Foreign Exchange Reserves and How They Work

Foreign exchange reserves are the foreign currencies held by a country's central bank. They are also called foreign currency reserves or foreign reserves. There are seven reasons why banks hold reserves. The most important reason is to manage their currencies' values.

How Foreign Exchange Reserves Work

The country's exporters deposit foreign currency into their local banks. They transfer the currency to the central bank. Exporters are paid by their trading partners in U.S. dollars, euros, or other currencies. The exporters exchange them for the local currency. They use it to pay their workers and local suppliers.

The banks prefer to use the cash to buy sovereign debt because it pays a small interest rate. The most popular are Treasury bills because most foreign trade is done in the U.S. dollar due to its status as the world's global currency.

Banks are increasing their holdings of euro-denominated assets, such as high-quality corporate bonds. That continued despite the eurozone crisis. They'll also hold gold and special drawing rights. A third asset is any reserve balances they've deposited with the International Monetary Fund.

Purpose

There are seven ways central banks use foreign exchange reserves.

First, countries use their foreign exchange reserves to keep the value of their currencies at a fixed rate. A good example is China, which pegs the value of its currency, the yuan, to the dollar. When China stockpiles dollars, it raises the dollar value compared to that of the yuan. That makes Chinese exports cheaper than American-made goods, increasing sales.

Second, those with a floating exchange rate system use reserves to keep the value of their currency lower than the dollar. They do this for the same reasons as those with fixed-rate systems. Even though Japan's currency, the yen, is a floating system, the Central Bank of Japan buys U.S. Treasurys to keep its value lower than the dollar. Like China, this keeps Japan's exports relatively cheaper, boosting trade and economic growth. Such currency trading takes place in the foreign exchange market.

A third and critical function is to maintain liquidity in case of an economic crisis. For example, a flood or volcano might temporarily suspend local exporters' ability to produce goods. That cuts off their supply of foreign currency to pay for imports. In that case, the central bank can exchange its foreign currency for their local currency, allowing them to pay for and receive the imports.

Similarly, foreign investors will get spooked if a country has a war, military coup, or other blow to confidence. They withdraw their deposits from the country's banks, creating a severe shortage in foreign currency. This pushes down the value of the local currency since fewer people want it. That makes imports more expensive, creating inflation. 

The central bank supplies foreign currency to keep markets steady. It also buys the local currency to support its value and prevent inflation. This reassures foreign investors, who return to the economy. 

 A fourth reason is to provide confidence. The central bank assures foreign investors that it's ready to take action to protect their investments. It will also prevent a sudden flight to safety and loss of capital for the country. In that way, a strong position in foreign currency reserves can prevent economic crises caused when an event triggers a flight to safety. 

Fifth, reserves are always needed to make sure a country will meet its external obligations. These include international payment obligations, including sovereign and commercial debts. They also include financing of imports and the ability to absorb any unexpected capital movements.

Sixth, some countries use their reserves to fund sectors, such as infrastructure. China, for instance, has used part of its forex reserves for recapitalizing some of its state-owned banks. 

Seventh, most central banks want to boost returns without compromising safety. They know the best way to do that is to diversify their portfolios. They'll often hold gold and other safe, interest-bearing investments.

Guidelines

How much are enough reserves? At a minimum, countries have enough to pay for three to six months of imports. That prevents food shortages, for example.

Another guideline is to have enough to cover the country's debt payments and current account deficits for 12 months. In 2015, Greece was not able to do this. It then used its reserves with the IMF to make a debt payment to the European Central Bank. The huge sovereign debt the Greek government incurred led to the Greek debt crisis.

By Country

The countries with the largest trade surpluses are the ones with the greatest foreign reserves. They wind up stockpiling dollars because they export more than they import. They receive dollars in payment. 

Here are the countries with reserves of more than $100 billion as of December 31, 2017:

Source: CIA World Factbook, "Reserves of Foreign Exchange and Gold."

Frequently Asked Questions (FAQs)