Foreign Exchange Reserves: Purpose, Ranking by Country

Posted by jenni on July 31st, 2017

Definition: Foreign exchange reserves are the foreign currencies held by a country's central bank. They are also called foreign currency reserves or foreign reserves. There are seven reasons why banks hold reserves. The most important reason is to manage their currencies' values.

How Foreign Exchange Reserves Work

The country's exporters deposit foreign currency into their local banks. They transfer the currency to the central bank.

Purpose

Here are the seven ways central banks use foreign exchange reserves.

• First, countries use their foreign exchange reserves to keep the value of their currencies at a fixed rate.
• Second, those with a floating exchange rate system use reserves to keep their value of their currency lower than the dollar.
• A third, and critical, function is to maintain liquidity in case of an economic crisis. For example, a flood or volcano might temporarily suspend local exporters' ability to produce goods. That cuts off their supply of foreign currency to pay for imports. In that case, the central bank can exchange its foreign currency for their local currency, allowing them to pay for and receive the imports.
• A fourth reason is to provide confidence. The central bank assures foreign investors that it's ready to take action to protect their investments. It will also prevent a sudden flight to safety and loss of capital for the country. In that way, a strong position in foreign currency reserves can prevent economic crises caused when an event triggers a flight to safety.
• Fifth, reserves are always needed to make sure a country will meet its external obligations. These include international payment obligations, including sovereign and commercial debts. They also include financing of imports and the ability to absorb any unexpected capital movements.
• Sixth, some countries use their reserves to fund sectors, such as infrastructure. China, for instance, has used part of its forex reserves for recapitalizing some of its state-owned banks.
• Seventh, most central banks want to boost returns without compromising safety. They know the best way to do that is to diversify their portfolios. That's why they'll often hold gold and other safe, interest-bearing investments. (Source: "Why Do Countries Keep Foreign Exchange Reserves?" The Economic Times, November 22, 2004.)

Guidelines

How much are enough reserves? At a minimum, countries have enough to pay for three to six months of imports. That prevents food shortages, for example.

By Country

The countries with the largest trade surpluses are the ones with the greatest foreign reserves. That's because they wind up stockpiling dollars because they export more than they import. They receive dollars in payment.

Source : www.thebalance.com/foreign-exchange-reserves-3306258