Introduction

   Dr. Wolassa Kumo
Foreign exchange reserves also known sometimes as official international reserves or official reserves consist of official public sector foreign assets that are readily available to and controlled by the monetary authorities. Reserve asset portfolios usually have special characteristics that distinguish them from other foreign currency assets. First and foremost, official reserve assets normally consist of liquid or easily marketable foreign currency assets that are under the effective control of, and readily available to, the reserve management entity. Furthermore, to be liquid and freely useable for settlements of international transactions, they need to be held in the form of convertible foreign currency claims of the authorities on nonresidents (IMF, 2001.)

The most common reserve currency is the US dollar. However, euro is also used as a reserve currency to some extent and is gradually becoming an alternative reserve currency globally. As stated earlier, reserves are held by the central bank to back its liabilities which include the local currency issued, and various bank reserves deposited by other financial institutions or government.

Official foreign exchange reserves are held in support of a range of objectives including to (IMF, 2001):

•    support and maintain confidence in the policies for monetary and exchange rate management including the capacity to intervene in support of the national or union currency;

•    limit external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis or when access to borrowing is curtailed and in doing so;

•    provide a level of confidence to markets that a country can meet its external obligations;

•    demonstrate the backing of domestic currency by external assets;

•    assist the government in meeting its foreign exchange needs and external debt obligations; and

•    maintain a reserve for national disasters or emergencies.

Since the collapse of the Bretton Woods System, it became necessary to maintain official reserves by the monetary authorities globally.

Official Reserves and Exchange Rate Policies

In a flexible exchange rate regime, the central bank can use its official reserves to stabilize the value of the domestic currency. This happens when the central bank uses the official reserves to purchase the local currency printed by it but considered to be its liability. The central bank can also influence the exchange rates by buying and selling the official international reserves. In other words, in a flexible exchange rate regime, the central bank clears the excess demand for or supply of local currency by purchasing or selling the foreign currency.

Therefore, countries with large foreign currency reserves will be able to easily manipulate exchange rates in the sense of stabilizing the rate to provide a more favorable economic environment. This is particularly important when economies are in crisis such as the one we are witnessing at present. However, since most countries hold their official reserves in foreign currency, the fluctuations in the values of these foreign currencies can result in a relative loss of wealth. Apart from this, inflation leads to declining purchasing power of money.

Thus in order to be able to continually manipulate the exchange rate, the central bank must constantly increase the amount of its reserves. Since the return from the reverse or the interest income earned would not be able to offset the fall in purchasing power of the reserves due to inflation, some analysts suggest that larger reserves are better used if they are invested in high yielding assets.

Countries with the Largest Foreign Reserves

At the end of March 2009, China and Japan held the largest foreign reserves in the world. The size of their reserves is US $1953 billion and US $1019 billion respectively. The other emerging economies dominate the remaining top ten positions. Russia is a distant third in the size of foreign reserve with US$385 billion during the same period while India, South Korea, Brazil, Hong Kong, Singapore and Germany hold the remaining 5 to 10 positions in the size of foreign reserve respectively. The size of Germany’s foreign reserve is about US$144 billion at about the same period.

China’s reserves are very large. They constitute nearly one-third of the GDP and over one year of the country’s import value (Conventionally, reserves amounting to three months of a country’s import value were considered to be adequate). The emerging economic giants, the BRIC countries, hold the largest foreign exchange reserve globally.

According to Xinhua (April 11, 2009), of the China’s total foreign reserves outstanding foreign currency loans constituted US$235.2 billion. A large proportion of the country’s foreign exchange reserves are invested in U.S. treasuries and notes. Recently, the U.S. Federal Reserve announced a plan to buy up to 300 billion U.S. dollars in long-term treasuries. However, as the US dollar tend to weaken due to economic crisis, the risk of China’s foreign reserve rises.

However, China is planning to increase the size of its gold reserves to counter the risk of possible US currency devaluation affecting the country’s foreign exchange reserves. To stabilize the value of its huge foreign reserves, China is increasing the percentage of gold in the national exchange reserve system. At present China’s gold reserves is more than 1000 tons with 454 tons added during the past 6 years (CRIENGLISH.COM). The value of gold is more stable than hard currencies during the financial crisis and hence an increase in the gold reserve is expected to offset the risk of possible US dollar depreciation. The US dollar constitutes major part of China’s foreign exchange reserve.

China’s exports and trade surpluses have sharply declined during the first quarter of 2009 but this had no major impact on the size of the foreign exchange reserves. Exports fell 17.5 percent, 25.7 percent, and 17.1 percent in January, February and March respectively. In February, trade surplus plummeted by 34.3 billion U.S. dollars to 4.8 billion (Xinhua, 2009).

During the past decade, foreign exchanges reserves have been growing rapidly even in the poorer regions of the world. According to the Economist (2007) foreign exchange reserves in sub-Saharan Africa has grown five fold from US $ 21 billion in 1996 to US$108 billion in 2006. In 2007 they reached about US$131 billion. Globally, reserves have tripled on average during the same period and, according to the IMF, even the developing world has failed to match Africa’s stockpiling. Much of the increase has come from the African oil-producing countries, where reserves went from just under $6 billion at the end of 1996 to $56 billion at the end of 2006. The reserves in these countries reached nearly US$74 billion by the end of 2007 due primarily to higher oil prices that boosted export revenues. Although increased reserves implied buoyant commodity incomes, improvement in Africa’s foreign exchange earning management contributed significantly to the rise in the reserves.

