Foreign Exchange Reserves, Defined
We classify foreign exchange notes and government debt held by the world’s central banks as foreign exchange reserves. The management of these foreign exchange reserves, of course, presents far-reaching implications for the global economy. A country may influence exchange rates through these reserves, and consequently, its own positioning within international trade.
Government agencies 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 do signal financial strength. A nation is therefore motivated to build up its FOREX reserves – so that it can negotiate lower interest rates upon its debt and deal with international trading partners on better terms.
Central bank officials may influence exchange rates 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.
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.
A central bank may also drive interest rates higher to slow down an overheated economy and curb inflationary risks. The domestic currency would then be likely to appreciate, as foreign investors and capital are attracted into this home market for its higher interest rates and return potential.
The Dollar Peg
Developing nations often purchase large amounts of U.S. dollars and Euros as foreign exchange reserves, as a means 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 and guard against debt crises and social unrest.
Without fixed exchange rates, a developing nation and its economy may be prone to wild swings of boom, bust, and hyperinflation. Fixed exchange rates, however, make it more difficult for a developing nation to mend its own economy with targeted policy.
Venezuela, for example, 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.