Foreign Exchange Reserves

Foreign exchange reserves, sometimes called forex reserve, is the foreign currencies that are held by a central bank. Nowadays reserves are made up of currency deposits and currency bonds as well as gold and Special Drawing Rights (SDRs). An SDR is an international reserve asset created by the International Monetary Fund which is a basket of reserve currencies, the US dollar, the pound sterling, the Japanese yen and the euro. The value of the SDR is calculated daily at midday on the basis of the exchange rates of the four currencies and is quoted as a dollar value.

Prior to 1944 the gold reserves which the central banks held were the only reserves that central banks held. However, under the Bretton Woods (Bretton Woods was the name of a conference that took place at Bretton Woods in the United States in 1944 where the International Monetary Fund was founded as was the World Bank. At Bretton Woods it was decided that the US dollar could be converted into gold through the Federal Reserve. This process was in place until 1968 when it was decided that only central banks could convert US dollars into gold. After 1973 no central bank could convert a reserve currency into gold. And gold could only be traded on the open market. Currencies however could act as a reserve currency.

Having a reserve of currencies in a floating rate system as we have nowadays, allows a central bank to use the currencies it has in its reserves as official international reserve assets to influence exchange rates and conduct monetary policy. Monetary policy is the regulation of money supply and interest rates by a central bank in order to stabilise exchange rates.

The value of countries reserves is changing day by day as the exchange rate of its domestic currency with other currencies changes. Most countries have the US dollar as a major part of their total reserve; however, as with all currencies if the dollar were to weaken against the domestic currency the value of their US dollar reserves would be reduced.

As a central bank implements monetary policy the quantity of its currency reserve changes depending on what policy the country implements. For example if the central bank sees that its own domestic currency is subject to volatile fluctuations and decreasing in value it might want to stabilise the exchange rate by selling a reserve currency and buying its domestic currency, thereby reducing the quantity of reserve currency it holds. Conversely if the central bank wanted to prevent its domestic currency from appreciating in a volatile market it would sell the domestic currency and buy foreign currency thereby increasing the quantity of reserves it holds.

A country that has large reserves of foreign currency has the ability to manipulate exchange rates and permit a more stable economic situation. In theory using reserve currencies to manipulate exchange rates is as good as having a gold standard. The more currency reserves a country has the more equipped it is to thwart any attempts by the markets or individual investors to attack its domestic currency. Also having large quantities of reserves indicates to the markets that the country is able to repay its foreign debt. Credit agencies such as Moody’s and Standard and Poor’s (Both Moody’s and Standard and Poor’s are credit agency’s who issue credit ratings to countries, financial institutions and corporations which indicate their credit worthiness (ability to pay back debts) to the markets), look at the level of countries currency reserves when they allocate a credit rating to a country.