What is Foreign Exchange Reserves

Foreign exchange reserves are the foreign currency denominated financial assets accumulated by the monetary authorities of a country. Foreign exchange reserves are held for various reasons. Most common uses are meeting foreign currency denominated payment obligations, management of exchange rate, control of money supply and interest rates, providing confidence to markets, and limiting external vulnerability. Because of these policy objectives, monetary authorities prefer to hold foreign exchange reserves in low-risk and liquid financial instruments; foreign exchange reserves in such instruments ensure that there is the capacity to intervene in markets at any moment.
While foreign exchange reserves provide economic benefits such as exchange rate management and reduced external vulnerability, they incur costs because foreign currencies in low-risk and liquid instruments yield less than various investment opportunities and debt and equity securities. Despite these costs, there is a secular trend especially visible in emerging market economies toward higher levels of foreign exchange reserves. This trend is particularly strong among East Asian economies.
A country accumulates foreign exchange reserves either because of a current account surplus or capital account surplus (in which case capital inflows exceed capital outflows). The surplus on the current account is, in general, caused by the excess of exports over imports, which leads to the receipt of payments in foreign currencies. Capital account surplus implies that a country is a net debtor, i.e., its receipt of foreign currency denominated assets surpasses the financial assets it sends to the rest of the world. In either case, monetary authorities (most often the central bank) accumulate foreign exchange through open market operations they buy foreign exchange from private economic agents at the prevailing market prices.
Foreign currency payments oblige monetary authorities to hold foreign exchange reserves, but the magnitude of foreign currency obligations is generally small relative to the gross domestic product of a country. Especially in developing and emerging market economies, monetary authorities opt for holding foreign exchange reserves as a policy tool or for precautionary purposes rather than for meeting payment obligations. One policy example is the dirty float. Under the dirty float, the long-term level of the exchange rate is determined by markets, but monetary authorities intervene in cases where the movements deviate from fundamentals. An example of precautionary purposes is the holding of reserves in order to keep the capacity to intervene in financial markets to prevent or mitigate a currency crisis.
Foreign exchange reserves are part of a country’s national wealth. Thus, like any other stock of capital, one would expect that foreign exchange reserves are put into projects or financial instruments that maximize revenue. However, this objective (maximization of revenue) is in conflict with holding foreign exchange reserves for policy or precautionary purposes. The commitment to a certain policy goal and to precautionary purposes necessitates that foreign exchange reserves are held in liquid instruments. The majority of foreign exchange reserves are held in fixed-income assets such as U.S. Treasury notes and bonds, which are considered to be safe and liquid investment instruments. However, safety and liquidity come with a price; low-risk fixed-income assets yield less compared to other financial instruments. Thus, foreign exchange reserves bear opportunity costs. While there is no consensus on the magnitude of the opportunity cost of holding large foreign exchange reserves, most scholars argue that the cost is significant.
Since the 1980s, the level of foreign exchange reserves (measured in relation to gross domestic product) remained relatively stable in advanced industrialized countries with stable financial markets and floating exchange rate regimes. In contrast, developing and emerging market economies began holding increasing levels of foreign exchange reserves by the early 1990s. This trend accelerated even further in recent years. Emerging economies in Asia particularly China are the leading figures in this significant reserve buildup. According to the CIA World Factbook, the combined value of the foreign exchange reserves in China, Japan, Russia, India, Taiwan, and South Korea stood at approximately $3.7 trillion at the end of 2007.