Currency reserves: what are they and why do they matter?

Currency reserves are a vital part of the global financial system. Most currency reserves are held in what are known as reserve currencies – the most famous of which is the US dollar. Find out more about currency reserves and why they’re so important.

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What are currency reserves?

Foreign exchange reserves, also called forex reserves, are cash and other assets – normally gold – that are held by central banks or other monetary authorities like the International Monetary Fund (IMF).

As an example, according to the Bank of England bulletin, the central bank held £30.7 billion in foreign currency reserves in April 2021. These reserves are made up of gold, foreign currency assets, IMF special drawing rights and the UK’s Reserve Tranch Position (RTP).

Central banks maintain these reserves to balance the country’s payments, help influence the foreign exchange rate, and support confidence in financial markets. They are essentially the bank’s back-up funds that can be used in case of emergency.

Most FX reserves are usually held in what is known as reserve currencies.  

What is a reserve currency?

A reserve currency is money held in significant amounts as reserves by central banks and monetary authorities as part of their foreign exchange reserves programme.

Reserve currencies get used in international transactions, investments and all aspects of global trade. They’re also commonly used as safe-haven currencies.

A reserve currency reduces exchange rate risk because there’s no need for a country to exchange its money for the reserve currency to enact trade, as they already have their own supply.

Commodities are often priced in reserve currencies, like the US dollar, to streamline payment for these goods.

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Central banks hold foreign exchange reserves for several reasons, including:

  1. To help keep the value of their domestic currency at a fixed rate.
    For  example, China pegs the value of its currency (the yuan) to the US dollar. If China stockpiles dollars, it raises the dollar value versus yuan, making Chinese exports cheaper than American-made goods, increasing China’s sales
  2. To keep a domestic currency lower than the dollar.
    In much the same way as fixed currencies, a lot of central banks with floating exchange rate systems use their reserves to keep their currency lower than the US dollar. For example, the Bank of Japan buys US Treasuries to keep its value lower than the dollar, ensuring that Japan’s exports stay relatively cheaper
  3. To maintain liquidity in case of economic crisis.
    In this case, a central bank can step in and exchange its foreign currency for the local currency, allowing local companies to continue importing and exporting competitively  
  4. To meet a country’s international financial obligations.
    These could include international payments like sovereign and commercial debts, financing imports and absorbing sudden capital movements
  5. To fund internal projects.
    Sometimes countries will use their currency reserves to provide cash to industries, most often infrastructure programmes
  6. To reassure foreign investors.
    Holding large amounts in forex reserves projects an air of confidence, which can prevent investors moving their capital to other countries, which could cause an economic downturn
  7. To diversify their portfolio
    By holding different currencies and other assets, such as gold, in reserve, a central bank can diversify its risk across different instruments. This provides protection should one investment decline

How do foreign currency reserves impact exchange rates?

Foreign currency reserves impact exchange rates when they are used and manipulated by central banks in favour of their domestic currency.

For example, say China wants to increase the value of its currency, the yuan. China could sell its US dollar reserves and buy yuan on the foreign exchange markets. The increased demand for yuan would cause the currency’s value to appreciate compared to the US dollar.

In fact, over recent years, the People's Bank of China - the country's central bank - has been doing the exact opposite. They have kept the yuan undervalued to maintain their competitive edge on the exports market – making Chinese products much cheaper than international counterparts. They’ve done this by selling yuan and buying US dollars.

This process has resulted in China amassing such a massive bank of US dollar reserves. It’s estimated that China holds $3399.9 billion in US dollar reserves alone – let alone all the other currencies and assets it holds.

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Largest foreign exchange reserves

Here are the top ten largest foreign exchange reserves held by country according to the International Monetary Fund.

As you can see, China not only tops the list, but has reserves greater than the countries ranking next three countries on the list.

Largest foreign exchange reserves

China

$3.330 trillion       

Japan

$1.368 trillion       

Switzerland

$1.052 trillion

Russia

$590 billion

India

$589 billion

Taiwan

$541 billion

Hong Kong

$490 billion

South Korea

$452 billion

Saudi Arabia

$448 billion

Singapore

$385 billion

The Swiss banking system is regarded as one of the safest and most secure on the planet. Hence its substantial reserves compared to the size of its economy.

It may come as a surprise to some that the USA doesn’t rank high on the list. The Federal Reserve’s declared assets are at $139 billion according to the latest data published by the Fed, ranking it at 21 globally.

Another notable absence is any European country. But combined, the European Union holds approximately $740 billion of reserves.

Is there a new world reserve currency coming?

One of the biggest trends taking over international currency markets has been the suggestion that the US dollar could be replaced as the global reserve currency. Fans of cryptocurrencies, such as Bitcoin, have suggested that these digital assets could challenge the dominance of the major currencies.

In fact, some central banks are investigating the blockchain technology behind cryptos for sovereign crypto digital coins. For example, while China does not recognise Bitcoin has legal tender, it is reportedly developing the digital yuan.


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