Foreign exchange reserves

Foreign exchange reserves

Overview
Foreign-exchange reserves (also called forex reserves or FX reserves) in a strict sense are 'only' the foreign currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...

 deposits and bonds held by central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

s and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold
Gold Reserve
Gold Reserve Inc. is a gold mining company with operations and mining property in Bolivar State, Venezuela.Founded in 1956, Gold Reserve Inc. is now headquartered in Spokane, Washington. The company has about ten employees at its Washington office and about 55 in Venezuela. Of these 55,...

, Special Drawing Rights
Special Drawing Rights
Special Drawing Rights are supplementary foreign exchange reserve assets defined and maintained by the International Monetary Fund . Not a currency, SDRs instead represent a claim to currency held by IMF member countries for which they may be exchanged...

 (SDRs) and International Monetary Fund
International Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...

 (IMF) reserve positions. This broader figure is more readily available, but it is more accurately termed official international reserves or international reserves.
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Encyclopedia
Foreign-exchange reserves (also called forex reserves or FX reserves) in a strict sense are 'only' the foreign currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...

 deposits and bonds held by central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

s and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold
Gold Reserve
Gold Reserve Inc. is a gold mining company with operations and mining property in Bolivar State, Venezuela.Founded in 1956, Gold Reserve Inc. is now headquartered in Spokane, Washington. The company has about ten employees at its Washington office and about 55 in Venezuela. Of these 55,...

, Special Drawing Rights
Special Drawing Rights
Special Drawing Rights are supplementary foreign exchange reserve assets defined and maintained by the International Monetary Fund . Not a currency, SDRs instead represent a claim to currency held by IMF member countries for which they may be exchanged...

 (SDRs) and International Monetary Fund
International Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...

 (IMF) reserve positions. This broader figure is more readily available, but it is more accurately termed official international reserves or international reserves. These are asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...

s of the central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

 held in different reserve currencies
Reserve currency
A reserve currency, or anchor currency, is a currency that is held in significant quantities by many governments and institutions as part of their foreign exchange reserves...

, mostly the United States dollar
United States dollar
The United States dollar , also referred to as the American dollar, is the official currency of the United States of America. It is divided into 100 smaller units called cents or pennies....

, and to a lesser extent the euro
Euro
The euro is the official currency of the eurozone: 17 of the 27 member states of the European Union. It is also the currency used by the Institutions of the European Union. The eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,...

, the pound sterling
Pound sterling
The pound sterling , commonly called the pound, is the official currency of the United Kingdom, its Crown Dependencies and the British Overseas Territories of South Georgia and the South Sandwich Islands, British Antarctic Territory and Tristan da Cunha. It is subdivided into 100 pence...

, and the Japanese yen
Japanese yen
The is the official currency of Japan. It is the third most traded currency in the foreign exchange market after the United States dollar and the euro. It is also widely used as a reserve currency after the U.S. dollar, the euro and the pound sterling...

, and used to back its liabilities, e.g., the local currency issued, and the various bank reserves
Bank reserves
Bank reserves are banks' holdings of deposits in accounts with their central bank , plus currency that is physically held in the bank's vault . The central banks of some nations set minimum reserve requirements...

 deposited
Deposit account
A deposit account is a current account, savings account, or other type of bank account, at a banking institution that allows money to be deposited and withdrawn by the account holder. These transactions are recorded on the bank's books, and the resulting balance is recorded as a liability for the...

 with the central bank, by the government
Government
Government refers to the legislators, administrators, and arbitrators in the administrative bureaucracy who control a state at a given time, and to the system of government by which they are organized...

 or financial institutions.

History


Official international reserves, the means of official international payments, formerly consisted only of gold, and occasionally silver. But under the Bretton Woods system
Bretton Woods system
The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century...

, the US dollar functioned as a reserve currency, so it too became part of a nation's official international reserve assets. From 1944–1968, the US dollar was convertible into gold through the Federal Reserve System, but after 1968 only central banks could convert dollars into gold from official gold reserves, and after 1973 no individual or institution could convert US dollars into gold from official gold reserves. Since 1973, no major currencies have been convertible into gold from official gold reserves. Individuals and institutions must now buy gold in private markets, just like other commodities. Even though US dollars and other currencies are no longer convertible into gold from official gold reserves, they still can function as official international reserves.

Purpose


In a flexible exchange rate system
Flexible exchange rate system
A flexible exchange-rate system is a currency system that allows the exchange rate to be determined by supply and demand.After the failure of Bretton Woods system several currency regimes have emerged spanning the spectrum of rigidly fixed rate regime to independently flexible regimes.Every country...

