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Foreign exchange reserves are very important for a country. Without adequate foreign exchange reserves, an economy can stall and potentially collapse due to the inability to pay for key imports, such as crude oil, or pay off foreign debt. . In this article, let’s find out what specific foreign exchange reserves are, why they are needed, and how are the foreign exchange reserves of countries around the world.
You are viewing: What is Forex Reserve
What is forex reserve?
According to the International Monetary Fund (IMF), foreign exchange reserves are foreign currency assets that a country’s monetary authority can use to meet its balance of financial settlement needs, which can affect the exchange rate. currency exchange rates and other related purposes.
From the above definition of the IMF, we can understand foreign exchange reserves as foreign currency reserves held by the Central Bank of a country. These reserves may include banknotes, deposits, bonds, treasury bills, gold, IMF drawing rights, special drawing rights (SDRs), and other government securities. Usually countries hold most of their foreign exchange reserves in US dollars and a small part in Euros.
Why do you need to reserve foreign exchange?
First, countries use foreign exchange reserves to maintain the value of their currencies at a fixed level.
A good example is China, thanks to its high foreign exchange reserves, the value of the renminbi relative to the US dollar is not compromised. In other words, When China reserves dollars, increases in value when compared to the renminbi. That makes Chinese exports cheaper than American goods, which in turn increases revenue.
Or in 2014, the United States and the European Union imposed economic sanctions on Russia for its involvement in the Ukraine conflict. This sanctions not only reduced the price of crude oil (a key export commodity) by 50%, but also severely affected the Russian economy, causing the ruble to fall 40% against the dollar in 2014. This could be much worse if Russia did not have the foreign exchange reserves to subsidize the ruble. Russia spent more than $80 billion in foreign exchange reserves and kept the ruble stable between 2015 and 2018, until the political situation in Ukraine calmed down.
Second, countries with floating exchange rates use reserves to keep the value of their currencies lower than the US dollar. They do this for the same reasons as those with a fixed exchange rate system (China). Despite the Japanese Yen, under a flexible (floating) exchange rate regime, the Bank of Japan buys US Treasury bills to keep the Yen’s value lower than the US dollar. Like China, this makes Japanese exports relatively cheaper, boosting trade and economic growth.
The third, and very important, function is to maintain liquidity in the event of an economic crisis. For example, floods or volcanoes can temporarily suspend the ability of local exporters to produce goods. That cuts off their supply of foreign currency to pay for imports. In that case, the Central Bank can exchange the foreign currency for the local currency, allowing them to pay for and receive imports.
Likewise, foreign investors will be stunned if a country goes to war, a military coup, or anything else that damages investor confidence. They withdraw their deposits from the country’s banks, causing a severe shortage of foreign currency. This reduces the value of the local currency because few people want to own it. This will make imports more expensive, creating inflation.
In this situation, the Central Bank will use foreign currency reserves to keep the market stable by buying local currency to support value and prevent inflation. This makes foreign investors feel secure and return to the economy.
Fourth is more confidence. The Central Bank assures foreign investors that they are ready to act to protect their long-term investment. If a country has strong foreign exchange reserves, it can prevent sudden or unforeseen economic crises.
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Fifth, reserves are needed to ensure that a country will meet external obligations. Includes international settlement obligations, including sovereign and commercial debts. They also include financing for imports and the ability to accommodate any unexpected capital movements.
Sixth, some countries use their reserves to finance industries, such as infrastructure. For example, China has used part of its foreign exchange reserves to restructure some state-owned banks.
Seventh, most Central Banks want to increase profits without compromising safety. They know the best way to do that is to diversify their portfolio. That’s why they often hold gold and safe, profitable investments.
Effect of foreign exchange reserves
The rapid growth of foreign exchange reserves strengthens the synergy of major countries, enhancing the country’s credit in the international arena. Foreign exchange reserves are an important measure of the aggregate strength of a country. An increase in a country’s foreign exchange reserves demonstrates its liquidity strength to the outside world and strengthens its ability to regulate its international revenues and expenditures. Adequate foreign exchange reserves can make a central bank The national central government has the ability to intervene in the external foreign exchange market, supporting the exchange rate of the domestic dong. Adequate foreign exchange reserves can comfortably cope with sudden financial crises, meet the need for effective participation in the external foreign exchange market, and maintain stability. of the domestic currency. Adequate foreign exchange reserves will promote the national economic development for the market. Firstly, adequate foreign exchange reserves can improve the country’s financial ability to the outside world, reduce the amount of investment capital of domestic units when participating in foreign investment, and promote international enterprises. internal search for a better investment environment and greater profitability. Second, adequate foreign exchange reserves can play an important role in such areas as economic reform, adjustment of industrial structure, and improvement of production techniques. Sufficient foreign exchange reserves can meet the need to import advanced technical equipment. Third, it can meet the people’s greater demand for foreign exchange. Sufficient foreign exchange reserves are also the last necessary condition for the domestic currency to be freely convertible into foreign currencies. A country’s large foreign exchange reserves ensure that the country can respond to exchange requirements that may arise at any time, maintaining relative stability in the market exchange rate. foreign exchange, counteracts the risks posed by currency exchange and mitigates potential negative effects. When a normal account is freely convertible, the goal of a country is to remove foreign exchange controls on the current account and the capital account, while not restricting normal international exchange operations. and capital flows, to realize fully convertible local currency. Sufficient foreign exchange reserves allow the central bank to effectively regulate the foreign exchange market, maintain the basic balance of international payments, and maintain the basic stability of the domestic currency exchange rate in the process. to freedom of conversion.
