In economics, the concept of foreign reserves describes the holdings of gold and foreign assets, such as foreign government bonds and foreign currency, by a country’s central bank or monetary authority. The amount of foreign reserves a central bank holds is largely determined by the macroeconomic policy and foreign transactions of the country. In balance-of-payments accounts, which record all the cross-border flows of foreign currency, central bank foreign reserves equilibrate inflows and outflows. If a country is running a trade surplus, more foreign currency is coming into the country through trade in goods and services than is leaving the country through this channel. This excess foreign currency could be used to lend to other countries (positive net foreign investment) through the banking industry or other financial institutions. If the country does not spend all the excess currency on foreign lending, the remainder will accumulate as central bank foreign reserves, also known as the official settlement balance or balance of payments (the narrow definition). For example, in the early 2000s the Chinese central bank accumulated a very large amount of U.S. Treasury bonds largely due to many years of a substantial trade surplus in China.
The foreign reserves of the central bank play a central role in the exchange rate policy. If a country’s monetary authority is following a regime of dirty float, it might want to intervene in the foreign exchange market to prevent large changes in the exchange rate. Frequently, such interventions are sterilized, in order not to affect the total amount of domestic currency in circulation. For example, if the U.S. Federal Reserve (Fed) wanted to keep the dollar from rising in value relative to the euro (that is, to keep the dollar from appreciating), the Fed would use dollars to purchase euros. The supply of dollars in circulation in the United States would increase because of this transaction. The Fed may sterilize this foreign exchange effect on the money supply by selling more U.S. bonds to the public in exchange for dollars, thereby reducing the money supply to its original level.
So, to prevent currency appreciation, the monetary authority would sell domestic currency and purchase foreign currency, thus accumulating foreign reserves. This is another reason, in addition to its trade surplus, that China had such large foreign reserve holdings: the Chinese monetary authority kept the Chinese currency, the renminbi, from appreciating with respect to the U.S. dollar.
To prevent currency depreciation, the monetary authority would sell some of its foreign reserves in exchange for domestic currency. In order to do that the monetary authority has to have sufficient holdings of foreign reserves to sell. For this reason, the central banks of many countries like to hold a substantial amount of foreign reserves to protect themselves from external shocks that could cause sharp depreciation of their currency, such as a sudden outflow of foreign investment from the country or a sudden drop in export revenues.
The amount of foreign reserves is particularly important for countries that follow a fixed exchange rate regime—that is, they commit to maintaining the value of their currency at a preannounced level. In many cases, such policies were adopted in order to anchor inflationary expectations and lower the level of inflation. In these cases, inflationary pressure in a flexible exchange rate regime would lead to currency depreciation. When the exchange rate is fixed, the monetary authority has to keep spending its foreign reserves to maintain the promised level of the exchange rate. Most of such fixed exchange rate regimes ended in currency crises, also known as balance-of-payments crises, because monetary authorities ran out of foreign reserves. Sometimes the currency crisis in such a situation can be delayed through currency devaluation, when the fixed exchange rate is reset to a new level. The most commonly used model that links foreign reserves to currency crises was developed in Paul Krugman’s 1979 article “A Model of Balance-of-Payments Crises,” modified later by Robert Flood and Peter Garber in their 1984 article “Collapsing Exchange Rate Regimes: Some Linear Examples.”
Historically, the currencies used for foreign reserves were largely dictated by the exchange rate policies in the economies that used paper money. Initially, when paper money was introduced, in order to make people believe in its value, many countries tied the value of the paper money to gold or silver—each banknote could be redeemed at the central bank in exchange for the amount of gold or silver indicated on that banknote. Such an arrangement required the central bank to hold sufficient reserves of gold or silver to exchange all of the banknotes it printed for precious metal. If the central bank did not have sufficient reserves, it would devalue the paper currency by lowering the amount of precious metal the holder of the banknote could obtain.
Under the Bretton Woods arrangement (1944–1971), participating countries’ currency values were tied to the U.S. dollar, while the value of the U.S. dollar was tied to gold. Thus, the Federal Reserve System, the central bank of the United States, would hold foreign reserves primarily in gold while other countries held their foreign reserves primarily in U.S. dollars. As a rule, countries that adopt fixed exchange rates tend to hold their foreign reserves in the foreign currency to which they tie the value of their national currency.
Most countries, regardless of their exchange rate regime, hold their foreign reserves in hard currencies, currencies that are known to have low inflation: the U.S. dollar, the euro (before the existence of the euro, the German mark), or the Japanese yen. As of 2004, as much as 75 percent of total world foreign reserves were held in U.S. dollars. This U.S. dollar dominance is due mainly to the fact that many countries held the U.S. dollar as their foreign reserves during the Bretton Woods period. In addition, as Cedric Tille and Linda Goldberg argue in “Vehicle Currency Use in International Trade” (2005), much of this dollar dominance today is due to the fact that most international trade is invoiced in U.S. dollars. Nevertheless, this need not be the case in the future—as Menzie Chinn and Jeffrey Frankel show in “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” (2005), the euro may surpass the U.S. dollar in the role of major currency as early as 2020, mostly due to a substantial depreciation of the U.S. dollar from 2001 to 2005.
SEE ALSO Banking Industry; Currency; Currency Appreciation and Depreciation; Currency Devaluation and Revaluation; Dirty Float; Exchange Rates; Greenspan, Alan; Hedging; Money; Mundell-Fleming Model; Purchasing Power Parity; Trade Surplus
Chinn, Menzie, and Jeffrey A. Frankel. 2005. Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency? KSG Faculty Research Working Paper Series RWP05–064. Also NBER Working Paper 11508.
Flood, Robert P., and Peter Garber. 1984. Collapsing Exchange Rate Regimes: Some Linear Examples. Journal of International Economics 17 (1): 1–13.
Krugman, Paul R. 1979. A Model of Balance-of-Payments Crises. Journal of Money, Credit, and Banking 11 (3): 311–325.