What is a Foreign Currency Reserve and Why Is It Called a lifeline of an economy?

What is a Foreign Currency Reserve and Why Is It Called a lifeline of an economy?

Foreign currency reserves, also referred to as forex reserves or foreign exchange reserves, comprise cash and assets such as gold that are held by central banks. These reserves serve as a safeguard against potential vulnerabilities that may arise due to sudden disruptions in international money flows during a crisis. As economists suggest, having sufficient forex reserves not only enables countries to combat or overcome economic instability but also promotes stability in their domestic currency! 

What Are Foreign Exchange Reserves? 

Foreign exchange reserves are the sum of other countries’ currencies and foreign assets held by a central bank or monetary authority, which can be easily converted into cash through the foreign exchange market in case of emergency. These reserves are often called foreign currency reserves as they include stocks of other nations’ currencies held in the central bank’s vaults or accounts. 

Foreign currency reserves form a crucial part of a country’s reserve assets and are utilized to diversify their portfolio of international reserves. Typically, countries hold a mix of currencies, including the U.S. dollar, euros, yen, Swiss francs, and British pounds sterling, to bolster their reserves. These reserves are used to purchase a country’s own currency.  

For instance, Japan can draw from its foreign reserves of the U.S. dollar to buy its own currency, the yen. The largest reserve holdings of foreign currency for the U.S. are euros and the yen. 

Why do Central Banks Hold and Manage Foreign Reserves? 

By using forex reserves, central banks can limit any vulnerability caused by a disruption in international money flows during a crisis. When external shocks occur, liquid currency protects against these consequences and supports the country’s critical imports.  

Find out the top 7 main reasons why central banks hold foreign currency reserves: 

  • To stabilize the value of a domestic currency. Let’s assume, China pegs its currency to the US dollar. Stockpiling dollars increases the dollar value against the yuan, increasing sales by reducing the cost of American-made goods compared to Chinese exports. 
  • To maintain a lower exchange rate than the dollar. As a floating exchange rate country, Japan purchases US bonds or treasuries to maintain a low yen against the dollar. The price of its exports is kept relatively low as a result of this. 
  • To ensure liquidity in times of economic crisis. To ensure companies are able to continue to import and export competitively, a central bank can use its foreign currency to exchange it for the local currency. 
  • To fulfill an international finance obligation. An example would be to repay debts, finance imports, and absorb sudden capital movements. 
  • To allocate funds for internal projects. This method is sometimes used to finance infrastructure or industry programmes. 
  • To give foreign investors a sense of security. During wars or periods of internal unrest, investors may consider moving their money overseas. The presence of forex reserves can provide an air of confidence and calm investors’ fears. 
  • To make their portfolio more diverse. It is possible for a central bank to diversify its risks and provide protection in the event of a decline in one investment by holding a variety of currencies and assets in reserve. 

Foreign currency reserves play a critical role in protecting economies from unexpected economic shocks and fluctuations. It is important for a country to maintain a well-managed foreign exchange reserve in order to stabilize exchange rates, protect against inflation and deflation, and provide them with the resources they need to trade and invest abroad. 

What makes the US Dollar a safe haven for Foreign reserve? 

During periods of economic uncertainty, investors and currency traders often look for a safe haven by exchanging their cash holdings into stable and dependable currencies. These currencies are usually those that are perceived as less risky, such as the Swiss franc, the Japanese yen, and the US dollar. The US dollar is particularly popular due to its role as the world’s reserve currency and its use in many international business transactions. It also has the largest gold reserves globally. 

Recently, the US dollar has been very strong compared to other major currencies, attracting investors who are optimistic about indications that the US Federal Reserve will raise interest rates more quickly than other central banks. As a result, according to Brent Donnelly, “the US dollar is the only secure haven left.” 

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Nevertheless, foreign currency reserves play an essential role in today’s interconnected global economy, and no country can afford to disregard their significance. Regardless of whether a country is a major economic power or a developing nation, possessing sufficient reserves of foreign currencies can significantly impact maintaining economic stability and avoiding chaos.  

The appropriate amount of foreign currency reserves a country need will depend on various factors, such as its economy’s size, level of trade and investment, and its exposure to global economic risks. A country with considerable foreign currency reserves can navigate economic challenges more easily, while a country lacking such a safety net may be more susceptible to economic volatility and instability. 

The emergence of another world reserve currency is possible! 

According to the International Monetary Fund, central banks have been reducing the amount of U.S. dollars held in reserve since the turn of the century in an effort to reduce reliance on a single currency and increasing their holdings of other currencies like the Australian and Canadian dollars. Around 70% of U.S. dollars were typically held in foreign exchange reserves by nations in 1999. This proportion has reduced to 59.5 percent, or roughly $6.6 trillion of the $11 trillion in total reserves worldwide, according to IMF data from the second quarter of 2022. 

President Vladimir Putin has expressed Russia’s readiness to collaborate with China and other members of the BRICS group of nations to create a global reserve currency. This currency could potentially be based on a basket of currencies from the organization’s members, which include Brazil, India, and South Africa. This proposal comes after Russia was isolated from the world’s financial system due to its invasion of Ukraine, which limited its access to US dollars.  

The development of a BRICS basket currency could appeal to a wider range of countries beyond the group’s members, including nations in South Asia and the Middle East. In addition to this, proponents of cryptocurrencies like Bitcoin believe that digital assets could challenge the dominance of major currencies. Some central banks are exploring blockchain technology to create sovereign crypto digital coins. While China does not recognize Bitcoin, it is reportedly developing a digital yuan, as per reports from City Index. 

