Forex reserve or foreign reserve refers to the foreign currencies held by the central bank or other countries monetary authority. It can be in the form of cash or assets that can be liquidated. There are many reasons why to maintain a good Forex reserve is important, the most important one is crucial in safeguarding the local currency’s value.
A country’s Forex reserves depend on its imports and exports. Local exporter is paid by its trading partner in USD, CAD, Euros, or other currency. The trader deposits this foreign currency into his local bank, and in exchange, he receives local currency, which you can use for your day to day transactions. Then local bank transfers the foreign currency to the central bank.
How are Foreign Exchange Reserves Accumulate?
Simply when a country imports any commodity, it has to pay the other country or the foreign trader in their respective currency. This leads to a decline in Forex reserves. Thus to accumulate Forex reserves, a country needs to increase its exports and decrease its imports.
Importance of Forex Reserves
Forex reserves are important for every nation because they include bonds, deposits, banknotes, treasury bills, gold, and other government securities. They can also ensure that the central government agency has backup funds to support the national currency if it devalues at some point.
The importance of Forex reserves for developing countries is based on the security of home currency positions, maintaining liquidity in economic crisis, economic growth boost, attracting foreign investments, funding infrastructure projects, etc…
Forex reserves include banknotes, deposits, bonds, treasury bills, and other government securities. These assets serve many purposes but are most significantly held to ensure that a central government agency has backup funds if their national currency rapidly devalues or becomes altogether insolvent.
For every nation maintaining a Forex reserve is important. Whether it is developing or developed, every country makes calculated moves to ensure that its foreign reserves never see a fall.
Forex Reserves Can Secure the Position of Home Currency
One of the most advantageous position that a country with considerable Forex reserves enjoy is its currency’s security. These maintain the value of home currency at a fixed rate. It safeguards the home currency against devaluation, and it also promotes sales.
For better understanding an example for you, China pegs the value of the yuan against the USD. By stockpiling USD, it raises the dollar’s value compared to the yuan, increasing their sales as Chinese exports become cheaper than American made goods.
Foreign Exchange Reserves Can Boost Economic Growth
The countries with floating exchange rate system use Forex reserves to keep their currency lower than USD. For example, with its floating currency, the yen, Japan buys U.S. treasuries to keep the yen’s value lower than USD. This encourage exports that leads to economic growth.
Forex Reserves Can Maintain Liquidity in Economic Crisis
Maintaining a Forex reserve allows a country to import necessary commodity, otherwise not being produced locally due to crises like volcanic eruptions or floods. In such cases, the central bank aids the local exporter by liquidating its foreign reserve.
The bank exchanges foreign currency to the local currency, enabling domestic exporters to import items. Similarly, situations like wars, military coups, or political instability can make foreign investor apprehensive about investing in an unstable country.
This can encourage them to withdraw their deposits from their bank, creating a foreign currency storage. You can encourage them to withdraw their deposits from their bank, creating a foreign currency shortage. This can lead to inflation as imports will become expensive. Such situations can be avoid, if only a country has enough foreign currency.
Foreign Exchange Reserves Can Attract Foreign Investment
‘Money brings” statement holds when we talking about foreign exchange reserves. Every country needs foreign investment for economic growth. To provide confidence to foreign investors, the central bank uses foreign reserves as leverage. It assures the investors that their investments will be protect.
Forex Reserves Can Meet External Obligations
The importance of Forex reserves for developing countries is incalculable, but this point is crucial. Countries require foreign currency to Settle international payments, including sovereign and commercial debts.
In additional, developing countries depend on financing and loans from international monetary authorities. If these countries don’t have enough foreign balance, it can reduce their borrowing powers.
Forex Reserves Can Fund Infrastructural Development
The importance of foreign reserves is not limited to financial interactions with foreign countries. Various countries use their reserves to fund their infrastructure sector as well. For example, China recapitalized some of its state-owned banks using its reserves.
Forex Reserves Can Boost Returns
Many countries hold various interest-bearing investments, to boost without compromising. That maybe gold, treasury bonds, or other assets that can be liquidated easily.
Why do You Need Foreign Currency?
We need foreign currency because we use currency as a medium of exchange for goods and services and we needed to buy products and services from a foreign country. Forex rate helps us to convert the price of one currency in terms of another, and to determine a nation’s economic health.
Ideally, a country must have enough Forex reserves to support three to six months of importing essential commodities like food. In addition, it should have a reserve surplus to settle its debt payments and current amount deficit of 12 months.
Countries and Forex Reserves
Countries with large trade surpluses are on the top of this list. Since their exports are higher than their imports, they end up stockpiling dollars. Countries on this list are the European union, Switzerland, Taiwan, Russia, Hong Kong, India, South Korea, Brazil, Singapore, Thailand, Germany, Mexico, France, Italy, Czech Republic, Indonesia, Iran, Poland, Israel, Turkey, and Malaysia.
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