Increasing inflationary pressure, affecting monetary authorities in making monetary policy independently. In recent years, the issuance of base currency in the form of foreign exchange funds has become the main channel for placing central bank currency. As foreign exchange reserves increase year by year, in order to maintain the stability of the foreign exchange market, the central bank must buy foreign exchange in the foreign exchange market and sell its own foreign currency. Through the effect of the money multiplier effect, the money supply is expanded, which not only affects the independence of monetary policy but also causes inflationary pressure. Central bank hedging tools are still relatively limited and the hedging effectiveness is unclear. Therefore, if foreign exchange reserves continue to increase at a faster rate, inflation pressure will continue to increase. Increasing pressure on domestic currency appreciation is not conducive to favorable development of foreign trade activities. . Huge foreign exchange reserves have increased pressure on an appreciating domestic currency rate, and put a country in a significant dilemma of both having difficulty reducing pressure on the domestic currency’s price and constraining its growth. money supply: reducing the over-issue of the base currency caused by foreign exchange. The country must increase withdrawals or raise interest rates due to market influences, but these activities will increase pressure on the domestic currency’s price. If the money supply increases or decreases interest rates to relieve pressure on the domestic currency’s price, the already very loose money market will change accordingly. It must be excessively loosened, thus stimulating the expansion of the country’s asset market bubble. The country could fall into a vicious circle of “rapid increase in foreign exchange reserves – expected appreciation of domestic currency – capital inflows – foreign exchange reserves continue to increase – appreciation and capital inflows”. In addition, an increase in foreign exchange reserves will further exacerbate trade conflicts and exacerbate international payment imbalances, which are not conducive to the sustainable development of the economy and foreign trade of the country. country.It brings high opportunity costs, increases capital gains risk, and increases exchange rate risk. Holding on to a country’s foreign exchange reserves means hoarding these resources, while giving up and sacrificing its investment opportunities, which creates a kind of economic loss. This loss is also an opportunity cost. The more foreign exchange reserves a country has, the higher the opportunity Cost. As the main asset of foreign exchange reserves, the US dollar is subject to frequent exchange rate fluctuations, and high foreign exchange reserves can bear the risk of US dollar depreciation. working cash surplus. Affecting the efficiency of capital use of banks, exacerbating the imbalance of economic structure. Massive trade surplus enters commercial banks through foreign exchange settlement and foreign currency fund conversion. The large-scale investment in foreign exchange funds as the base currency causes multiple expansions of the money supply by a currency multiplier mechanism, resulting in rapidly expanding market liquidity. The growing size of the deposit balances of commercial banks and the increase in liquidity in the money market are both related to this factor. Perhaps the more serious problem lies in the fact that excess liquidity will also cause a series of negative consequences such as falling corporate profits, overheating investment and inflation.
Situation of foreign exchange reserves around the world
According to data from the IMF, China is the largest holder of foreign exchange reserves in the world with 3,161.5 billion worth of assets in foreign currencies, mainly the US dollar.
Japan and Switzerland are followed by three countries with the largest foreign exchange reserves in the world, with $1,204.7 billion and $785.7 billion, respectively.
Other major economies such as the US and Europe have low foreign currency reserves because the US dollar and euro are the two most held foreign currencies today. Therefore, the US and the countries of the European Union do not need to reserve much foreign currency.
The Japanese Yen is one of the most reserve currencies, but Japan is still the second largest foreign currency reserve country in the world with more than 1.2 trillion USD. The reason is because Japan is an exporting country, bringing about 605 billion USD of exports abroad every year.
Vietnam’s foreign exchange reserves
Recently updated information shows that the foreign exchange reserve of the State Bank (SBV) has reached 73 billion USD at the end of October 2019, after 4 consecutive months of buying with a total value of up to 6.65 billion USD. USD.
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However, the above figure is still lower than the 8.35 billion USD bought in the first 4 months of 2019. The 73 billion USD figure is also the highest level ever. Thus, in the 10 months of this year, foreign exchange reserves have increased by 15 billion USD, marking the highest buying rate in many years.
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