Foreign Exchange Reserves: What They Are, Why Countries Hold Them

By the 1960s, however, the United States did not have enough gold to cover the dollars in circulation outside the United States, leading to fears of a run that could wipe out U.S. gold reserves. Following failed efforts to save the system, President Richard Nixon suspended the dollar’s convertibility to gold in August 1971, marking the beginning of the end of the Bretton Woods exchange rate system. The Smithsonian Agreement, struck a few months later by ten leading developed countries, attempted to salvage the system by devaluing the dollar and allowing exchange rates to fluctuate more, but it was short-lived.

1. The argument is that, in the absence of sufficiently large shocks, a currency that dominates the marketplace will not lose much ground to challengers.
2. The country’s wealth from oil exports significantly contributes to these reserves.
3. The central bank then uses the dollars to purchase U.S. government securities, which are considered to be among the safest investments on the planet.
4. Meanwhile, the dollar’s outsize role in international trade could have negative consequences for the global economy.
5. The percentage share held in gold of total foreign reserves is calculated by the World Gold Council.
6. For years, leaders of BRICS countries have discussed a framework for a shared currency, with proponents arguing that it would protect against devaluation when the dollar rises.

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The dollar’s status as the leading reserve currency has been called the “exorbitant privilege” of the United States, a phrase coined by former French Finance Minister Valery Giscard d’Estaing in the 1960s. At the time, French officials believed that the world’s appetite for dollars provided cheap financing for U.S. investment abroad. Over time, U.S. trade swung into a sustained deficit, supported in part by global demand for dollar reserves. Such demand helps the United States to issue bonds at a lower cost, since higher demand for a government’s bonds means it doesn’t have to pay as much interest to entice buyers, and helps to keep the cost of the United States’ now substantial external debt down. Russia’s foreign exchange reserves are held mostly in U.S. dollars, much like the rest of the world, but the country also keeps some of its reserves in gold. Since gold is a commodity with an underlying value, the risk in relying on gold in the event of a Russian economic decline is that the value of gold will not be significant enough to support the country’s needs.

China and Hong Kong

As of February 2022, Russia’s foreign exchange reserves totaled some $630 billion. However, sanctions imposed by the European Union (EU), the U.S., and other nations in response to Russia’s invasion of Ukraine in February 2022 rendered most of those reserves inaccessible to the central bank. The world’s largest current foreign exchange reserve holder is China, a country holding more than $3 trillion of its assets in a foreign currency. Such an arrangement makes international trade easier to execute since most of the trading takes place using the U.S. dollar. A simple explanation for China’s accumulation of foreign currency could be its consistently positive and substantial trade balance. When China exports goods and services, it accepts the foreign currency, usually U.S. dollars, and holds that currency in reserve.

Why Might a Country Run Out of Foreign Reserves?

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2. In the past due to the Plaza Accord, its predecessor bodies could directly manipulate rates to reverse large trade deficits.
3. These reserves are vital for maintaining the won’s stability and supporting South Korea’s dynamic economy.
4. It currently accounts for 3 percent of global reserves, but China has increasingly pushed to use the renminbi in bilateral trade, especially in the wake of the Ukraine war.
5. These reserves are essential for facilitating international trade, ensuring currency stability, and providing a financial buffer in times of economic uncertainty.

Foreign exchange reserves can include banknotes, deposits, bonds, treasury bills, and other government securities. These assets serve many purposes but are most significantly held to ensure that a central government agency has backup funds if their national currency rapidly devalues or becomes entirely insolvent. John Maynard Keynes proposed the bancor, a supranational currency to be used as unit of account in international trade, as reserve currency under the Bretton Woods Conference of 1945. Even though most of the world left the gold standard in 1971, most countries still retain large gold reserves. The United States, followed by Germany and Italy, held the largest amount of gold reserves worldwide as of December 2018. Treasury Secretary Janet Yellen, say that the aggressive use of sanctions could threaten the dollar’s hegemony.

It is a common practice in countries around the world for a central bank to hold a significant amount of reserves in its foreign exchange. Most of these reserves are held in the U.S. dollar since it is the most traded currency in the world. It is not uncommon for the foreign exchange reserves to be made up of the British pound (GBP), the euro (EUR), the Chinese yuan (CNY) or the Japanese yen (JPY) as well.

United States dollar

The substantial gold reserves underscore the country’s economic strength and financial security. Countries hold foreign reserves for several reasons, including to balance international trade, intervene in the currency markets to stabilize the domestic currency (for liquidity in times of crisis), and to provide confidence for foreign and domestic investors. In addition to accounting for the majority of global reserves, the dollar remains the currency of choice for international trade. Major commodities such as oil are primarily bought and sold using U.S. dollars, and some major economies, including Saudi Arabia, still peg their currencies to the dollar. Japan holds the second spot with a total of $1,290,604.98 million in reserves, including $1,230,377.14 million in forex and $60,227.84 million in gold.

These reserves are vital for maintaining the won’s stability and supporting South Korea’s dynamic economy. India ranks fifth with $651,950.34 million in total reserves, consisting of $593,423.00 million in forex and $58,527.34 million in gold. India’s growing reserves reflect its rising economic stature and proactive fiscal policies aimed at ensuring economic stability. China is a net exporter of goods, with much of that foreign trade being conducted in U.S. dollars. Chinese companies thus receive U.S. dollars but must convert them into Chinese currency via the banking system. The central bank then uses the dollars to purchase U.S. government securities, which are considered to be among the safest investments on the planet.

China has been trying to boost the global role of the renminbi, also known as the yuan, since the late 2000s. It currently accounts for 3 percent of global reserves, but China has increasingly pushed to use the renminbi in bilateral trade, especially in the wake of the Ukraine war. However, Chinese policymakers are wary of the lessons from previous currencies PDF that rapidly internationalized, and they have imposed strict controls on the flow of money that have hamstrung the renminbi’s growth. “China does not have the intention or the capacity to dethrone the dollar,” says CFR’s Zongyuan Zoe Liu. Most countries want to hold their reserves in a currency with large and open financial markets, since they want to be sure that they can access their reserves in a moment of need. Central banks often hold currency in the form of government bonds, such as U.S. treasuries.

The centrality of the dollar to the global economy confers some benefits to the United States, including borrowing money abroad more easily and extending the reach of U.S. financial sanctions. Foreign exchange reserves are assets that are denominated in a foreign currency held by a central bank. However, some economists, such as Barry Eichengreen, argue that this is not as true when it comes to the denomination of official reserves because the network externalities are not strong. As long as the currency’s market is sufficiently liquid, the benefits of reserve diversification are strong, as it insures against large capital losses. The implication is that the world may well soon begin to move away from a financial system dominated uniquely by the US dollar.

Meanwhile, the dollar’s outsize role in international trade could have negative consequences for the global economy. As a country’s currency weakens, its goods exports should become cheaper and thus more competitive. But because so much trade is conducted in U.S. dollars, other countries do not always see this benefit when their currencies depreciate. “Both the United States and the world at large would benefit from a less top 10 foreign reserve country dominant U.S. dollar,” writes Michael Pettis, a professor of finance at Peking University. For years, leaders of BRICS countries have discussed a framework for a shared currency, with proponents arguing that it would protect against devaluation when the dollar rises. However, experts point out that structural challenges in BRICS countries, including a lack of robust central banks and monetary policies, make it infeasible.