What Foreign Exchange Reserves Are, How They Work and Affect Us

Back few days ago I've read a very interesting article (you can find the link in the credits and sources at the end of this article) about FX Reserves, I've then decided to use it as an info base for this article which partially applies what Kimberly Amadeo has written to Malaysia. Most Countries’ Central Banks hold foreign currencies, these are called Foreign Exchange Reserves. Central banks are holding FX Reserve, for several reasons which, sometime and somehow might be affecting all of us. Let’s see the 7 Most Relevant reasons for Central Banks to hold reserves. The most important of them all is to manage their currency value and directly affect import/export trends and growth. 

Eight Reasons Why Central Banks Hold FX Reserves

#1 - With Floating Exchange Rate Environment to Support a Favourable Exchange Rate to USD (Own Currency<USD)

When a country has adopted floating exchange rate system, then it can use FX Reserves to ensure a favourable exchange rate against the USD and spur its export trading as values are more competitive compared to US-made goods. A good example of this is given by Japan whose Central Bank has kept on buying US Treasure bonds and maintained in this way a very competitive exchange rate towards the USD. Result has been a stable export component within the Japan’s GDP and an expanding growth of the latter. 

#2 - Supporting Own Currency Stable Exchange Rate (pegging USD)

Look at China, whose Yuan is pegged (kind of controlling and managing the exchange rate against the USD) to the dollar. China is a huge exporter to US market and this has allowed to stockpile US dollars. Doing so, by directly holding the currency or US treasury bonds, China raises the dollar value compared to that of the yuan. This action affect positively the export trends as it makes Chinese exports cheaper than US-made goods.

#3 - Mitigating effects of FDI out-flows

In situation as the current Covid-19 pandemic, foreign investors’ confidence in some countries or industries, has been blown away. In case of a massive outflow of FDI the immediate risk is a fast depreciation of the country’s currency and a short/medium risk is higher inflation caused by higher cost of import due to shortage of foreign currency. Central bank, again, can help in maintaining markets’ steadiness by providing foreign currency from the FX Reserves. Additionally, central banks buys the local currency to support its value. In the medium term this will prevent inflation and reassure foreign investors attracting them back.

#4 - Cash in hand for crisis or emergency

A strategic function of FX Reserves is to have “handy” liquidity in the event of an economic crisis. Let’s look into the current world-wide pandemic: with the Great Lockdown having taken place for almost three months exporters have slowed or ceased their goods’ production and/or export activities.  Immediate consequence is the zeroed “supply” of foreign currency much needed to pay for import of raw material or components. The central bank, in this case, can partially use the foreign currencies reserves and exchange in local currency allowing in this way these exporters to keep on paying and receiving the much needed supplies.

#5 - Raising confidence 

A strong a pro-active central bank, willing to use FX Reserves to stabilize the market and avoid “market shock” situations reassures foreign investors on the future of their investments. A strong FX Reserves position of the central bank can help preventing economic crises which happen when a negative event triggers a “flight to safety” sentiment in foreign investors.

#6 - Funding sectors or industries in need of cash-flow

FX Reserves can also be used by central banks and/or governments as “emergency funding” of designated sectors, such as banking or infrastructure. China, in the past, has used part of its FX Reserves for a recapitalization manoeuvre of state-owned banks.

#7 - Guarantee country’s external obligations

Countries around the world issue government bonds to finance their public spending. Strong FX Reserves are considered an indispensable “collateral” to make sure external obligations will always be met. 

#8 - Boosting returns with no compromise on security

Most central banks, in their “investor position” want to have boosted returns without the need of high risks. The best way to achieve this is through portfolio diversification. Often, Central Banks hold commodities such as gold and other safe, interest-bearing investments.

General Guidelines

Countries should have enough FX Reserves to pay for up to six months of their imports and enough to cover the country's debt payments and current account deficits for 12 months. Greece, in 2015, has set a good example of what a country shouldn’t do. Greece’s almost defaults led to the infamous Greek debt crisis. 

"Malaysia Case Study" FX Reserves Past & Present: Status Quo

Malaysia has been building a strong FX Reserves since the ’97/98 financial crisis. The graphic below show clearly how good its position has been and is today by being included in the shortlist of countries with more than USD100 billions in FX Reserves. By looking at the current situation and the uncertain future within the Covid-19 pandemic, countries with a strong and stable control exercised by their Central Banks over the management of FX Reserves should be preferred destination of FDI or investors looking for a safe and stable haven.

I always like to compare countries based on the most important asset of them all, people or, in other words, population. Here is a table to compare FX Reserves based on population. From here it’s quite clear, even though the Malaysian FX Reserve performance has been good and steady for the past 20 years, that we still have a long way before being able to compare ourselves to the tops pf the list instead of the bottom ones.

FX Reserves By Country

Below is a comparative list of countries with reserves of more than $100 billion as of December 31, 2017 and Q1 2020.

Credits and Source: Kimberly Amadeo article in The Balance  CIA World Factbook, "Reserves of Foreign Exchange and Gold Bank Negara Malaysia and REI Group Archives and data sets

About the Author

The opinions expressed in this article are solely of the author, Dr Daniele Gambero. He has been an expatriate to Malaysia from Italy, since 1998 and has more than 35 years of real estate experience. He is the co-founder and group CEO of REI Group of Companies, the deputy president of the Malaysia Proptech Association, international sought-after speaker and bestselling author. 

He can be reached at: daniele.g@reigroup.com.my