Exchange Reserves and How They Affect The Forex Market

By: Justin Stewart

Also called Forex Reserves, foreign exchange reserves refer to only the foreign currency that is deposited and held by central banks and other monetary authorities. However, the more popular usage of the term "reserves" refers to not only foreign exchange, but also to gold, IMF reserve positions, and Special Drawing Rights (or SDR's). These are more appropriately termed as international or official reserves.

These reserves apply to the various assets in the central bank that are held in different currencies such as the United States Dollar (USD), the Euro, and the Yen. Normally, reserves are used to back a financial institution's liabilities in the form of the local currency as well as bank reserves that have been deposited in the central bank by other financial entities and the government.

Under the Bretton Woods system, reserves were held in gold and referred to as official gold reserves. At the time the United States allowed the dollar to be converted into gold and the expression "as good as gold" was never truer. In 1971, the US abandoned this practice and the dollar became known as a flat currency --- money that has a value only because a government demands it for payment of taxes.

Over the past few decades, all other currencies have followed the United States' lead in that they have all abandoned the concept of convertibility to gold. Consequently, this has resulted in the devaluation of currencies globally. Typically, central banks hold major reserves in a variety of currencies despite the fact that the USD is still the most significant currency where forex reserves are concerned.

Where a fixed exchange rate system is concerned, central banks benefit from having reserves in that this allows them to purchase currencies in order to reduce liabilities by exchanging assets. The protection of the monetary system from shock as well as the stabilization of the currency from volatility is enabled because of reserves. Additionally, it is also a safeguard against traders that buy an asset and then quickly resell it for a profit. This is a technique that is referred to as flipping.

Large quantities of reserves are perceived to be a sign of strength because it is indicative of the backing that a currency has. During a currency crisis, low or falling reserves are normally an indicator of an imminent run on the bank and its currency. The holding of large reserves is viewed as a security measure for central banks. To an extent, this is true. However, it's only true if a bank can boost its currency by being able to spend those reserves.

The practice is generally seen as large-scale manipulation where the global currency market is concerned. Since 1971 when the Bretton Woods system was abandoned, some central banks have attempted doing this. In addition to this, there have been instances where multiple banks have teamed up in an attempt to manipulate currency exchange rates. It still remains unclear as to how effective the practice really is. Listed below is a chart of the monetary authorities with the largest reserves in 2008 to date.

Country/Monetary Authority
billion USD (end of month)
change in year 2007

$ 1682 (March) 1

$ 1016 (March)
$ 563 (March)

$ 534 (May 1) 2

$ 313 (May 2) 2

$ 289 (April)

South Korea
$ 260 (April)

$ 196 (May 6) 3

$ 176 (April)

Hong Kong
$ 160 (April)

$ 150 (March)

Foreign Exchange

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