Foreign exchange reserves
Foreign exchange reserves are cash and other reserve assets such as gold and silver held by a central bank or other monetary authority 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 and to a lesser extent the euro.
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 and from their storage, security costs, etc.
Definition
Foreign exchange reserves are also known as reserve assets and include foreign banknotes, foreign bank deposits, foreign treasury bills, and short and long-term foreign government securities, as well as gold reserves, special drawing rights, and International Monetary Fund reserve positions.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. In terms of financial assets classifications, 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, investment fund shares and other financial contracts. 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, 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.
A central bank which chooses to implement a fixed exchange rate policy may face a situation where supply and demand would tend to push the value of the currency lower or higher 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 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 regime. Milton Friedman was a strong advocate of flexible exchange rates, since he considered that independent monetary 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 than the whole set of prices of goods and wages of the economy, that are less flexible.
Mixed exchange rate regimes 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 monetary policy. Foreign exchange operations can be sterilized or unsterilized.
Non-sterilization will cause an expansion or contraction in the amount of domestic currency in circulation, and hence directly affect inflation 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 the domestic money supply is increasing, 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 is limited, a currency crisis or devaluation 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 operations to prevent inflation from rising. On the other hand, this is costly, since the sterilization is usually done by public debt instruments.
In practice, few central banks or currency regimes operate on such a simplistic level, and numerous other factors 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. 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.