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Before we can discuss why governments hold foreign currency reserves we should touch base on what foreign currency reserves are.
Foreign currency reserves are typically foreign currency deposits and bonds that central banks hold. These deposits include paper and coin, but also gold. These central bank assets are not held in one currency, but usually several of the most reliable standard currencies like the US dollar, and even sometimes the euro, Great Britain pound sterling, and Japan’s yuan. Central banks use these assets to back liabilities like the local currency they issue and different central bank deposits from depositors like governments.
Because national central banks have reserves in numerous currencies they can purchase their own domestic currency, which is a liability to them, with another currency the bank holds. Governments sometimes decide to do this in order to stabilize their own currency in turbulent economic times, and to influence global exchange rates. One of the most famous examples of this is in 1945, after World War II was over. Before this point, the entire world’s reserve currency—the safest, most dependable currency in the world, accepted everywhere, universally known—was Great Britain’s pound sterling. Because of Great Britain’s absolute decimation during the war, their currency was weaker than ever before, and it was widely asserted that the USD should replace the GBP as the world’s reserve currency. As such, a gradual shift—instigated and sustained, in large part, by several central banks buying and selling their reserves in US dollars—unseated the GBP as the world’s go-to currency and replaced it with the US dollar.
A Closer Look at Market Stability
We have already established that countries buy their own currency using another currency they have in reserve in order to calm market volatility associated with the domestic currency. This is done mainly because the foreign exchange market is extremely sensitive to market disruptions, probably more sensitive to fluctuations than any other financial market today. There are several reasons for this, too many to get into in this article. What’s important though is that this incredible sensitivity and the foreign exchange market’s heavy influence on other financial markets are the motivators for governments and central banks to buy and sell reserve currencies in an effort to lessen the negative impacts felt by the foreign exchange market. With that in mind, the amount of reserves a bank keeps is always in flux, dependent upon the country’s monetary policies. For instance, if the bank implements a policy of a fixed exchange rate the flow of supply and demand will move the value of the currency up or down. If the bank were to implement a flexible rate, this ebb and flow happens automatically with the bank handling excesses by buying or selling the foreign currency.
Unsterilized foreign exchange operations (influencing exchange rates and/or monetary supply without buying or selling domestic currency) cause expansions and contractions in a domestic monetary supply, directly influencing the country’s monetary policy and rates of inflation.
Exchange Rate Targets and Demand
Inflation and exchange rate targets are inseparable; you cannot have one without the other. If a country has a desirable exchange rate goal, and there is an increased demand for the domestic currency at that rate the bank can print more domestic currency and purchase it with a foreign one it has in reserves, increasing the value of those reserves. This is currency manipulation, artificially suppressing the value of a currency, and it eventually instigates domestic inflation. If a bank is holding a currency that nobody wants, devaluation of the currency occurs. If the currency is particularly popular, and demand is increasing rapidly, the increased volume of the currency will eventually result in high inflation and reduced demand for it.
Currency reserves is a complex topic, one that can be discussed much further than within the confines of this article. Despite all its intricacies, the purpose of government banks stashing amounts of foreign currencies away is to bring them out in order to make their own domestic currency value better and to better support the country’s domestic actions and monetary policies.