Foreign exchange reserves (also referred to as Forex reserves) in a strict sense are only the foreign currency deposits and bonds that are held by central banks and monetary authorities. However, commonly foreign exchange and gold, SDRs and IMF reserve positions are included in the term in popular usage.
This broader figure is more readily available, but more accurately it is referred to as official international reserves or international reserves. These are assets of the central bank that the central bank holds in different reserve currencies, mostly in the US dollar, and to a lesser extent in the euro, the UK pound, and the Japanese yen, and it is used to back its liabilities, e.g. the local currency issued, and the various bank reserves that are deposited with the central bank, by the government or financial institutions.
History
Official international reserves, that were the means of official international payments, formerly consisted only of gold, and occasionally silver. But under the Bretton Woods system, the US dollar functioned as a reserve currency, so the US dollar also became part of a nation’s official international reserve assets. From 1944-1968, through the Federal Reserve System the US dollar was convertible into gold, but after 1968 only central banks were able to convert dollars into gold from official gold reserves, and after 1973 no individual or institution has the permission to convert US dollars into gold from official gold reserves.
No major currencies have been convertible into gold from official gold reserves since 1973. Now in order to buy gold, Individuals and institutions have to go to the private markets, just like when they have to buy other commodities they go to market. Although, US dollars and other currencies can no longer be convertible into gold from official gold reserves, but still they can function as official international reserves.
Purpose
In a flexible exchange rate system, central bank are allowed by the official international reserve assets to purchase the domestic currency, and it is considered as a liability for the central bank (since it prints the money itself as IOUs). This action of central bank can stabilize the value of the domestic currency.
Throughout the world Central banks have sometimes shown cooperation in buying and selling official international reserves in order to influence exchange rates.
Changes in Reserves
As the monetary policy is implemented by the Central bank, the quantity of foreign exchange reserves can change. If a fixed exchange rate policy is implemented by central bank then it 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 vise versa). In a flexible exchange rate regime, these operations takes place automatically, and in the with flexible exchange rate regime the central bank clear any excess demand or supply by purchasing or selling the foreign currency. The use of foreign exchange operations (sterilized or unsterilized) are required for mixed exchange rate regimes (‘dirty floats’, target bands or similar variations) in order to maintain the targeted exchange rate within the prescribed limits (China has been repeatedly accused of doing this by the USA).
Unsterilized foreign exchange operations will cause an expansion or contraction in the amount of domestic currency that is circulating, and hence this will have a direct effect on monetary policy and inflation: An exchange rate target cannot be independent of an inflation target. Countries by which a specific exchange rate is not targeted are said to have a floating exchange rate, and it will allow the market to set the exchange rate; for countries that are having floating exchange rates, generally it is preferred to have other instruments of monetary policy and the type and amount of foreign exchange interventions may be limited by them. Even those central banks by which foreign exchange interventions are strictly limited, however, often recognize that the currency markets can be volatile and they may intervene to counter disruptive short-term movements.
If there is increased demand then in order to maintain the same exchange rate, the central bank can issue more of the domestic currency and purchase the foreign currency, by doing this the sum of foreign reserves will be increased. In this case, the currency’s value is being held down; since (if there is no sterilization) there is an increase in the domestic money supply (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 there is a limited availability of the amount of foreign reserves to defend a weak currency (a currency in low demand), a foreign exchange crisis or devaluation could be the end result. For a currency that is in very high and rising demand, foreign exchange reserves can theoretically be accumulated continuously, although inflation will be the result of increased domestic money supply and it will reduce the demand for the domestic currency (as its value relative to goods and services falls). In practice, through open market operations some central banks, 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 the eventual outcome will be effected by numerous other factors (domestic demand, production and productivity, imports and exports, relative prices of goods and services, etc). As it will take months or even years for certain impacts (such as inflation) 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.
Costs, Benefits, and Criticisms
Due to large reserves of foreign currency a government is allowed to manipulate exchange rates, this is usually done by the government to stabilize the foreign exchange rates in order to provide a more favorable economic environment. Theoretically the stability can be provided by the manipulation of foreign currency exchange rates, but in practice this has not been the case.
There are costs for maintaining large currency reserves. If there are fluctuations in exchange markets then this will result in gains and losses in the purchasing power of reserves. Fluctuations can result in huge losses, even though there is an absence of a currency crisis. For example, huge U.S. dollar-denominated assets are being held by China, but the U.S. dollar has been weakening on the exchange markets, which will result in a relative loss of wealth. In addition to fluctuations in exchange rates, there would be a constant decrease in the purchasing power of fiat money due to devaluation through inflation. Therefore, it is required that a central bank must continually increase the amount of its reserves in order to maintain the same power for manipulating exchange rates. A small return in interest is provided by the reserves of foreign currency. Despite of all the facts, this may be less than the reduction in purchasing power of that currency over the same period of time due to inflation, which will effectively result in a negative return that is known as the “quasi-fiscal cost”. In addition to this, there could have been an investment in higher yielding assets if there would be large currency reserves.
Excess Reserves
Foreign exchange reserves serves as an important indicators of the ability to repay foreign debt and for currency defense, and they are used to determine credit ratings of nations, however, there are other government funds that are counted as liquid assets and that can be applied to liabilities in times of crisis, these government funds include stabilization funds, that are otherwise known as sovereign wealth funds. If we include them then,on these lists Norway and Persian Gulf States would rank higher, and UAE’s $1.3 trillion Abu Dhabi Investment Authority would be second after China. Singapore also posses significant government funds that includes Temasek Holdings and GIC.
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