Foreign Exchange Reserves are monies held by the central banks or central government of a country, denominated in the currencies of other countries or in gold. Traditionally, foreign exchange reserves were held in gold, and this determined the value of a nation’s currency. Since World War II, the majority of foreign exchange reserves have been held in US dollars, as this has been the de facto international currency, or the “reserve currency”. With the rise of the European Union, the Euro is now taking on an increasing role as a foreign reserve currency, while the dollar’s role has been slightly decreased.
Foreign reserves are generated when a government receives funds from another country, generally via trade, in exchange for goods and services. If a nation has an export surplus, it will generate reserves in other nations’ currencies.
Due to China’s policy of fueling the growth of the economy via trade exports, China has become by far the country with the largest amount of foreign reserves, with well over a trillion dollars held by that nation’s central banks. If current trends continue, that amount will soon reach two trillion, and currently stands at over one thousand dollars per Chinese citizen. China is followed by Japan, the Eurozone, Russia, and India in the amount of foreign reserves held. It is interesting to note, also, that Brazil is the nation that growing its foreign reserves at the fastest rate currently.
Foreign reserves affect the value of a country’s currency. The more foreign reserves a nation has, the more their currency is likely to be valued. If a country has low foreign reserves, their currency will correspondingly have a low value because there will be little value backing that currency. The larger the trade surplus the nation has, the more the reserves will grow, and the more their local currency will appreciate in value, which is why we see China with such a large amount of foreign exchange reserves. The only reason their currency has not appreciated in value is because it is pegged to the dollar and the government does not allow it to fluctuate freely.
Foreign exchange reserve holdings also affect the volatility of a currency. There is likely to be more volatility in the exchange rate of a currency if it has little foreign reserves because the currency will be less stable. If a country has low reserves and they increase or decrease, the impact on the currency will be greater and we can expect larger price movements in the value of that currency than we would expect had they larger reserves.
Currently, there is some speculation as to the dollar’s position as reserve currency. Due to the great amount of deficit spending and the large debt that is tied to the dollar’s value, some prognosticators foresee a diminished role for the dollar as the reserve currency. The dollar’s value has been suffering over recent years, partially because so many nations have accumulated a great number of dollars and have less need for them now. There is also a risk for the value of the dollar that some countries could begin to “dump” their reserves on the market, meaning that the world could become awash in dollars, and the value would subsequently plummet.
Other Forex Articles
- Forex Trading books you should read
- How a forex trade works
- Making money in forex trading
- What is forex trading?
- Forex trading books
- Factors that affect currency trading
- What is speculation in forex trading?
- What is a Forex swap?
- Understanding Foreign Exchange Rates
- Should you become a forex trader?
- The History of the Forex Market
- Retail forex brokers
- Algorithmic trading in forex
- A closer look at forex options
- Foreign exchange hedge
- Foreign exchange reserves
- Forex Forward contracts
- Forex scams
- How to get started in forex trading
- 10 forex trading terms every trader should know
