is an increase in the quantity and quality of the economic goods and Service (economics), services that a society Production (economics), produces. It can be measured as the increase in the inflation-adjusted Outp ...
literature. The argument is that the tradable sector of an economy is more capital intense than the non-tradable sector. The
private sector The private sector is the part of the economy which is owned by private groups, usually as a means of establishment for profit or non profit, rather than being owned by the government. Employment The private sector employs most of the workfo ...
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 is an indirect cost (external cost) or indirect benefit (external benefit) to an uninvolved third party that arises as an effect of another party's (or parties') activity. Externalities can be considered as unpriced ...
(like improvements in
human capital Human capital or human assets is a concept used by economists to designate personal attributes considered useful in the production process. It encompasses employee knowledge, skills, know-how, good health, and education. Human capital has a subs ...
, higher competition, technological spillovers and increasing returns to scale). The government could improve the equilibrium by imposing
subsidies A subsidy, subvention or government incentive is a type of government expenditure for individuals and households, as well as businesses with the aim of stabilizing the economy. It ensures that individuals and households are viable by having acce ...
and
tariff A tariff or import tax is a duty (tax), duty imposed by a national Government, government, customs territory, or supranational union on imports of goods and is paid by the importer. Exceptionally, an export tax may be levied on exports of goods ...
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 by manipulating the social or political environment without creating new wealth. 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 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), or sovereign investment fund, is a state-owned investment fund that invests in real and financial assets such as stocks, Bond (finance), bonds, real estate, precious metals, or in alternative investments such as ...
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 is a type of government-issued currency that is not backed by a precious metal, such as gold or silver, nor by any other tangible asset or commodity. Fiat currency is typically designated by the issuing government to be legal tende ...
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 debtor 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 f ...
. 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; ; ; ; ) is the central bank of Switzerland, responsible for the nation's monetary policy and the sole issuer of Swiss franc banknotes. The primary goal of its mandate is to ensure price stability, while taking econ ...
, the central bank of Switzerland. The Swiss franc is regarded as a safe haven currency, 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 crisis, often also referred to as the eurozone crisis, European debt crisis, or European sovereign debt crisis, was a multi-year debt crisis and financial crisis in the European Union (EU) from 2009 until, in Greece, 2018. The ...
, the
Swiss franc The Swiss franc, or simply the 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) iss ...
(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, also referred to as the Austro-Hungarian Empire, the Dual Monarchy or the Habsburg Monarchy, was a multi-national constitutional monarchy in Central Europe#Before World War I, Central Europe between 1867 and 1918. A military ...
,
Belgium Belgium, officially the Kingdom of Belgium, is a country in Northwestern Europe. Situated in a coastal lowland region known as the Low Countries, it is bordered by the Netherlands to the north, Germany to the east, Luxembourg to the southeas ...
,
Canadian Confederation Canadian Confederation () 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 Name of Canada#Adoption of Dominion, Dominion of Ca ...
,
Denmark Denmark is a Nordic countries, Nordic country in Northern Europe. It is the metropole and most populous constituent of the Kingdom of Denmark,, . also known as the Danish Realm, a constitutionally unitary state that includes the Autonomous a ...
,
Grand Duchy of Finland The Grand Duchy of Finland was the predecessor state of modern Finland. It existed from 1809 to 1917 as an Autonomous region, autonomous state within the Russian Empire. Originating in the 16th century as a titular grand duchy held by the Monarc ...
,
German Empire The German Empire (),; ; World Book, Inc. ''The World Book dictionary, Volume 1''. World Book, Inc., 2003. p. 572. States that Deutsches Reich translates as "German Realm" and was a former official name of Germany. also referred to as Imperia ...
and Sweden-Norway. 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 to 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 "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 Kingdom of England, English Government's banker and debt manager, and still one ...
borrowed GBP 2 million from the
Bank of France The Bank of France ( ) is the national central bank for France within the Eurosystem. It was the French central bank between 1800 and 1998, issuing the French franc. It does not translate its name to English, and thus calls itself ''Banque de F ...
. The same was true for the Louvre Accord 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 1997 Asian financial crisis gripped much of East Asia, East and Southeast Asia during the late 1990s. The crisis began in Thailand in July 1997 before spreading to several other countries with a ripple effect, raising fears of a worldwide eco ...
, 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 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. 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 Union of Soviet Socialist Republics. (USSR), commonly known as the Soviet Union, was a List of former transcontinental countries#Since 1700, transcontinental country that spanned much of Eurasia from 1922 until Dissolution of the Soviet ...
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, ...
. By 2007, the world had experienced yet another financial crisis, this time the US Federal Reserve organized central bank liquidity swaps 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 we ...
. The resistance to appreciation and the fear of lost
competitiveness Competition is a rivalry where two or more parties strive for a common goal which cannot be shared: where one's gain is the other's loss (an example of which is a zero-sum game). Competition can arise between entities such as organisms, individ ...
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 relations, international affairs where countries seek to gain a trade advantage over other countries by causing the exchange rate of their currency to fall in r ...
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 an 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. 8â ...
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 fund A stabilization fund is a mechanism set up by a government or central bank to insulate the domestic economy from large influxes of revenue, as from commodities such as oil. A primary motivation is maintaining a steady level of government revenue in ...
s. If those were included,
Norway Norway, officially the Kingdom of Norway, is a Nordic countries, Nordic country located on the Scandinavian Peninsula in Northern Europe. The remote Arctic island of Jan Mayen and the archipelago of Svalbard also form part of the Kingdom of ...
,
Singapore Singapore, officially the Republic of Singapore, is an island country and city-state in Southeast Asia. The country's territory comprises one main island, 63 satellite islands and islets, and one outlying islet. It is about one degree ...
and Persian Gulf States would rank higher on these lists, and
United Arab Emirates The United Arab Emirates (UAE), or simply the Emirates, is a country in West Asia, in the Middle East, at the eastern end of the Arabian Peninsula. It is a Federal monarchy, federal elective monarchy made up of Emirates of the United Arab E ...
' estimated $627 billion Abu Dhabi Investment Authority 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 ( ) is a Singaporean State ownership, state-owned multinational investment firm. Incorporated on 25 June 1974, Temasek has a net portfolio of US$288 billion (S$389 billion) as of 2024. Headquartered at Orchard ...
(last valued at US$375 billion) and GIC (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


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 * Foreign-exchange reserves of China * Foreign-exchange reserves of India * International Reserves of the Russian Federation *
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. By trading volume, ...
* Global assets under management *
List of countries by foreign-exchange reserves Foreign exchange reserves, also called Forex reserves, in a strict sense, are foreign-currency deposits held by nationals and monetary authority, monetary authorities. However, in Populism, popular usage and in the list below, it also includes ...


References


External links


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 2002

Marion 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