What are Forex Exchange Reserves?

There can be no doubt that the US dollar (USD) remains the single most influential currency in the world, with the greenback involved in 88% of all forex trades.

Interestingly, countries across the globe also hold huge amounts of US dollars in currency exchange reserves, which refer to assets that are denominated in a foriegn currency and held in reserve by central banks.

We’ll explore forex exchange reserves below, while asking why countries hold onto them on a consistent basis.

How do Exchange Reserves Work?

The denominated assets held in reserve can include a diverse array of instruments, from currencies and bonds to treasury bills and a raft of other government securities.

However, most foreign exchange reserves are held in US dollars, while overseas governments are thought to own $6.13 trillion worth of US Treasury bonds alone. Incredibly, mainland China holds $1.1 trillion, with this sum having grown incrementally during the last decade.

But how exactly do they work? Well, foreign denominated assets are usually secured in bulk by central banks across the globe, before being held in reserve and away from the secondary or primary financial markets.

Interestingly, interest isn’t paid on foreign cash reserves or gold holdings, although a central bank will usually earn interest on government securities. 

However, such banks may make a profit in instances where a particular reserve currency depreciates or incurs a loss on its appreciation, but this is typically offset by the costs of holding reserve funds (especially in cash). These usually take the form of storage and security costs, and they vary depending on the value of assets held.

Why do Countries Hold Foreign Reserves?

The holding of assets can hold several purposes, but from the perspective of forex reserves, these are largely held to provide back-up funds in the event that a country’s domestic currency depreciates sharply or becomes completely insolvent.

Foreign exchange reserves are not only used to provide a source of fiscal security and back liabilities, but also influence global monetary policy decisions.

Economists believe that it’s far better to hold the foreign exchange reserves in a major currency rather than alternative assets, although it’s widely recommended that countries build cash holdings that aren’t directly connected to their own domestic currency.

This creates an additional layer of economic security in the event of a market shock, with developments such as the great recession of 2008 tending to have the same impact on similar assets and intertwined currencies across the globe.

Of course, traders and no deposit bonus forex account holders are able to negate this by profiting directly from volatility and price movements, but the same cannot be said for holders of forex reserves.

Of course, there’s an inherent risk with focusing solely on building currency reserves, with these having been borne out by the coronavirus pandemic. For example, most nations sought to slash their base interest rates in order to manage inflation increases, with this reducing capital inflows from overseas and lowering currency values across the board in the process.

This is why countries diversify into other assets as part of their reserve exchanges, while holding the vast majority of their funds in currency.