, official international reserve assets allow a central bank to purchase the domestic currency, which is considered a liability for the central bank (since it prints the money or fiat currency as IOU
IOU
An IOU or I.O.U. is an acknowledgment of debt. The term may also refer to:*I.O.U. , by jazz fusion guitarist Allan Holdsworth*"I.O.U." , by jazz-funk group Freeez*I.O.U in Western Australia...

s). This action can stabilize the value of the domestic currency.

Central banks throughout the world have sometimes cooperated in buying and selling official international reserves to attempt to influence exchange rates. This coordinated strategy was used to replace pound sterling with US dollar as the world reference currency during the 20th century. The lack of such international cooperation is also a big concern for the replacement of US Dollar in this role of reference currency in foreign exchange reserves.

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 flexible 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
Sterilization (economics)
Sterilization in macroeconomics refers to the actions taken by a country's central bank to counter the effects on the money supply caused by a balance of payments surplus or deficit....

 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
Floating exchange rate
A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency....

, 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 strictly 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
Sterilization (economics)
Sterilization in macroeconomics refers to the actions taken by a country's central bank to counter the effects on the money supply caused by a balance of payments surplus or deficit....

) 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).

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
Devaluation
Devaluation is a reduction in the value of a currency with respect to those goods, services or other monetary units with which that currency can be exchanged....

 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, benefits, and criticisms


Large reserves of foreign currency allow a government to manipulate exchange rates – usually to stabilize the foreign exchange rates to provide a more favorable economic environment. In theory the manipulation of foreign currency exchange rates can provide the stability that a gold standard
Gold standard
The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold. There are distinct kinds of gold standard...

 provides, but in practice this has not been the case. Also, the greater a country's foreign reserves, the better position it is in to defend itself from speculative attack
Speculative attack
A speculative attack is a term used by economists to denote a precipitous acquisition of something by previously inactive speculators. The first model of a speculative attack was contained in a 1975 discussion paper on the gold market by Stephen Salant and Dale Henderson at the Federal Reserve Board...

s on the domestic currency.

There are costs in maintaining large currency reserves. Fluctuations in exchange markets result in gains and losses in the purchasing power of reserves. Even in the absence of a currency crisis, fluctuations can result in huge losses. For example, China holds huge U.S. dollar-denominated assets, but if the U.S. dollar weakens on the exchange markets, the decline results in a relative loss of wealth for China. In addition to fluctuations in exchange rates, the purchasing power of fiat money decreases constantly due to devaluation through inflation. Therefore, a central bank must continually increase the amount of its reserves to maintain the same power to manipulate exchange rates. Reserves of foreign currency provide a small return in interest. However, this may be less than the reduction in purchasing power of that currency over the same period of time due to inflation, effectively resulting in a negative return known as the "quasi-fiscal cost". In addition, large currency reserves could have been invested in higher yielding assets.

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 fund
Stabilization fund
A stabilization fund generally refers to a mechanism set up by a government or central bank to insulate the domestic economy from large influxes of revenue, as from commodities such as oil...

s, otherwise known as sovereign wealth fund
Sovereign wealth fund
A sovereign wealth fund is a state-owned investment fund composed of financial assets such as stocks, bonds, property, precious metals or other financial instruments. Sovereign wealth funds invest globally. Some of them have grabbed attention making bad investments in several Wall Street financial...

s. If those were included, Norway
Norway
Norway , officially the Kingdom of Norway, is a Nordic unitary constitutional monarchy whose territory comprises the western portion of the Scandinavian Peninsula, Jan Mayen, and the Arctic archipelago of Svalbard and Bouvet Island. Norway has a total area of and a population of about 4.9 million...

, Singapore
Singapore
Singapore , officially the Republic of Singapore, is a Southeast Asian city-state off the southern tip of the Malay Peninsula, north of the equator. An island country made up of 63 islands, it is separated from Malaysia by the Straits of Johor to its north and from Indonesia's Riau Islands by the...

 and Persian Gulf States
Persian Gulf States
Persian Gulf States can refer to:* Countries in the Middle East bordering the Persian Gulf and sometimes known as the Gulf States: Bahrain, Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates....

 would rank higher on these lists, and United Arab Emirates
United Arab Emirates
The United Arab Emirates, abbreviated as the UAE, or shortened to "the Emirates", is a state situated in the southeast of the Arabian Peninsula in Western Asia on the Persian Gulf, bordering Oman, and Saudi Arabia, and sharing sea borders with Iraq, Kuwait, Bahrain, Qatar, and Iran.The UAE is a...

' $1.3 trillion Abu Dhabi Investment Authority
Abu Dhabi Investment Authority
The Abu Dhabi Investment Authority is a sovereign wealth fund owned by Abu Dhabi, United Arab Emirates founded for the purpose of investing funds on behalf of the Government of Abu Dhabi....

 would be second after China
China
Chinese civilization may refer to:* China for more general discussion of the country.* Chinese culture* Greater China, the transnational community of ethnic Chinese.* History of China* Sinosphere, the area historically affected by Chinese culture...

