Foreign Exchange Reserves

FOREX reserves refer to foreign exchange notes and government debt held by the world’s central banks. As such, the management of these reserves presents far-reaching implications for the global economy. Through its FOREX reserves, a country can influence exchange rates, and consequently, its own positioning within international trade.

Government officials use foreign exchange reserves to make official international payments. These official international payments may be spent to procure various goods and services, such as raw materials, real estate, and military equipment. High levels of FOREX reserves signal financial strength. A nation is therefore motivated to build up its FOREX reserves – so that it can negotiate lower interest rates on its debt and deal with international trading partners on better terms.

Central Banks

Central bank officials can manage exchange rates on domestic currency through their FOREX reserves. To strengthen the value of the home currency, a nation will spend its foreign exchange reserves to buy its domestic banknotes. This buying activity increases demand for the domestic currency, which translates into higher valuations. Alternatively, a country will spend its foreign exchange reserves to buy international banknotes – when it intends to devalue its home currency. In America, the Federal Reserve Bank of New York is responsible for official foreign exchange reserve transactions.

International Trade

Nations with strong export economies target weak exchange rates. At that point, exported goods become more affordable for foreign buyers. In addition to exports, a weak domestic currency will also attract buying interest for the nation’s investment securities, which are then also cheap for foreign buyers.

Low exchange rates for domestic currency, however, can be inflationary because imports become more expensive at home. A central bank may then use FOREX reserves to buy its domestic currency and support higher exchange rates – when inflation is a concern.

Dollar Peg

Developing nations often purchase large amounts of U.S. dollars and Euros as foreign exchange reserves, which are designed to establish a fixed exchange rate, or currency peg. Developing nations, such as Venezuela, Morocco, and Ivory Coast, peg their currencies to U.S. Dollars and Euros to stabilize their respective economies.

Without fixed exchange rates, a developing nation and its economy may be prone to wild swings of boom, bust, and inflation. Fixed exchange rates, however, make it more difficult for a developing nation to mend its own economy with targeted policy. For example, Venezuela may be better served with low exchange rates to help its export economy, while its Dollar peg forces the nation to accept artificially strong valuations for the Venezuelan Bolivar.