What are foreign reserves?
Foreign reserves, also known as foreign exchange reserves, refer to a country’s holdings of foreign currencies and other assets that are used to support its international transactions and stabilize its economy. These reserves typically include foreign currencies, such as U.S. dollars, euros, and yen, as well as gold, special drawing rights (SDRs)[1] and other assets that can be easily converted into foreign currencies.
Foreign reserves are important for a country’s economic stability and ability to engage in international trade and investment. They provide a buffer against external shocks, such as changes in exchange rates, and can help to maintain confidence in the country’s economy. Additionally, foreign reserves can be used to intervene in the foreign exchange market to influence the value of the country’s currency.
Who holds foreign reserves?
Foreign reserves are typically held by central banks and governments. Central banks are responsible for managing a country’s monetary policy, which includes regulating the supply and demand for money in the economy, maintaining price stability, and promoting economic growth. To achieve these goals, central banks often hold foreign reserves to support their currency and provide stability to the financial system.
Governments may also hold foreign reserves to manage their international transactions, such as paying for imports or servicing their foreign debt. In addition, foreign reserves can serve as a buffer against economic shocks, such as sudden changes in global commodity prices or financial crises in other countries.
In what currencies are foreign reserves held?
As of the end of 2021, the US dollar remained as the dominant reserve currency in the world, and a significant portion of foreign reserves are held in US dollars. According to the International Monetary Fund’s (IMF) Currency Composition of Official Foreign Exchange Reserves (COFER) data, as of the third quarter of 2021, about 58.8% of global foreign exchange reserves were held in US dollars.
The next most widely held currencies in foreign reserves were the euro, which accounted for about 20.8%, the Japanese yen at 5.5%, and the Chinese yuan at 2.5%. Other currencies accounted for the remaining 12.5%.
It’s worth noting that the percentage of foreign reserves held in US dollars has declined slightly over the past decade as other currencies, particularly the Chinese yuan, have gained in prominence. However, the US dollar remains the most widely held currency in foreign reserves by a significant margin.
Which countries hold the most foreign reserves?
As of the end of 2021, the countries with the largest foreign exchange reserves are:
- China: $3.2 trillion
- Japan: $1.4 trillion
- Switzerland: $1.1 trillion
- Russia: $585 billion
- India: $635 billion
- Taiwan: $556 billion
- South Korea: $446 billion
- Brazil: $379 billion
- Saudi Arabia: $386 billion
- Hong Kong SAR: $437 billion
Why does the USA hold so little in foreign reserves?
As of the end of 2021, the United States holds approximately $155 billion in foreign exchange reserves, according to data from the International Monetary Fund (IMF). This amount is relatively small compared to other major economies.
The fact that the US holds a relatively small amount of foreign reserves is partly due to the unique role of the US dollar as the world’s dominant reserve currency. Because the US dollar is widely accepted as a means of payment for international trade and is the primary currency used to settle international transactions, the US does not need to hold as many foreign reserves as other countries. In other words, the US can rely on the fact that other countries hold US dollars as reserves, rather than needing to hold a large amount of foreign reserves itself.
Additionally, as the issuer of the US dollar, the US Federal Reserve Bank can effectively create new dollars as needed to meet the demands of the global economy. This gives the US a degree of flexibility and leverage that other countries may not have. However, it’s worth noting that holding a relatively small amount of foreign reserves does not mean that the US is immune to international economic risks and fluctuations. The US economy can still be affected by changes in global economic conditions and financial markets.
How do countries earn foreign reserves?
Countries can earn foreign reserves in a variety of ways, including:
Exports: One of the primary ways that countries earn foreign reserves is through exports. When a country sells goods or services to another country, it receives payment in the currency of that country, which can then be used to build up its foreign reserves.
Foreign Direct Investment (FDI): Foreign direct investment involves investing in businesses or assets in other countries. When a country invests in another country, it may receive returns in the form of profits or dividends, which can then be used to build up its foreign reserves.
International borrowing: Countries can also earn foreign reserves by borrowing money from international lenders, such as the International Monetary Fund (IMF) or other countries, and receiving payment in foreign currencies.
Tourism: Another way that countries can earn foreign reserves is through tourism. When foreign tourists visit a country, they typically spend money on things like hotels, restaurants, and souvenirs, which can contribute to the country’s foreign reserves.
Remittances: Remittances refer to money that is sent by individuals working in other countries back to their home countries. These remittances can be a significant source of foreign reserves for some countries.
The amount and composition of a country’s foreign reserves can vary depending on several factors, including its level of international trade, its exchange rate policy, and its overall economic and political situation.
Why do developing countries struggle to accumulate foreign reserves?
Developing countries can face several challenges in accumulating foreign reserves, which can make it more difficult for them to manage their economies and protect against external shocks. Some of the key reasons why developing countries may struggle to accumulate foreign reserves include:
Limited export earnings: Developing countries often have economies that are heavily dependent on a few key exports, such as oil or agricultural products. This can make them vulnerable to fluctuations in global commodity prices, which can reduce their export earnings and make it harder to accumulate foreign reserves.
High levels of debt: Many developing countries have high levels of external debt, which can make it difficult for them to borrow or accumulate foreign reserves. When a country has a high level of debt, lenders may be hesitant to extend further credit, and the country may have to use its foreign reserves to service its debt payments.
Capital flight: Developing countries may also experience capital flight, which occurs when investors withdraw their money from the country’s financial system in response to economic or political instability. This can reduce the country’s foreign reserves and make it harder to attract new investment.
Currency depreciation: In some cases, developing countries may face currency depreciation, which occurs when the value of their currency declines relative to other currencies. This can make it more expensive to import goods and services and can reduce the value of the country’s foreign reserves.
Despite these challenges, many developing countries have made significant efforts to accumulate foreign reserves in recent years, often through a combination of export-oriented growth strategies, debt restructuring, and policy reforms aimed at attracting foreign investment.
What does the US dollar’s status mean for developing countries?
The US dollar’s status as the most predominant reserve currency can lead to developing countries’ foreign debt being denominated in US dollars, which can create risks and challenges for these countries. When developing countries borrow in US dollars, they are exposed to exchange rate risk, which means that if the value of their currency declines relative to the US dollar, the cost of servicing their debt increases.
In addition, when a country’s debt is denominated in a foreign currency, it can make it more difficult for them to respond to economic shocks, since they cannot simply print more money to pay off their debt. This can create a “debt trap” scenario, where a country becomes stuck in a cycle of borrowing to service its existing debt, without making progress towards paying off the principal.
[1] Special Drawing Rights (SDRs) are an international reserve asset created by the International Monetary Fund (IMF) in 1969 to supplement the existing reserve assets of member countries. SDRs are not a currency but rather a type of monetary reserve that can be exchanged between IMF member countries to facilitate international transactions and support global economic stability.
The value of SDRs is determined by a basket of major currencies, currently including the US dollar, the euro, the Chinese yuan, the Japanese yen, and the British pound sterling. The basket is reviewed every five years to ensure that it reflects the relative importance of currencies in the global economy.