What are foreign exchange reserves?
Foreign exchange reserves are assets held in reserve by a central bank in foreign currencies. These reserves are used to cover liabilities and influence monetary policy. It includes any foreign money held by a central bank, such as the United States Federal Reserve.
Key points to remember
- Foreign exchange reserves are assets held in reserve by a central bank in foreign currencies, which may include bonds, treasury bills and other government securities.
- Most foreign exchange reserves are held in US dollars, with China being the largest holder of foreign exchange reserves in the world.
- Economists suggest that it is best to hold foreign exchange reserves in a currency that is not directly linked to the country’s currency.
U.S. foreign exchange reserves totaled $ 126 billion in February 2019, compared to $ 3 trillion in China.
How foreign exchange reserves work
Foreign exchange reserves can include banknotes, deposits, bonds, treasury bills and other government securities. These assets serve many purposes, but are mostly held to ensure that a central government agency has relief funds if their national currency quickly devalues or becomes insolvent together.
It is common practice in countries around the world for their central bank to hold a significant amount of reserves in their currencies. Most of these reserves are held in US dollars because it is the most traded currency in the world. It is not uncommon for foreign exchange reserves to also consist of the British pound (GBP), the euro (EUR), the Chinese yuan (CNY) or the Japanese yen (JPY).
Economists theorize that it is better to hold foreign exchange reserves in a currency that is not directly linked to the country’s currency in order to act as a barrier in the event of a market shock. However, this practice has become more difficult as currencies have become more nested as world trade has become easier.
Foreign exchange reserves are not only used to cover liabilities but also influence monetary policy.
Example of foreign exchange reserves
The largest holder of foreign exchange reserves in the world today is China, a country that holds more than $ 3 trillion in foreign currency assets. Most of their reserves are held in US dollars. This is mainly due to the fact that it facilitates international trade, since most of the trade is done using the US dollar.
Saudi Arabia also holds considerable foreign exchange reserves, as the country depends mainly on the export of its vast oil reserves. If oil prices start to drop quickly, their economy could suffer. They keep large amounts of foreign funds in reserves to serve as a cushion if this occurs, even if it is only a temporary solution.
Foreign exchange reserves of Russia are mainly held in US dollars, like the rest of the world, but the country also keeps some of its gold reserves. Since gold is a commodity with an underlying value, the risk of resorting to gold in the event of a Russian economic decline is that the value of gold will not be large enough to meet the country’s needs.
Another danger of using gold as a reserve is that the asset is only worth what someone else is willing to pay for it. In an economic crash, this would put the power to determine the value of the gold reserve, and therefore the financial downturn of Russia, in the hands of the entity willing to buy it.