Foreign exchange reserves
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Foreign exchange reserves (also called Forex reserves) in a strict sense are only the foreign currency deposits held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, SDRs and IMF reserve positions. This broader figure is more readily available, but it is more accurately termed official reserves or international reserves. These are assets of the central bank held in different reserve currencies, such as the dollar, euro and yen, and used to back its liabilities, e.g. the local currency issued, and the various bank reserves deposited with the central bank, by the government or financial institutions.
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[edit] History
Reserves were formerly held only in gold, as official gold reserves. Under the Bretton Woods system, the United States pegged the dollar to gold, and allowed convertibility of dollars to gold. This effectively made dollars appear as good as gold. In 1971, however, the U.S. abandoned the convertibility of dollars to gold, and the dollar became a fiat currency. Since then, all major currencies have removed convertibility to gold, resulting in a general devaluation of world currencies over time. The dollar has remained the most significant reserve currency, though central banks now typically hold large amounts of multiple currencies in reserve.
[edit] Purpose
In a non fixed exchange rate system, reserves allow a central bank to purchase the issued currency, exchanging its assets to reduce its liability. The purpose of reserves is to allow central banks an additional means to stabilise the issued currency from excessive volatility, and protect the monetary system from shock, such as from currency traders engaged in flipping. Large reserves are often seen as a strength, as it indicates the backing a currency has. Low or falling reserves may be indicative of an imminent bank run on the currency or default, such as in a currency crisis. Central banks sometimes claim that holding large reserves is a security measure. This is true to the extent that a central bank can prop up its own currency by spending reserves. (This practice is essentially large-scale manipulation of the global currency market. Central banks have sometimes attempted this in the years since the 1971 collapse of the Bretton Woods system. A few times, multiple central banks have cooperated to attempt to manipulate exchange rates. It is unclear just how effective the practice is.) But often, very large reserves are not a hedge against inflation but rather a direct consequence of the opposite policy: the bank has purchased large amounts of foreign currency in order to keep its own currency relatively cheap.
[edit] Changes in reserves
The quantity of foreign exchange reserves can change as a central bank implements monetary policy. A central bank that implements 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 (an increase in demand for the currency would tend to push its value higher, and a decrease lower). In a fixed exchange rate regime, these operations occur automatically, with the central bank clearing any excess demand or supply by purchasing or selling the foreign currency. Mixed exchange rate regimes ('dirty floats', target bands or similar variations) may require the use of foreign exchange operations (sterilized or unsterilized[clarify]) to maintain the targeted exchange rate within the prescribed limits.
Foreign exchange operations that are unsterilized will cause an expansion or contraction in the amount of domestic currency in circulation, and hence directly affect monetary policy and inflation: An exchange rate target cannot be independent of an inflation target. Countries that do not target a specific exchange rate are said to have a floating exchange rate, and allow the market to set the exchange rate; for countries with floating exchange rates, other instruments of monetary policy are generally preferred and they may limit the type and amount of foreign exchange interventions. Even those central banks that strictly limit foreign exchange interventions, however, often recognize that currency markets can be volatile and may intervene to counter disruptive short-term movements.
To maintain the same exchange rate if there is increased demand, the central bank can issue more of the domestic currency and purchase the foreign currency, which will increase the sum of foreign reserves. In this case, the currency's value is being held down; since (if there is no sterilization) the domestic money supply is increasing (money is being 'printed'), this may provoke domestic inflation (the value of the domestic currency falls relative to the value of goods and services).
Since the amount of foreign reserves available to defend a weak currency (a currency in low demand) is limited, a foreign exchange crisis or devaluation could be the end result. For a currency in very high and rising demand, foreign exchange reserves can theoretically be continuously accumulated, although eventually the increased domestic money supply will result in inflation and reduce the demand for the domestic currency (as its value relative to goods and services falls). In practice, some central banks, through open market operations aimed at preventing their currency from appreciating, can at the same time build substantial reserves.
In practice, few central banks or currency regimes operate on such a simplistic level, and numerous other factors (domestic demand, production and productivity, imports and exports, relative prices of goods and services, etc) will affect the eventual outcome. As certain impacts (such as inflation) can take many months or even years to become evident, changes in foreign reserves and currency values in the short term may be quite large as different markets react to imperfect data.
[edit] Costs, Benefits, and Criticisms
Large reserves of foreign currency allow a government to manipulate exchange rates - usually to stabilize the foreign exchange rates to provide a more favorable economic environment. In theory the manipulation of foreign currency exchange rates can provide the stability that a gold standard provides, but in practice this has not been the case.
There are costs in maintaining large currency reserves. Fluctuations in exchange markets result in gains and losses in the purchasing power of reserves. Even in the absence of a currency crisis, fluctuations can result in huge loses. For example, China holds huge U.S. dollar-denominated assets, but the greenback has been weakening on the exchange markets, resulting in a relative loss of wealth. In addition to fluctuations in exchange rates, the purchasing power of fiat money 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 manipulate exchange rates. Reserves of foreign currency provide a small return in interest. 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.
[edit] Excess reserves
Foreign exchange reserves are important indicators of ability to repay foreign debt and for currency defense, and are used to determine credit ratings of nations, however, other government funds that are counted as liquid assets that can be applied to liabilities in times of crisis include stabilization funds, otherwise known as Sovereign wealth funds. If those were included, Norway and Persian Gulf States would rank higher on these lists, and UAE's $1.3 trillion Abu Dhabi Investment Authority would be second after China. Singapore also has significant government funds including Temasek Holdings and GIC. India is also planning to create its own investment firm from its foreign exchange reserves.
[edit] Levels
At the end of 2007, 63.90% of the identified official foreign exchange reserves in the world were held in United States dollars and 26.5% in euros [1].
Monetary Authorities with the largest foreign reserves in 2008.
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Note:
- Note 1: China updates its information quarterly.
- Note 2: Russia and India update their information weekly and monthly.
- Note 3: Brazil updates its information daily.
These few holders account for more than 60% of total world foreign currency reserves. The adequacy of the foreign exchange reserves is more often expressed not as an absolute level, but as a percentage of short-term foreign debt, money supply, or average monthly imports.
[edit] See also
- Balance of payments
- Endaka
- Global assets under management
- List of countries by foreign exchange reserves
- Official gold reserves
- Reserve currency
- Sovereign wealth funds
- Special Drawing Rights
[edit] External links
[edit] Source
- IMF's data on current foreign exchange reserves of reporting countries
- The World Factbook, CIA
- Taiwan's Department of Investment Services data on foreign exchange reserves of major countries
- Bank of Korea's top ten foreign exchange reserves holding countries monthly
- Hong Kong Official Reserves Ranking
- European Central Bank data on eurosystem reserves
[edit] Articles
- Guidelines for foreign exchange reserve management Accompanying Document 1 Document 2 Appendix
- 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? -- April 25, 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
[edit] Speeches
- Alan Greenspan: discusses recent trends in the management of foreign exchange reserves -- April 29, 1999
- Y V Reddy: India’s foreign exchange reserves - policy, status and issues -- May 10, 2002
- Marion Williams: foreign exchange reserves - how much is enough? -- November 2, 2005
- Lawrence H. Summers: Reflections on global account imbalances and emerging markets reserve accumulation -- March 24, 2006
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