As we speak about current trends, here’s what’s latest with the US Dollar and Why do countries ditch USD! 

Why Are Foreign Currency Reserves Important? 

As foreign currency reserves support a country’s currency exchange rate and monetary system, they are crucial for a country’s monetary framework. Maintaining reserves can be used to demonstrate a nation’s capacity to pay its debts to other nations as well as to set aside monies that can be used as emergency reserves. High levels of foreign reserves might also reassure foreign investors that a country is ready to endure economic shocks. For instance, a nation may use its reserves to help prevent loan default. 

Which Country has the highest Foreign Currency Reserve in 2023? 

China boasts the largest foreign currency reserves globally since it is the world’s largest exporter of all nations. In fact, China’s forex reserves are over two and a half times those of Japan, the second-largest holder. When China’s and Hong Kong’s reserves are combined, the total surpasses $4 trillion. Almost half of the $6.6 trillion held in reserves worldwide are held by the People’s Bank of China, the country’s central bank. 

As of April 2023, the top 10 countries with the largest foreign currency reserve assets are: 

  1. China – over $4.3 trillion 
  1. Japan – over $1.7 trillion 
  1. Switzerland – over $1 trillion 
  1. Russia – over $625 billion 
  1. Taiwan – over $560 billion 
  1. India – over $525 billion 
  1. South Korea – over $500 billion 
  1. Brazil – over $375 billion 
  1. Hong Kong – over $360 billion 
  1. Singapore – over $290 billion 

Due to various economic and political factors, it is important to take note that the figure for foreign currency reserve assets may vary from time to time depending on a number of factors. 

What Happens When a Country Depletes Its Foreign Reserves? 

If a country manages its foreign exchange reserves with prudence, it can win the backing of foreign investors. However, there have been instances where central banks have utilized their entire foreign exchange reserves, to the detriment of their economic prosperity.  

The East Asian Financial Crisis of 1997-98 is a classic example of this phenomenon. 

The Thai baht crisis was triggered by an overvalued currency due to a sluggish economy, large current account deficit, and rising foreign investment and borrowing. Speculators began shorting the currency, leading the Bank of Thailand to deplete its $30 billion reserves to buy baht and support its value. This strategy failed, causing a loss of confidence in the economy, and other Southeast Asian countries with currencies pegged to the US dollar were also affected.  

The IMF intervened by offering loans with austerity measures to prevent economic collapse, and the countries eventually recovered, but their currencies never regained their pre-crisis values. Central banks learned a valuable lesson and began maintaining high foreign exchange reserves to gain the support of international investors. 

Lebanon, Sri Lanka & Bolivia lost the most foreign reserves since Covid-19 

According to an analysis by the Financial Times of central bank data from 75 countries collected via Haver Analytics, the majority of developing economies have experienced a significant decrease in their foreign exchange reserves since the start of the Covid-19 pandemic. Specifically, 39 of these countries saw their import cover ratios decline by 25% or more.  

The sharpest falls were observed in Bolivia, Sri Lanka, Lebanon, Pakistan, and Kyrgyzstan, with at least a 75% decline in foreign exchange reserves from March 2020. As a result, these countries have been constrained in their ability to finance their fiscal deficits and import essential goods like food and fuel, leading to rising poverty levels and widespread protests in Lebanon and Sri Lanka. 

This trend is consistent with a growing disparity in foreign direct investment (FDI) between developed and developing economies, which has been worsening since 2016. The pandemic has further amplified this pre-existing issue, with developing nations bearing the brunt of the decline in global FDI. Of particular concern is the fact that low-income nations have seen the greatest decrease in greenfield FDI since the start of the pandemic, posing a significant challenge to their economic growth and development. 

Impacts of Foreign Exchange Reserve Accumulation on the Economy 

The accumulation of foreign exchange reserves has significant effects on developing countries’ economies. Some of the potential impacts include: 

  • Reduced liquidity risk costs: The increase in foreign exchange reserves can help stabilize financial markets by reducing liquidity risk costs. 
  • Increase in external debt: Foreign exchange reserves can lead to an increase in both liquid and total external debt outstanding, thus leading to a shorter maturity period. 
  • Boost investment and economic growth: Foreign exchange reserves can increase investment and economic growth in the tradable sector if it is capital intensive. 
  • Positive impact disappears when controlling for investment: Economic growth is negatively affected when investment is taken into account. 
  • Permanent decline in consumption: An increase in foreign exchange reserves can result in a permanent decrease in consumption if the interest rate on foreign exchange reserves is low. 

The accumulation of foreign exchange reserves can have both positive and negative effects on developing economies. Reserves need to be carefully managed to avoid unsustainable debt levels or negatively impacting consumption. 

How Foreign Currency Reserves Influence Forex Trading? 

Forex trading can be impacted in multiple ways by foreign exchange reserves. Market confidence, investor sentiment, central bank interventions, and currency stability are among the ways through which foreign exchange reserves can affect forex trading. High foreign exchange reserves suggest financial stability, which leads to stable forex markets and greater demand for a country’s currency. Conversely, low reserves can destabilize the market and decrease investor confidence. Furthermore, foreign exchange reserves play a crucial part in central bank interventions and currency stability. 

Long Position and Short Position: A Beginner’s Guide

The forex market experiences continuous fluctuations due to volatility, and it is crucial to adjust your trading strategy in response to these changes. Observing price action at the peaks and troughs can help you understand market conditions. If there are higher highs and higher lows, or worse, higher highs and the same lows, this suggests an uptrend. Conversely, lower highs or lower lows indicate a downtrend. Forex traders employ trend analysis to identify and anticipate market trends. 

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