Foreign exchange reserves are the foreign currencies held by a country's central bank. There are seven reasons why banks hold reserves. The most important reason is to manage their currencies' values. They transfer the currency to the central bank. Exporters are paid by their trading partners in U. The exporters exchange them for the local currency. They use it to pay their workers and local suppliers. The most popular are Treasury bills. That's because most foreign trade is done in the U.
That continued despite the eurozone crisis. A third asset is any reserve balances they've deposited with the International Monetary Fund. First, countries use their foreign exchange reserves to keep the value of their currencies at a fixed rate. When China stockpiles dollars, that raises its value when compared to the yuan. That makes Chinese exports cheaper than American-made goods, increasing sales.
Second, those with a floating exchange rate system use reserves to keep their value of their currency lower than the dollar. They do this for the same reasons as those with fixed rate systems. Treasuries to keep its value lower than the dollar. Like China, this keeps Japan's exports relatively cheaper, boosting trade and economic growth.
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 supplies foreign currency to keep markets steady. It also buys the local currency to support its value and prevent inflation.
This reassures foreign investors, who return to the economy. 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.
Fifth, reserves are always needed to make sure a country will meet its external obligations. 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.
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 , Greece was not able to do this. 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. Updated July 28, Guidelines How much are enough reserves?
By Country The countries with the largest trade surpluses are the ones with the greatest foreign reserves. Hurt by low prices.More...