FOREIGN EXCHANGE RESERVES

(Redirected from Foreign reserves)

'Foreign exchange reserves' (also called 'Forex reserves') in a strict sense are ''only'' the foreign currency deposits held by central banks and monetary authorities. However, the term foreign exchange reserves in popular usage commonly includes foreign exchange and gold, SDRs and IMF reserve position as this total figure is more readily available, however it is accurately deemed as 'official reserves' or 'international reserves'. These are assets of the central banks which are held in different reserve currencies such as the dollar, euro and yen, and which are used to back its liabilities, e.g. the local currency issued, and the various bank reserves deposited with the central bank, by the government or financial institutions.

History

Reserves were formerly held only in gold, as official gold reserves. But under the Bretton Woods system, the United States pegged the dollar to gold, and allowed convertibility of dollars to gold. This effectively made dollars appear as good as gold. The U.S. later abandoned the gold standard, but the dollar has remained relatively stable as a fiat currency, and it is still the most significant reserve currency. Central banks now typically hold large amounts of multiple currencies in reserve.

Purpose

In a non fixed exchange rate system, reserves allow a central bank to purchase the issued currency, exchanging its assets to reduce its liability. The purpose of reserves is to allow central banks an additional means to stabilise the issued currency from excessive volatility, and protect the monetary system from shock, such as from currency traders engaged in flipping. Large reserves are often seen as a strength, as it indicates the backing a currency has. Low or falling reserves may be indicative of an imminent bank run on the currency or default, such as in a currency crisis.
Central banks sometimes claim that holding large reserves is a security measure. This is true to the extent that a central bank can prop up its own currency by spending reserves. (This practice is essentially large-scale manipulation of the global currency market. Central banks have sometimes attempted this in the years since the 1971 collapse of the Bretton Woods system. A few times, multiple central banks have cooperated to attempt to manipulate exchange rates. It is unclear just how effective the practice is.) But often, very large reserves are not a hedge against inflation but rather a direct consequence of the opposite policy: the bank has purchased large amounts of foreign currency in order to keep its own currency relatively cheap.

Changes in reserves

The quantity of foreign exchange reserves can change as a central bank implements monetary policy. A central bank that implements a fixed exchange rate policy 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 a decrease lower). In a fixed exchange rate regime, these operations occur automatically, with the central bank clearing any excess demand or supply by purchasing or selling the foreign currency. Mixed exchange rate regimes ('dirty floats', target bands or similar variations) may require the use of foreign exchange operations (sterilized or unsterilized) to maintain the targeted exchange rate within the prescribed limits.
Foreign exchange operations that are unsterilized will cause an expansion or contraction in the amount of domestic currency in circulation, and hence directly affect monetary policy and inflation: "An exchange rate target cannot be independent of an inflation target. Countries that do not target a specific exchange rate are said to have a floating exchange rate, and allow the market to set the exchange rate; for countries with floating exchange rates, other instruments of monetary policy are generally preferred and they may limit the type and amount of foreign exchange interventions. Even those central banks that stricly limit foreign exchange interventions, however, often recognize that currency markets can be volatile and may intervene to counter disruptive short-term movements.
To maintain the same exchange rate if there is increased demand, the central bank can issue more of the domestic currency and purchase the foreign currency, which will increase the sum of foreign reserves. In this case, the currency's value is being held down; since (if there is no sterilization) the domestic money supply is increasing (money is being 'printed'), this may provoke domestic inflation (the value of the domestic currency falls relative to the value of goods and services).
To maintain the same exchange rate if there is decreased demand, the central bank can purchase the domestic currency using its foreign reserves, effectively removing the domestic currency from circulation; the total foreign exchange reserves will fall. If there is no sterilization, the domestic money supply is also falling, which will tend to restrain domestic inflation (the value of the domestic currency rises relative to the value of goods and services).
Since the amount of foreign reserves available to defend a weak currency (a currency in low demand) is limited, a foreign exchange crisis or devaluation could be the end result. For a currency in very high and rising demand, foreign exchange reserves can theoretically be continuously accumulated, although eventually the increased domestic money supply will result in inflation and reduce the demand for the domestic currency (as its value relative to goods and services falls). In practice, "Some central banks, through open market operations 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 numerous other factors (domestic demand, production and productivity, imports and exports, relative prices of goods and services, etc) will affect the eventual outcome. As certain impacts (such as inflation) can take many months or even years 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 and benefits

On one hand, if a country desires to have a government-influenced exchange rate, then holding bigger reserves gives the country a bigger ability to manipulate the currency market. On the other hand, holding reserves does induce opportunity cost. The "quasi-fiscal costs" of holding reserves are the gap between the low-yield assets that returns managers typically hold, and the average cost of government debt in the country. In addition, many governments have suffered huge losses on the management of the reserves portfolio - all of which is ultimately fiscal. When there is a currency crisis and all reserves vanish, this is ultimately a fiscal cost. Even when there is no currency crisis, there can be a fiscal cost, as is taking place in 2005 and 2006 with China, which holds huge USD assets but the RMB has been continually appreciating.

Excess Reserves

Foreign exchange reserves are important indicators of ability to repay foreign debt and for currency defense, and are used to determine credit ratings of nations, however, other government funds that are counted as liquid assets that can be applied to liabilities in times of crisis include stabilization funds. If those were included, Norway and Persian Gulf States would rank higher on these lists, and UAE's $875 billion Abu Dhabi Investment Authority would be third after Japan and China. Singapore also has significant government funds including Temasek Holdings and GIC. India is also planning to create its own investment firm from its forex reserves.

Levels

Reserves of foreign exchange and gold in 2006

At the end of 2004, 66% of the identified official foreign exchange reserves in the world were held in United States dollars and 25% in euros [1].

'Monetary Authorities with the largest foreign reserves in 2007.'

'Rank'	'Country/Monetary Authority'	'billion USD (end of ''month'')'
1		$1333 (June) ^[1]
2		$932 (August)
—	Eurozone	$451 (July)
3		$416 (September 1) ^[2]
4	Republic of China (Taiwan)	$261 (August)
5	South Korea	$255 (July)
6		$229 (August 31) ^[3]
7		$162 (September 05) ^[4]
8		$148 (August)
9		$138 (August)
10		$117 (July)

''Note:''
1. China updates its information quarterly.
2. Russia updates its information weekly and monthly.
3. India updates its information weekly.
4. Brazil updates its information Daily.

These few holders account for more than 50% of total world foreign currency reserves.
The adequacy of the foreign exchange reserves is more often expressed not as an absolute level, but as a percentage of short-term foreign debt, money supply, or average monthly imports.

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This article provided by Wikipedia. To edit the contents of this article, click here for original source.

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