This section needs additional citations for verification. In a strict sense, foreign-exchange reserves should only include foreign banknotes, foreign bank deposits, foreign treasury bills, and short and long-term foreign government securities. Foreign-monetary quotes reserves are called reserve assets in the balance of payments and are located in the capital account.
Theoretically, in this case reserves are not necessary. Non-sterilization will cause an expansion or contraction in the amount of domestic currency in circulation, and hence directly affect inflation and monetary policy. For example, to maintain the same exchange rate if there is increased demand, the central bank can issue more of the domestic currency and purchase foreign currency, which will increase the sum of foreign reserves. Thus, intervention does not mean that they are defending a specific exchange rate level. After the end of the Bretton Woods system in the early 1970s, many countries adopted flexible exchange rates. However, the opposite happened and foreign reserves present a strong upward trend.
Ratios relating reserves to other external sector variables are popular among credit risk agencies and international organizations to assess the external vulnerability of a country. Reserves are used as savings for potential times of crises, especially balance of payments crises. Original fears were related to the current account, but this gradually changed to also include financial account needs. Furthermore, the creation of the IMF was viewed as a response to the need of countries to accumulate reserves. Most countries engage in international trade, so to ensure no interruption, reserves are important. A rule usually followed by central banks is to hold the equivalency of at least three months of imports in foreign currency. The opening of a financial account of the balance of payments has been important during the last decade.
Hence, financial flows such as direct investment and portfolio investment became more important. Reserve accumulation can be an instrument to interfere with the exchange rate. 1995, the regulation of trade is a major concern for most countries throughout the world. Reserve accumulation can be seen as a way of “forced savings”.
The government, by closing the financial account, would force the private sector to buy domestic debt in the lack of better alternatives. With these resources, the government buys foreign assets. Thus, the government coordinates the savings accumulation in the form of reserves. There are costs in maintaining large currency reserves. Price fluctuations in exchange markets result in gains and losses in the purchasing power of reserves. In addition to fluctuations in exchange rates, the purchasing power of fiat money decreases constantly due to devaluation through inflation. Several calculations have been attempted to measure the cost of reserves.
The traditional one is the spread between government debt and the yield on reserves. The caveat is that higher reserves can decrease the perception of risk and thus the government bond interest rate, so this measures can overstate the cost. Alternatively, another measure compares the yield in reserves with the alternative scenario of the resources being invested in capital stock to the economy, which is hard to measure. A case to point out is that of the Swiss National Bank, the central bank of Switzerland.
The Swiss franc is regarded as a safe haven currency, so it usually appreciates during market’s stress. The modern exchange market as tied to the prices of gold began during 1880. Official international reserves, the means of official international payments, formerly consisted only of gold, and occasionally silver. But under the Bretton Woods system, the US dollar functioned as a reserve currency, so it too became part of a nation’s official international reserve assets. Central banks throughout the world have sometimes cooperated in buying and selling official international reserves to attempt to influence exchange rates and avert financial crisis. By 2007, the world had experienced yet another financial crisis, this time the US Federal Reserve organized Central bank liquidity swaps with other institutions. Developed countries authorities adopted extra expansionary monetary and fiscal policies, which led to the appreciation of currencies of some emerging markets.
The IMF proposed a new metric to assess reserves adequacy in 2011. The metric was based on the careful analysis of sources of outflow during crisis. Those liquidity needs are calculated taking in consideration the correlation between various components of the balance of payments and the probability of tail events. Reserves that are above the adequacy ratio can be used in other government funds invested in more risky assets such as sovereign wealth funds or as insurance to time of crisis, such as stabilization funds. International Monetary Fund, Currency Composition of Official Foreign Exchange Reserves, 2 July 2018. IMF Data – Currency Composition of Official Foreign Exchange Reserve – At a Glance”. Archived from the original on 8 October 2014.
Quotes from “The Case for Flexible Exchange Rates” by Milton Friedman”. Archived from the original on 29 May 2015. The social cost of foreign exchange reserves. Bastourre, Diego, Jorge Carrera, and Javier Ibarlucia. Intergovernmental Group of Twenty-Four on International Monetary Affairs and Development: Communiqué”. Archived from the original on 16 March 2015. Archived 6 November 2014 at the Wayback Machine.