However the sharp decline in oil and other commodity prices since the mid 2008 led to a substantial decline in foreign exchange reserves in many of the commodity dependent African economies. For instance, Botswana’s foreign exchange reserve decline from US$10.3 billion in July 2008 to US9.1 Billion in December 2008, in just 6 months following the steep decline in export of diamonds, Botswana’s major foreign exchange earner.

The Optimal Size of Foreign Reserves

There is no unified theoretical and practical standard regarding the size of an optimal foreign exchange reserve for a country. Various factors are taken into consideration in deciding the size of foreign reserve in a country. Relevant factors have traditionally included a country’s monetary and exchange rate arrangements, and the size, nature, and variability of its balance of payments and external position. More recently, financial risks associated with a country’s external debt position and the volatility of its capital flows have received particular attention, especially for economies with significant but not fully certain access to international markets. In the process, ensuring the availability of reserves will be influenced by the exchange rate system, and the particular objectives for which they are held (IMF, 2001).

Therefore, when deciding on an appropriate level of foreign exchange reserves, countries should take all economic factors into consideration such as the scale and speed of the national economic development, opening degree of the economy, the situation of foreign trade development, capacity of foreign capital utilization and international financing as well as capability of national macroeconomic regulation and control.

Since the actual conditions of countries are varied, the levels of their foreign reserves differ enormously. For instance, developed countries generally reserve less foreign exchange, for they have a stronger comprehensive power, and their domestic currency is an international reserve currency which can be used for direct foreign payment and has a floating exchange rate as well. In the case of developing countries, they have a relatively backward economic level and have scarce foreign exchange resources, and their home currency is not convertible, they institute different degrees of exchange rate control, so the size of their foreign exchange reserves in their possession is larger accordingly (peopledaily.com.cn).

Regarding the size of China’s foreign reserve, Robert Mundell, the 1999 Nobel Laureate in Economics, expressed the opinion that, although it is proper for China to control its foreign exchange reserve at around US$100 billion in accordance with conventional theory, China’s special situation requires a much higher level of foreign reserve than that under normal conditions. Considering that the domestic financial system is incomplete and the RMB is not yet convertible, China thus needs more foreign exchange reserve to serve as a powerful backing, in a bid to prevent venture capital from disturbing the economic stability and safeguard the financial security (peopledaily.com.cn).

Foreign Reserves during Economic Crisis

During economic crisis, countries worldwide pay more attention to foreign exchange reserves. As stated earlier, however, there is no agreement regarding the optimal level of foreign exchange reserves. The International Monetary Fund and other institutions have proposed several measurement methods, including dividing foreign reserves by national short-term foreign debt, dividing foreign exchange reserves by M2, dividing foreign exchange reserve by import value, dividing foreign reserves by total foreign debt, and dividing foreign reserves by GDP (Jiwei, 2009).

However, analysts argue that this kind of measurement is meaningful under normal conditions, but the situation is different in a crisis. For example, a bank should secure an 8 percent capital adequacy rate in normal times. In times of crisis, this percentage seems far from enough. Thus, the proper level of reserves should vary according to a country’s individual needs.

Some East Asian countries have maintained relatively high foreign exchange reserves or sovereign assets because, in line with their traditions and culture, their citizens are willing to maintain high reserves. And especially since the 1998 Asian financial crisis, East Asian countries have substantially increased their foreign exchange reserve capacities to prevent flows of global speculative capital linked to ineffective supervision. Amid the current crisis, a relatively high foreign capacity has had a positive impact by preventing a contagion of crises and stabilizing foreign exchange rates for these countries (Jiwei, 2009).

The ability of emerging economies to stockpile sizable foreign reserves particularly since the 1998 Asian financial crisis have largely insulated these economies from the current Great Recession. Although the decline in demand for their export in advanced economies and slump in commodity prices substantially eroded their balance of payments and trade surpluses, emerging and developing economies, managed to largely maintain foreign exchange stability, and post economic growth amid serious global economic downturn.

Emerging economies with large portion of their reserves denominated in US dollar still face the risk of decline in wealth with possible depreciation of the US dollar. However, the benefit of holding large foreign exchange reserves during financial and economic crisis far outweighs the costs associated with reserve currency depreciation and inflationary erosion of the purchasing power of fiat money.

References

•    IMF (2001). Guidelines for Foreign Exchange Reserve Management. WWW.IMF.org (2001); September 20, 2001.

•    China’s foreign reserves hit $1.95 trillion at end of March 11/04/2009 available at: http://news.xinhuanet.com/english/2009-04/11/content_11167852.htm

•    Increasing Gold Reserve Conducive to Reduce Risks of Foreign Exchange Reserve. 27 /04/2009 available at CRIENGLISH.COM

•    Jiwei, L. 2009. Sovereign Wealth and the Financial Crisis. available at http://english.peopledaily.com.cn/

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