Foreign exchange reserves: Benefits and costs

Foreign currency deposit held by the central bank and the monetary authorities of a country is termed as the foreign exchange reserve of the country. A broader definition of foreign exchange reserve would include not only the foreign currency deposits but also gold reserves, special drawing rights (SDRs) and reserve positions at the International Monetary Fund (IMF). This broader definition excludes currency swaps conducted by central banks. The US dollar is the most preferred currency that is held in foreign exchange reserves.

Increased globalisation, trade and integration of various countries to the world economy has led to an increase in foreign exchange reserves. Trade surplus and capital inflows to a country lead to high level of foreign exchange reserves. Also, remittance sent by migrant workers can boost a country’s foreign exchange reserves. As Figure 1 shows, more than $7 trillion of foreign currency reserves are held by central banks all over the world by 2012. Of this amount, advanced economies hold one-third of the total foreign exchange reserves while the emerging and developing countries hold two-third of the reserves (Table 1). Developing Asia, which includes major emerging economies like China and India, holds 37.9 per cent of the total foreign exchange reserves. It is encouraging to observe that all the lines in Figure1 are upward sloping; this indicates that foreign currency reserves are not only increasing globally but also in both advanced and emerging economies.

The phenomenal growth experienced by the Chinese economy in the last three decades allowed China to build the largest foreign exchange reserve in the world. By early 2013, it holds more than US$3.4 trillion of foreign exchange reserves. Most of its reserves are held in US Treasury bills. Figure 2 shows the top 10 countries/monetary authority which hold foreign exchange reserves. China is followed by the third-largest economy in the world, Japan. Oil-rich Saudi Arabia belongs to the top 10 countries while two of the BRICS countries, Brazil and Russia, also appear in the list. High prices of commodities allowed commodity-exporting countries to enjoy trade surpluses and build sizable reserves. Finally, Hong Kong is the tenth member with US$303.6 billion of foreign exchange reserves.
The largest economy in the world, the United States, has foreign exchange reserves of US$145.3 billion. Other G-7 countries like the United Kingdom has reserves of US$ 129.2 billion while Canada has reserves of US$ 69.8 billion. Of the emerging economies in Asia, Indonesia has reserves of US$ 98.1 billion while Vietnam has US $20.9 billion in reserves.
Bangladesh has experienced an impressive growth in its foreign exchange reserves. The upward sloping line in Figure 3 depicts the rise of the country’s foreign exchange reserves. In 2003-2004, Bangladesh’s foreign exchange reserve was US $2.7 billion. It grew by an impressive 466.2 per cent during the period 2003-2004 to 2012-2013. Currently, Bangladesh’s reserves stand at US

$16.3 billion. The country’s foreign exchange reserve is second among the SAARC countries as shown in Figure 4 and Table 2. India has foreign exchange reserves of US $287.9 billion, followed by Bangladesh. After Bangladesh, Pakistan has the third-highest foreign exchange reserve among the SAARC countries, of US $11.8 billion.

Under a flexible exchange rate system, a country needs to keep less stock of foreign exchange reserves as its central bank is not obligated to maintain the exchange rate at a particular level through market interventions. However, in practice, most countries maintain foreign exchange reserves to adjust fluctuations in balance of payments or counter speculative attacks on its currencies. Under a fixed exchange rate system, a country may hold foreign exchange reserves to maintain the exchange rate at a certain level that is favourable for export growth.
A high level of foreign exchange reserves brings benefit to a country as well as some concerns. The most important advantage of a high level of foreign exchange reserves is that it can allow import of essentials such as food. It has been observed by some people that reserves that can finance 3 months’ worth of import bills, is adequate. Currently, Bangladesh has reserves that will finance 6 months import bill, which is impressive. Again, the Greenspan-Guidotti rule is sometimes used as a benchmark in maintaining foreign exchange reserves. The rule suggests that developing countries should maintain reserves equal to all external debts that are becoming due next year.
In addition, countries maintain large foreign exchange reserves as precautionary holdings — a lesson learned from the Asian financial crisis when countries like South Korea, Malaysia, Indonesia and Thailand suffered. When countries ran out of foreign exchange reserves due to turmoil in financial markets, their economies suffered significantly. There was international intervention and austerity measures were prescribed for these countries.
There are, however, some costs of maintaining high levels of foreign exchange reserves.
BALANCE SHEET RISK: When a country holds most of its foreign exchange reserves in terms of foreign currencies, its central bank runs a risk.

There is a risk that the foreign currencies would depreciate. This would decrease the value of the foreign exchange reserves.
OPPORTUNITY RISK: When most of the reserves are held in terms of foreign currencies, the country enjoys a low rate of return. The country could invest these reserves in international financial markets like in equities, and enjoy a higher rate of return.
A country can also use its foreign exchange reserves to pay off its sovereign short-term external debt and use it to finance infrastructure development. Rather than borrowing from external sources, a country can use its foreign exchange reserves to build roads, highways and bridges that will lead to higher growth, development and employment in the country. Again, it could be used to finance other investment projects like import of foreign engineering or medical equipment. This can be beneficial to a country that has a considerable number of its citizens going abroad for medical treatment. Also, a country may forego a portion of its reserve accumulation and allow the private sector to allocate the foreign exchange earnings. This may help domestic companies to go for international expansion.
STERILISATION COST: The accumulation of reserves can lead to inflationary pressures in the domestic economy. The central bank can neutralise the inflationary pressures through money market operations in the domestic market. However, this type of sterilisation has two costs, fiscal cost and indirect cost. The central bank pays a higher rate on the domestic debt used to sterilise the reserves and earns a lower return on its international reserves. The difference between the two is termed as fiscal cost. The indirect cost is that sterilisation can influence the exchange rate and distort price signal that determines resource allocation. This may lead to overinvestment in tradable sectors. When there are expectations of eventual adjustment, this may attract speculative capital inflow and the creation of asset bubbles.
Foreign exchange reserves have increased all over the world, especially in emerging and developing economies. Countries have used portions of their foreign exchange reserves to create sovereign wealth funds to maximise long-term returns. A high level of foreign exchange reserves can help a country withstand possible external shocks to the economy.

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