. Apart from high foreign exchange reserves, Singapore
Singapore
Singapore , officially the Republic of Singapore, is a Southeast Asian city-state off the southern tip of the Malay Peninsula, north of the equator. An island country made up of 63 islands, it is separated from Malaysia by the Straits of Johor to its north and from Indonesia's Riau Islands by the...

 also has significant government and sovereign wealth funds including Temasek Holdings
Temasek Holdings
Temasek Holdings is an investment company owned by the government of Singapore. With an international staff of 380 people, it manages a portfolio of about S$193 billion at end of March 2011, focused primarily in Asia...

, valued in excess of $145 billion and Government of Singapore Investment Corporation
Government of Singapore Investment Corporation
The Government of Singapore Investment Corporation Private Limited is a sovereign wealth fund established by the Government of Singapore in 1981 to manage Singapore's foreign reserves...

, valued in excess of $330 billion. India
India
India , officially the Republic of India , is a country in South Asia. It is the seventh-largest country by geographical area, the second-most populous country with over 1.2 billion people, and the most populous democracy in the world...

 is also planning to create its own investment firm from its foreign exchange reserves.

On May 2011, an estimated that Asia has $3.5 trillion of foreign reserves or is around two-thirds of the world's reserves and a stark contrast to the indebtedness in many developed Western economies.

List of countries by foreign exchange reserves


The following is a list of the top 20 largest countries by foreign exchange reserves:
Rank Country Billion USD (end of month)
1   People's Republic of China
People's Republic of China
China , officially the People's Republic of China , is the most populous country in the world, with over 1.3 billion citizens. Located in East Asia, the country covers approximately 9.6 million square kilometres...

 
$ 3,201 (Sep 2011)
2 $ 1,138 (Jun 2011)
3 $ 516 (Sep 2011)
4 $ 484 (Aug 2011)
5 $ 400 (Aug 2011)
6 $ 352 (Aug 2011)
7 $ 320.39 (Nov 4 2011)
8 $ 311 (Jul 2011)
9 $ 289 (May 2011)
10 $ 277 (Jun 2011)
11 $ 249 (Jul 2011)
12 $ 231 (Jun 2011)
13 $ 186 (Jul 2011)
14 $ 182 (May 2011)
15 $ 175 (Dec 2010)
16 $ 170 (May 2011)
17 $ 143 (Jul 2011)
18 $ 140 (Nov 2011)
19 $ 134 (Jun 2011)
20 $ 122 (Jul 2011)


The following is a list of inter-governmental free-trade associations and supranational organizations.
Rank Country Billion USD (end of month)
  European Economic Area
European Economic Area
The European Economic Area was established on 1 January 1994 following an agreement between the member states of the European Free Trade Association and the European Community, later the European Union . Specifically, it allows Iceland, Liechtenstein and Norway to participate in the EU's Internal...

 
$ 1 416 (Feb 2011)
  European Union
European Union
The European Union is an economic and political union of 27 independent member states which are located primarily in Europe. The EU traces its origins from the European Coal and Steel Community and the European Economic Community , formed by six countries in 1958...

 
$ 1 356 (Feb 2011)
  Eurozone
Eurozone
The eurozone , officially called the euro area, is an economic and monetary union of seventeen European Union member states that have adopted the euro as their common currency and sole legal tender...

 
$ 840 (Jun 2011)

These few holders account for more than 60% 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.

See also

  • Balance of payments
    Balance of payments
    Balance of payments accounts are an accounting record of all monetary transactions between a country and the rest of the world.These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers...

  • Endaka
    Endaka
    Endaka or Endaka Fukyo is a state in which the value of the Japanese yen is high compared to other currencies. Since the Economy of Japan is highly dependent on exports, this can cause Japan to fall into an economic recession....

  • Global assets under management
    Global assets under management
    Global asset allocation or Global assets under management consists of pension funds, insurance companies and mutual funds. Other funds under management include private wealth and alternative assets such as hedge funds and private equity...

  • List of countries by foreign exchange reserves
  • Official gold reserves
    Official gold reserves
    A gold reserve is the gold held by a central bank or nation intended as a store of value and as a guarantee to redeem promises to pay depositors, note holders , or trading peers, or to secure a currency....

  • Reserve currency
    Reserve currency
    A reserve currency, or anchor currency, is a currency that is held in significant quantities by many governments and institutions as part of their foreign exchange reserves...

  • Sovereign wealth funds
  • Special Drawing Rights
    Special Drawing Rights
    Special Drawing Rights are supplementary foreign exchange reserve assets defined and maintained by the International Monetary Fund . Not a currency, SDRs instead represent a claim to currency held by IMF member countries for which they may be exchanged...

  • Foreign exchange reserves of the People's Republic of China

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