What Are Foreign Exchange Reserves?

Foreign exchange reserves are the foreign assets or currencies held by the central bank of a particular country. The respective central banks often use the reserves to back their liabilities and influence monetary policies. So, they can manage their currency values.

The assets in the foreign exchange reserves are denominated in foreign currencies and not domestic currencies. For instance, the Canadian government bonds held by the U.S. Federal Reserve System are foreign assets for the United States.

If you’re interested in trading on the foreign exchange market, it’s crucial to understand how the foreign exchange reserves work. Thankfully, this guide will help you learn more.

How Foreign Exchange Reserves Operate

Foreign exchange reserves comprise foreign assets, which can be bonds, deposits, banknotes, treasury bills, or other government securities. While the assets serve various purposes, they are mainly held to act as backup for domestic currencies.

If the national currency depreciates rapidly or becomes insolvent, the central bank of the particular country can use the foreign exchange reserves as backup funds. Most central banks hold the reserves in the U.S. dollar as it’s the most traded currency worldwide.

An example of how the foreign exchange reserves come into action is when a country’s exporter deposits foreign currencies into their local banks. That is when the exporter gets paid in U.S. dollars or other currencies by their trading partners overseas.

The exporter will convert the funds to the local currency and pay their local workers and suppliers. On the other hand, the local banks will transfer the foreign currencies to the central bank for reservation after completing the transaction.

Most banks prefer using cash to buy sovereign debt because it pays small interest rates. The most popular assets in the foreign exchange reserves are the treasury bills. That’s because most foreign trades involve the most trade currency, the U.S. dollar.

How Central Banks Utilize Foreign Exchange Reserves

Here are the ways some of the central banks utilize foreign exchange reserves.

1.    To Keep Currency Values Fixed

Some countries use foreign exchange reserves to maintain their currencies’ value at a fixed exchange rate. An excellent example is China, which pegs the Chinese Yuan’s value to the U.S. dollar.

If the Asian country stockpiles dollars, the dollar value will rise compared to the Yuan’s value. As a result, Chinese exports will be cheaper than U.S.-made goods.

2.    To Maintain Liquidity of a Currency

Another way the foreign exchange reserves can help central banks is by maintaining the liquidity of a currency during an economic crisis.

For instance, a natural disaster might temporarily halt the local exporters from producing goods. This will cut off the country’s supply of foreign currencies to pay for imports.

In the case above, the country’s central bank can change its foreign currency for the local currency. This allows them to pay for the imports and receive them on time.

Similarly, many foreign investors will shy away from investing in a country that has war or a military coup. They will withdraw their investments from the country’s banks. This will create a severe shortage of foreign currencies in the country’s foreign reserve.

3.    To Keep a Currency’s Value Lower than the Dollar

Countries with floating exchange rate systems utilize reserves to keep their currency’s value lower than the U.S. dollar. Their reason for doing this is similar to that of countries with fixed-rate systems.

An excellent example is the case of Japan. Although the Japanese Yen uses a floating system, its central bank buys the U.S. treasury bills to keep its currency value lower than the U.S. dollar.

Like China, the move helps keep Japan’s exports relatively cheaper, encouraging trade and economic growth. Trading of the U.S. treasury bills occurs in the foreign exchange market.

4.    To Build Confidence in Foreign Investors

Another reason central banks use foreign exchange reserves is to build confidence in foreign investors. It’s a sign that they’ll take action to safeguard their investments.

The foreign exchange reserves prevent the sudden loss of capital or a flight to safety when the market plunges. That can help to avoid an economic crisis caused when certain events trigger a flight to safety.

5.    To Fulfill External Obligations

Foreign exchange reserves are always helpful to ensure a country fulfills its external obligations. They include international payment obligations, such as commercial and sovereign debts. Another commitment can be financing the imports and the ability to absorbing unexpected capital movements.

6.    To Safely Boost Returns

The primary goal of many central banks is to boost returns and not at the expense of safety. They achieve that by diversifying their portfolios. For example, they can hold gold and other interest-bearing investments proven to be safe.

Foreign Exchange Reserves by Country

Countries with the biggest trade surpluses usually have the greatest foreign reserves. Since they export more than what they import, they receive a lot of dollars in payment.

Here are the ten countries with the highest foreign exchange reserves in billions of U.S. dollars as of April 2021.

Source: Wikipedia and International Monetary Fund (IMF).

The above table has listed Hong Kong’s and China’s reserves separately. China’s foreign currency reserves are the largest, with more than twice Japan, the second-largest reserve holder. Notably, Asian countries dominate foreign currency reserves.

As of April 2021, Canada’s foreign currency reserves were values at US$84,237 million. On the other hand, the United States foreign currency reserves, mostly in Japanese yen or euros, were valued at US$142,211 million in the same month.

Final Words

Foreign exchange reserves play a significant role in maintaining the economic health and stability of a country. The U.S. dollar-denominated assets are the most popular in most countries foreign exchange reserves, followed by euro-denominated assets.