Forex reserves provide security to countries in times of financial or international emergencies.
Forex reserve represents the amount of foreign currency deposits, gold reserves, and International Monetary Fund’s SDRs (Special Drawing Rights) that a country’s central banks possess.
Just as individuals hold deposits in terms of currency, gold, and other assets as a part of their savings portfolios, countries hold forex reserves as their (international) savings portfolio. In that regard, such reserves, as the name suggests, provide a security to countries in times of financial or international emergencies.
Currency reserves and gold, in general, are a result of trading operations such as imports and exports (of goods and services) and investment flows.
SDR refers to a “potential claim on the freely usable currencies of the IMF members”. IMF members could exchange their currencies for SDRs either through voluntary exchange or by IMF’s mandate in certain situations.
From fixed to floating rates
One of the significant historical shifts in international monetary denominations happened in 1971, the year in which the Bretton Woods system ended. Until then, (beginning 1946), the Bretton Woods arrangement ensured that countries could buy gold from the US at a fixed rate of $35 per ounce.
This process essentially guaranteed that, globally, international exchange rates were fixed at the specified measure of gold, for which, the US dollar-gold exchange served as the anchor.
What this means is that until 1971, the forex reserves of countries were typically denominated in one unified and standard metric, which was the amount (and value) of gold. Once the Bretton Woods fell apart, the formal connection between the value of real commodities and currencies severed.
This disconnect gave way to countries opting to let their currency values to be determined by market forces instead of a fixed value related to gold. It also paved way for countries to diversify their reserves into different classes, as what is currently being followed.
Changes in forex reserves
The composition of forex reserves, as one could imagine, changes based on various factors, the most obvious of which is risk diversification. For instance, during times of economic distress of a particular country, other countries may want to hold less of the suffering country’s currency.
For instance, after the economic turmoil in the late 2008, many countries, including India, accumulated gold into their reserves. This partially substituted other global currencies.
Typically, the level of currency reserves, disregarding the time-frame, increases when the domestic country experiences one or more of the following:
The country runs a trade surplus (exports higher than imports) so that foreign money flows in;
The country experiences an increase in FDI or FII inflows;
The country receives remittances from its non-residents living in foreign countries, and
The central bank buys foreign currencies to keep the value of the domestic currency at low levels.
Increases in FDI or FII inflows are susceptible to being reversed out of the country after specific points in time. Similarly, central bank’s intervention is an artificial process, and thus not sustainable. Consistent trade surpluses alone represent a sustainable and healthy increase in forex reserves.