Foreign Currency Reserves

We strongly recommend reading our articles on Forex, before starting with this one. Here, we will try to explain what are foreign currency reserves and how are they accumulated.

Let’s start with an example. Suppose there are two countries: Dorne and Vale. Dorne’s currency is D$ and Vale’s currency is V$. Currently the exchange rate is 1D$ = 2V$. So for every D$ desired by the citizens of Vale, they will have to pay 2 V$. Dorne announces some new economic policy and the country suddenly becomes a hot investment destination. After these new changes lots of people from Vale want to invest in Dorne. This will increase the supply of V$ in the forex market, and demand for D$ will increase. We know that when demand for a product increases, its price rises. So the price of D$ will increase. Let’s say the exchange rate moves upto 1D$=4V$. Again as we learnt in our article on FX, this appreciation of D$ will make Dorne’s exports costly, as Vale’s citizens will now have to pay more V$ to buy the same amount of D$.

In our article on Central bank, we learnt that managing volatility in forex market and printing money are among the important functions of a central bank. In the above example, appreciation of D$ occurred because supply of V$ increased against D$. Let’s say Dorne’s central bank doesn’t like this and starts printing more D$ to pump into forex market in order to buy and absorb increased supply of V$. As the central bank starts buying V$, with the newly printed D$, it will start accumulating V$. This accumulated pie of V$ is called foreign currency reserves.

Now let’s understand why these foreign currency reserves are very important. Suppose suddenly the situation in Dorne turns bad due to collapse of the Central Government and now all the citizens of Vale, who had earlier invested in Dorne, want to pull out their investments. All of them will start selling D$ to convert it into V$, which they can take back to Vale. This will increase the supply of D$ in the forex market. Again as the supply increases we know that price of D$ will go down and it will depreciate against V$. Dorne’s central bank doesn’t want that to happen. So it starts selling V$ from its foreign currency reserves to buy D$ and increase the demand to match supply. In this way it will be able to control excessive depreciation of its currency.

When the central bank of a country tries to control excessive currency appreciation, through printing its own currency, in order to buy foreign currency, it ends up building foreign currency reserves. It can use these reserves to control excessive depreciation of its own currency – by selling foreign currency from reserve and buying its own currency. But the important point to note is that there is no limit upto which a Central Bank can print its own currency. However foreign currency reserves held by the bank are limited. So the extent upto which a central bank can protect its currency depreciation depends on the level of foreign currency reserves it holds.

Now, let’s understand the role played by foreign currency reserves in balance of payment.