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Why Are Foreign Reserves Important?

October 11, 2021
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Foreign reserves are very important for the economic stability of countries around the world, but most specifically to smaller countries that require a constant inflow of foreign currency. The forex or foreign reserves as held by central banks around the world and they could be made up of different currencies and precious metals.

In general, foreign currency reserves are held in “reserve currencies” which tend to have a stable value, large liquidity and that could be used with the most important trading partners. Every country around the world has foreign reserves and they can be used for a wide range of things. 

What are Foreign Currencies?

A foreign currency is considered to be any type of currency created by another country and used as a legal tender currency in at least a jurisdiction in the world. Foreign currencies are very important as the world does not have a single currency to function. Some countries have weaker but some other countries have stronger currencies. 

Banks and other financial institutions hold and trade different foreign currencies in order to be able to offer services to clients. At the same time, these foreign currencies are used to establish balances in foreign currency with banks and other organizations or companies. 

Central banks around the world are also large holders of foreign currencies due to different reasons. But if a country has its own currency, why does it want to hold foreign currencies?

Why are Foreign Reserves Important?

Forex or foreign reserves are very important as they play different financial roles for the stability of a country. For example, they help the local currency keep its value. The larger the reserves of a country are usually related to a stronger local currency. 

The currency held by a central bank or centralized monetary authority is very important as they are used to manage and handle the balance of payments of the country. Every single time that there is a currency exchange, these reserves move. Thus, they reflect how strong a currency is in terms of exports and imports (balance of payment). 

Some central banks have a more interventionist role in the economy than others. For example, they could use their foreign reserves in order to keep their local currency closer to the price they want in terms of U.S. dollars (USD). Let’s not forget that the United States has a very important role as the country with the reserve currency of the world. 

If a country needs a cheaper currency to stimulate exports, then the central bank would immediately take the necessary actions to do so. But the same can happen if they want to have a stronger currency. Additionally, the foreign reserves of a country could also be used in periods of crisis to maintain liquidity in the market and help companies conduct their economic activities as usual. 

In addition, countries need foreign reserves to be able to meet financial obligations. Usually, there are commercial and public debts that have to be paid in foreign currency. Holding a foreign reserve currency is usually useful as these are the most commonly used currencies. 

But there are two other things that we should take into consideration. Central banks must also diversify their portfolio when holding currencies. This is why they usually select reserve currencies and also gold. If one of these currencies fall, there is another one that would be cover for the losses. If that does not happen, gold usually remains a stable asset. 

Finally, central banks have to also reassure foreign investors with their large forex reserves. This lets large investors make sure that the country is prepared against a possible economic crisis and that they would be able to properly operate in that jurisdiction.

Thus, having large and diversified foreign reserves is definitely important for the economic well-being of a country. 

Reserve Currencies or Gold?

Now, it is time to understand whether it is better to have reserve currencies or gold. Usually, central banks have a combination of both. They hold large amounts of foreign currencies (reserve currencies) and gold. 

Reserve currencies include the U.S. Dollar (USD), the British pound (GBP) or the Euro (EUR), among others. Usually, central banks hold none or few currency reserves from small countries or weak currencies (currencies that constantly devalue). 

Gold is among the most important precious metals that a central bank could hold. Having gold on their foreign reserves would make the country stronger against possible financial crises combined with a balanced reserve currency portfolio.