Foreign exchange reserves

Lore & Background

Foreign exchange reserves assets can comprise banknotes, bank deposits, and government securities of the reserve currency, such as bonds and treasury bills. Some countries hold a part of their reserves in gold, and special drawing rights 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. In a central bank's accounts, foreign exchange reserves are called reserve assets in the capital account of the balance of payments, and may be labeled as reserve assets under assets by functional category. Reserve assets can be classified as gold bullion, unallocated gold accounts, special drawing rights, currency, reserve position in the IMF, interbank position, other transferable deposits, other deposits, debt securities, loans, company shares (listed and unlisted), investment fund shares and other financial contracts.

Reader's Guide

Foreign exchange reserves serve critical functions for a country's central bank, including supporting and maintaining confidence in national monetary and exchange rate management policies, limiting external vulnerability to shocks during crises, providing 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 allow a central bank to purchase the domestic currency, which is considered a liability for the central bank. The quantity of foreign exchange reserves can change as a central bank implements monetary policy, but this dynamic should be analyzed in the context of capital mobility, the exchange rate regime, and other factors—known as the trilemma or impossible trinity. In a pure flexible exchange rate regime, the central bank does not intervene, and reserves are theoretically unnecessary. However, even central banks that limit foreign exchange interventions may intervene to counter disruptive short-term movements, such as speculative attacks. The higher the reserves, the higher the capacity of the central bank to smooth volatility of the Balance of Payments and assure consumption smoothing in the long term. After the end of the Bretton Woods system in the early 1970s, many countries adopted flexible exchange rates, yet foreign reserves have shown a strong upward trend, growing more than gross domestic product.

Did You Know?

• Foreign exchange reserves are also called forex reserves or FX reserves.
• Reserves are held in one or more reserve currencies, mostly the United States dollar and to a lesser extent the euro.
• Normally, interest is not paid on foreign cash reserves, nor on gold holdings, but the central bank usually earns interest on government securities.
• In a pure flexible exchange rate regime, the central bank does not intervene in the exchange rate dynamics, and reserves are theoretically not necessary.