Foreign Exchange Reserve

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21 Aug, 2024

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Foreign Exchange Reserve Meaning

Foreign exchange reserves, also known as forex reserves, refer to the assets denominated in foreign currencies held by the central bank of a nation. It can comprise foreign currencies, gold, government securities of the reserve currency, special drawing rights (SDRs), reserve position with the IMF, etc.

Lessons from the major financial crisis portrayed the importance of having large forex reserves. The reserves are primarily financial assets that can be applied to offset liabilities. Moreover, some of the assets provide periodic income also. For example, foreign countries can receive interest income and increase forex reserves by investing in US Treasury bonds.

Foreign Exchange Reserve Meaning

Foreign exchange reserves refer to the reserve assets held by its central bank and valued in foreign currency.
The United States dollar is the most commonly used currency for forex reserves.
China has the world's largest forex reserves. By January 2022, the figure had risen to $3.39 trillion.
It is important because it keeps the economies regulated and well maintained along with the exchange rate and currency value.

Foreign Exchange Reserve Explained

Foreign exchange reserves are the reserve assets held and managed by the central bank. Efficient forex reserve management with clear objectives, transparency, and clarity by the central bank promotes prompt processing of policies for meeting national objectives and reduces external vulnerabilities. For example, reserve management makes it easy for central banks to apply monetary policies like currency intervention to manage the country's currency value.

Countries with the largest foreign exchange reserves

Based on IMF data of "World-Official Foreign Exchange Reserves by Currency" and "World-Allocated Reserves by Currency for 2021Q3," most countries prefer to use the US dollar as the reserve currency. It is followed by the preference for Euro, Chinese renminbi, pounds sterling, Japanese yen, Australian dollars, Canadian dollars, Swiss francs, and other currencies. The desirableness towards the US dollar is based on several factors like the easy availability of dollar-denominated securities and their liquidity. Furthermore, the list of top seven countries with the largest forex reserves are China, Japan, Switzerland, Russia, India, Taiwan, and Hong Kong.

Example of Foreign Exchange Reserve

#1 - India

The central bank of India is known as the Reserve Bank of India (RBI), which manages the reserves assets where the primary element is foreign currency assets. India has substantial forex reserves, majorly consisting of Foreign Currency Assets (FCA), gold, Special Drawing Right (SDRs), Reserve Tranche Position. FCA is preserved as a multicurrency portfolio and valued in the US dollar. The multicurrency portfolio includes currencies such as the US dollar, Euro, Pound sterling, Japanese yen, etc. The foreign exchange reserve of India has increased to $634.287 billion on 31 January 2022 compared to the level of US$ 5.8 billion at the end-March 1991, pointing to the progress made since the economic reforms in 1991.

#2 - Pakistan

The foreign exchange reserve of Pakistan drops by $289 million to reach $16,806.5 million by 18 February 2022, compared to the previous week's level of $17,095.8 million. Meeting external debt obligations and a growing current account deficit are eroding the country's forex reserves, forcing it to solicit a bailout package from the International Monetary Fund (IMF) to avoid a balance of payment crisis and provide relief to its struggling economy.

#3 - China

China's foreign exchange reserves are the world's largest hence first place on the list of foreign exchange reserves by country. The level reached $3.39 trillion by January 2022. China's reserves are too big, satisfying most of the tests assessing reserve adequacy conducted by the IMF. The high reserve act as a hedge for the country's currency and entire financial system. The main reasons for China's consistent BOP surplus and increasing forex reserves are economic globalization, global industrial transfer, and structural or economic reforms. Amidst the COVID-19 pandemic challenges, China's economy shows strong signs of recovery, with resilience supporting overall stability in the scale of foreign reserves.

Why is it Important?

Forex reserve accumulation benefits a nation in many ways. First, it can be utilized to meet the balance of payment and foreign exchange needs. It protects the country from the impacts of financial crises or associated economic shocks. During a crisis, having forex reserve accumulation reduces the dependence on borrowings and points to the capacity to meet external debt obligations. Hence it also spreads a level of confidence in the financial markets.

Frequently Asked Questions (FAQs)

What are foreign exchange reserves?

It refers to the reserve assets of a central bank denominated by foreign currencies. The forex reserves' assets can be foreign currencies, gold reserves, etc. It helps manage the Balance of Payment (BOP) and maintain financial market stability.

What is the current foreign exchange reserve of India?

India is in the top ten countries with the largest forex reserve. As of March 2022, the forex reserve of India is USD 622.275 Billion. The central bank of India, RBI, is the custodian of forex reserves. The primary trend of increase in India's forex reserves is attributed to factors like increased FDIs.

Why are forex reserves important?

Having an adequate forex reserve level helps a nation in many ways. For example, it serves the purpose of reserve absorbing the economic shocks associated with a financial crisis, providing stability to the domestic financial markets, and assisting the government in accomplishing their foreign exchange goals and external debt obligations.