7 Ways Central Banks Use Foreign Exchange Reserves

foreign currency reserves
Central banks use currency reserves to make the economy work better. Photo: sndr/Getty Images

Definition: Foreign exchange reserves are the foreign currencies held by a country's central bank and its member banks. They are also referred to as foreign currency reserves or foreign reserves.

The country's exporters deposit foreign currencies into their local banks who then transfer them to the central bank. Exporters are paid by their trading partners in U.S. dollars, euros, or other currencies.

The exporters exchange them for the local currency they can use to pay their workers and local suppliers.

The banks prefer to use the cash to purchase sovereign debt because it pays a small interest rate. The most popular are Treasury bills since most foreign trade is done in dollars thanks to its status as the world's global currency.

Banks are increasing their holdings of euro-denominated assets, such as high-quality corporate bonds. That has continued despite the eurozone crisis. In addition, they'll hold gold, special drawing rights (SDR), and any reserve balances they've deposited with the International Monetary Fund (IMF). (Source: COFER Table, IMF)

Purpose

First, countries use their foreign exchange reserves to keep the value of their currencies at a fixed rate. A good example is China, which pegs the value of its currency, the yuan, to the dollar. When China stockpiles dollars, that raises its value when compared to the yuan.

That makes Chinese exports cheaper than American-made goods, increasing sales.

Those with a floating exchange rate system can still use reserves to keep their value of their currency lower than the dollar, for the same reasons. Even though Japan's currency, the yen, is a floating system, the Central Bank of Japan buys U.S. Treasuries to keep its value lower than the dollar.

Like China, this keeps Japan's exports relatively cheaper, boosting trade and economic growth. For more, see How Foreign Exchange Markets Work.

A third, and critical, function are 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.

Similarly, foreign investors will get spooked if a country has a war, military coup, or other blow to confidence. They withdraw their deposits from the country's banks, creating a severe shortage in foreign currency. This pushes down the value of the local currency since fewer people want it. That makes imports more expensive, creating inflation

The central bank can supply foreign currency, to keep markets steady, and buy up the local currency, to support its value and prevent inflation. This reassures foreign investors, who return to the economy. (Source: Haukur C. Benediktsson and Sturla Palsson, "Central Bank Foreign Reserves," Monetary Bulletin, Central Bank of Iceland, 2005)

A fourth reason is to provide confidence and assure foreign investors that the central bank is ready to take action to protect their investments, and 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, financing of imports, and 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. That's why they'll often hold gold and other safe, interest-bearing investments, to diversify their portfolios. (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.

Another guideline is to have enough to cover the country's debt payments and current account deficits for the next 12 months. In 2015, Greece was not able to do this. It then used its reserves with the IMF to make a debt payment to the European Central Bank. For more, see Greece debt crisis.  

By Country

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

Here are the reserves for the top countries with $100 billion or more of reserves as of December 2014:

CountryReserves (in billions)Comments
China $3,980.0 Consumer products, parts exporter
Japan $1,260.6 Auto, parts, consumer products exporter
European Union   $743.4 Exports machinery, equipment, autos.
Saudi Arabia   $732.4 Exports oil.
Switzerland   $545.4 Exports financial services.
Russia   $385.5 Exports natural gas and oil, hurt by sanctions
South Korea     $363.6 Exports electronics.
Brazil   $363.6 Exports oil and commodities.
Hong Kong   $328.5 
India   $320.7 
Singapore   $256.9 
Mexico   $195.7 Exports oil, produce, thanks to NAFTA.
Germany   $192.7 Exports autos
Thailand   $157.1 
France   $143.5 
Italy   $142.2 
United Kingdom   $135.6 
United States   $132.2 
Turkey   $127.3 
Indonesia   $111.9 
Poland   $100.4 

Source: eLibrary Data, IMF; Reserves of Foreign Currency and GoldCIA World Factbook

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