Foreign exchange reserve or foreign reserve refers to the foreign currencies held by the central bank or other monetary authority of a country. It can be in the form of cash or assets that can be liquidated. There are numerous reasons why maintaining a good foreign exchange reserve is important, the most crucial being safeguarding the value of the local currency.
We are part of a global economy where trade is done beyond boundaries. A country’s foreign exchange reserves depend on its total imports and exports. A local exporter is paid by its trading partner in USD, CAD, Euros, or any other currency. This foreign currency is deposited by the trader into his local bank and in exchange, he receives local currency which he can use for his day-to-day transactions. The local bank, then, transfers the foreign currency to the central bank.
How are Foreign Exchange Reserves Accumulated?
Similarly, when a country imports any commodity, it has to pay the other country or the foreign trader in their respective currency. This leads to a decline in foreign exchange reserves. Thus, to accumulate foreign exchange reserves, a country needs to increase its exports and decrease its imports.
Why Foreign Exchange Reserves are Important?
The importance of foreign exchange reserves for developing countries is based on the security of positions of home currency, economic growth boost, maintain liquidity in economic crisis, attract foreign investments, fund infrastructure projects, etc.
Maintaining a foreign exchange reserve is important for every nation. Whether developing or developed, every country makes calculated moves to ensure that its foreign reserves never see a fall. There are seven reasons why these reserves are important:
1. To Secure the Position of Home Currency
One of the most advantageous positions that a country with considerable foreign exchange reserves enjoys is the security of their currency. These reserves maintain the value of the home currency at a fixed rate. It safeguards the home currency against devaluation. It also promotes sales. For example, China pegs the value of the yuan against USD. By stockpiling USD, it raises the value of the dollar compared to the yuan, thus, increasing their sales as Chinese exports become cheaper than American-made goods.
2. To Boost Economic Growth
Some countries with a floating exchange rate system use foreign exchange reserves to keep the value of their currency lower than USD. For example, Japan, with its floating currency, yen, buys U.S. treasuries to keep yen’s value lowers than USD. This encourages exports that leads to economic growth.
3. To Maintain Liquidity in Economic Crisis
Maintaining a foreign exchange reserve allows a country to import necessary commodities that are otherwise not getting produced locally due to crises like a volcanic eruption or a flood. In such cases, the central bank aids the local exporter by liquidating its foreign reserve. The bank exchanges foreign currency to the local currency, enabling domestic exporters to import important items.
Similarly, situations like wars, military coup, or political instability can make foreign investors apprehensive about investing in an unstable country. This can promote them to withdraw their deposits from the country’s bank, creating a shortage of foreign currency. This can lead to inflation as imports will become expensive. If a country has enough foreign currency, such situations can be avoided.
4. To Attract Foreign Investment
‘Money brings brings’. This statement holds true when we are talking about foreign exchange reserves. Every country needs foreign investment for economic growth. To provide confidence to the foreign investors, the central bank uses foreign reserves as leverage. It assures the investors that their investments will be protected.
5. To Meet External Obligations
Importance of foreign exchange reserves for developing countries in incalculable, but this point is the most crucial one. Countries require foreign currency to settle international payments, including sovereign and commercial debts. Developing countries depend on financing and loans from international monetary authorities. If these countries don’t have enough foreign balance, it can reduce their borrowing powers.
6. To Fund Infrastructural Development
The importance of foreign reserves is not limited to financial interaction with foreign countries. Various countries use their reserves to fund their infrastructure sector as well. For example, China recapitalized some of its state-owned banks using its reserves.
7. To Boost Returns
To boost returns without compromising safety, many countries hold various interest-bearing investments. This can be in the form of gold, treasury bonds, or other assets that can be liquidated easily.
Key Points of Foreign Exchange Reserves
- These can be stocked in the form of banknotes, treasury bills, bonds, deposits, and other government securities.
- These work as emergency funds for a country in case of uncertainties like floods, volcanic eruptions, wars, etc.
- USD, the global currency, is the most preferred currency of foreign exchange reserves. China is the leader in holding the highest foreign reserves in USD.
- These are required to maintain the value of the local currency, maintain competitively priced imports, and to assure foreign investors.
- These are required to maintain the borrowing power of a country and to settle international debts.
What are the Guidelines?
Ideally, a country must have enough foreign exchange reserves to support three to six months of imports of essential commodities like food. It should have a reserve surplus to settle its debt payments and current account deficit of 12 months. In 2015, when Greece faced economic crises, it used its reserves with the IMF to repay the European Central Bank.
Countries and Foreign Exchange Reserves
Countries with large trade surplus are on the top of this list. Since their exports are higher than their imports, they end up stockpiling dollars.
As of 31st December 2017, there are several countries with foreign exchange reserves of more than $100 billion, with China being the leading country with a reserve of $3,236 billion. Its major export is consumer goods and parts. It is followed by Japan that has reserves of $1,264.0 billion following exports of auto parts, and consumer products. Saudi Arabia made it to the list by being an exporter of oil. By exporting manufactured goods, and chemicals, the United Kingdom has a reserve of $150.8 billion. The United States, too, exports manufactured goods and chemicals. It has foreign exchange reserves worth $123.3 billion.
Other countries on this list are the European Union, Switzerland, Taiwan, Russia, Hong Kong, India, South Korea, Brazil, Singapore, Thailand, Germany, Mexico, France, Italy, Czech Republic, Indonesia, Iran, Poland, Israel, Turkey, and Malaysia.