Foreign Exchange Reserves: Composition, Importance, Impacts on Economy

What’s it: Foreign exchange reserves are liquid assets denominated in foreign currency held by the central bank or government for future use. This includes reserves in hard currency (such as dollars, euros, and yen), government securities (domestic and foreign), special drawing rights, etc. They are useful for fulfilling financial obligations in international transactions. The central bank can also use it for monetary operations, such as intervening in the foreign exchange market.

By far, China is the country with the largest foreign exchange reserves, much larger than Japan, the country with the second-largest foreign exchange reserves. China’s foreign exchange reserves reached $ 3.17 trillion in 2019, while Japan had $1.3 trillion. The following is a list of 100 countries with the largest foreign exchange reserves in 2019.

Importance of foreign exchange reserves

Foreign exchange reserves are essential to fulfill international trade obligations, foreign payments, or during emergencies, such as crises. Countries use it to maintain domestic economic stability. The central bank or monetary authority needs it to carry out monetary policy, both for market operations and maintaining rupiah stability.

In general, foreign exchange reserves are essential for several reasons:

• Support the payment of foreign obligations such as imports and foreign debt
• Intervening in the exchange rate market by maintaining foreign currency liquidity to absorb shocks during times of crisis.
• Providing confidence in the financial market, particularly about a country’s creditworthiness (sovereign rating).

Composition of foreign exchange reserves

Central banks manage the foreign exchange reserve. They use it to support the exchange rate and carry out monetary policy. A fixed or managed floating exchange rate system requires sufficient foreign exchange reserve to credibly intervene in domestic currency exchange rates.

The foreign exchange reserve component consists of hard currencies, widely used in international markets such as the US dollar, Euro, British pound (GBP), and the Japanese yen. Other components are deposits, securities of other countries (such as the US Treasury), special drawing rights (SDR), and financial derivatives.

China, for example, keeps some of its foreign exchange reserves in US government debt securities. Its value reached $ 1.06 trillion as of September 2020, or the second largest after Japan.

As of the second quarter of 2020, the US dollar was the main currency in currency composition. It accounted for approximately 57.9% of total foreign reserves in the world. Here is the list:

The US dollar is the de facto global currency for most international transactions. Most international transactions continue to use it even though the United States is not a party to the transaction. Besides, most commodity markets (such as crude oil and gold) use the US dollar as a reference price.

One of the reasons the US dollar is becoming a global currency is because the United States is home to the benchmark global financial markets. It is also considered to have a strong economy, law, and politics, both domestically and globally. As a result, the US dollar is a relatively stable currency, so there is no need to worry about its value fluctuations.

How foreign exchange reserves affect the economy

Foreign exchange reserves affect central bank intervention’s credibility in the exchange rate market, especially under a fixed or managed floating exchange rate. Its insufficiency will result in the exchange rate moving out of control when speculative attacks occur.

The exchange rate ultimately affects other macroeconomic variables such as exports, imports, international investment, foreign debt, interest rates, economic growth, and inflation. A sharp appreciation of the exchange rate, for example, makes export products less competitive because they are more expensive. This can disrupt domestic production, mainly if producers rely on sales from exports. On the other hand, imported raw materials and capital goods are cheaper, thereby reducing imported inflation.

In short, the drastic change in the exchange rate disrupts macroeconomic stability. This prompted the central bank to intervene using foreign exchange reserves.

Accumulated foreign exchange reserves also affect a country’s credibility in meeting international obligations such as foreign debt. When the global crisis occurs, sovereign risk increases. Countries with large debts should be forced to allow their currencies to depreciate. Or, they withdraw their foreign currency reserves to refinance their debt.

How foreign exchange reserves affect exchange rates

Foreign exchange reserves act as a damper when external factors, such as speculation, jeopardize the exchange rate and economic stability. The central bank uses it to maintain a stable exchange rate.

Under a fixed exchange rate, the intervention’s credibility depends on a country’s foreign exchange reserves. When insufficient, the exchange rate is vulnerable and is likely to move away from the target. The central bank will sell or buy foreign currency depending on exchange rate movements to intervene in the market.

When the domestic currency depreciates, many people sell the domestic currency and exchange it for foreign currency. The central bank then sells its foreign currency reserves (say US dollars) to buy the domestic currency. That increases the demand for domestic currency. Thus, the depreciation pressure on the domestic currency eases.

On the other hand, when the domestic currency appreciates, the demand for domestic currency increases. The central bank will buy US dollars in exchange for domestic currency. Finally, the supply of domestic currency increases and reduces appreciation pressure.

When a country does not have sufficient or depleted foreign exchange reserves, the central bank is forced to devalue or revaluate the domestic currency. Devaluation is a deliberate depreciation under a fixed exchange rate regime. The opposite is revaluation, that is, intentional appreciation. Devaluation causes export products to be cheap but imported goods to be expensive. On the other hand, revaluation causes export products to be expensive but imported products to become cheaper.

Devaluation may not have to occur when foreign reserves run out. A country may deliberately use it as a strategy in international trade. The country weakens its currency to increase the competitiveness of domestic products in international markets. China is one of the countries running it, enabling it to become the country with the world’s largest trade surplus.

How do foreign exchange reserves increase

Two sources of increased foreign exchange reserves come from:

• Trade surplus
• International investment surplus

A trade surplus is when exports exceed imports. Through exports, the domestic economy collects foreign currency as payment. In contrast, the domestic economy requires foreign currency to pay for imports. Thus, when exports exceed imports, the economy gains more foreign currency. The central bank then absorbs the supply of foreign currency as foreign exchange reserves.

The factors driving the trade surplus vary between countries. Oil exporting countries will see an increase in foreign reserves as long as crude oil prices skyrocket. This makes oil exports far exceed imports. On the other hand, oil-importing countries will suffer deficits and see their foreign reserves decline.

The international investment surplus occurs when foreign investment to domestic is more significant than domestic investment abroad. Foreigners bring foreign currency into the domestic market and increase the demand for domestic currency. The central bank sells domestic currency and accepts foreign currency in return.

The return spread between the domestic market and the international market is a factor affecting international investment. Economists usually use interest rate spreads to explain this. Besides, fundamental economic factors, such as economic growth and the investment climate, are other factors, especially the direct investments.