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What are Foreign Exchange Reserves?

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  • Written By: Patrick Lynch
  • Edited By: R. Halprin
  • Last Modified Date: 26 September 2016
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Foreign exchange reserves are also called Forex or FX reserves and are supposed to be the amount of foreign currency deposits that a country’s central bank holds. A nation’s central bank will have these reserves in different currencies; the dollar and the euro are the most commonly used. Governments are able to keep their currencies stable by holding the currencies of other nations as reserves; this also reduces the effect of economic problems. Once the gold standard declined, foreign exchange reserves became popular.

A central bank’s monetary policies alter the amount of reserves available to a country. For example, if a nation’s currency is in high demand but that particular country wishes to keep its foreign exchange rate at the same level, the central bank can issue more domestic currency while purchasing foreign currency. This can have the effect of increasing the country’s foreign exchange reserves. Yet this may not be a good idea because excess printing of a currency can lead to domestic inflation.

In general, there are very few central banks that will adopt such a simple monetary policy, however. A variety of factors such as production and imports and exports affect a currency’s foreign exchange rate. Inflation can take years to become apparent which could lead to a major short-term change in foreign exchange reserves as the market reacts to incomplete data.

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One criticism of foreign exchange reserves is that large nations with huge amounts of these reserves can alter exchange rates in their favor by stabilizing the rates of foreign currencies. This could lead to a more desirable economic environment for their country. Those countries with a sizable amount of foreign exchange reserves can also protect their currency from speculative attacks. Yet nations with a massive amount of reserves are at the mercy of exchange market fluctuations. These market movements can result in a big loss for a country with enormous foreign exchange reserves.

The nation with the greatest amount of foreign exchange reserves at present is the People’s Republic of China which has approximately $2.65 trillion U.S Dollars (USD) worth of foreign currency in reserve. Although the amount of reserves a nation owns is often considered to be a measure of its credit rating, China was roundly criticized by other nations. The practice of purchasing too much foreign currency to keep a nation’s own currency in check can have the effect of destabilizing the global currency system.

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