A country’s foreign exchange reserves are held for international trade. This means that they can use the currency to buy goods and services from other countries without first selling domestic goods and services. The more a country needs foreign currencies, the more it will have to sell domestically – this is called running a trade deficit.
For example, if China has lots of exports but only imports a few, it must export even more to accumulate enough money to import what it wants. Therefore, its foreign currency reserves would also increase. If, however, it imported more than it exported, which often happens for developing countries, these reserves would decrease as they would be spending them faster than they earned them.
Why do Foreign Exchange Reserves Matter?
When a country invests its money in another country, it is effectively borrowing that foreign currency. If the US loans China $2bn in exchange for ten years of interest, then this would mean that at the end of the term, the American government will owe China $2bn * (10/365) = $69m per day. However, if their total foreign currency reserve were to drop by more than this amount, they may need to find ways to make up for it, such as selling domestic goods and services or even gold which could cause inflation due to less supply of these products and services.
Forex reserves are also significant when considering international debts. For example, if America loans China $2bn but only has reserves of $1.7bn, it would mean that they can’t borrow any more – or else they run the risk of not being able to pay back their debt and losing gold and foreign currency. The same logic applies to any country borrowing from another, and therefore Forex reserves matter to creditors.
The value of a country’s Forex reserve is generally considered a sign of its economically strong. For this reason, sometimes countries target certain levels such as three months import worth of foreign currencies to become ‘investment grade’. This means that other countries will feel safer investing in them since there is less likelihood of default.
Benefits of Forex trading
Forex Reserves give countries increased spending power, and they can import more than they export, making them an attractive creditor nation since others will want to borrow from them. The status of having a lot of Forex Reserves is called “Creditor Nation” – one example is Japan which had held the title since the 1990s when it surpassed America as the world’s largest international creditor country.
Forex Reserves provide insurance against external shocks such as currency devaluation or a sudden drop in investment income. This means they are seen as safer than other investments since there is little chance of defaulting on them. It enables countries to buffer against any unforeseen future events happening.
Finally, holding large amounts of foreign currencies provides a country with considerable power within world politics through what’s known as ‘currency wars’, pushing down their currency to make exports cheaper and gain an advantage over trading partners.
Foreign exchange reserves are a vital part of macroeconomic management and policy making, and they matter for creditors and debtors alike. Countries with high levels of foreign currency reserves tend to be stronger economically than those with low levels, who pay more attention to keeping their currency at the desired level so that they can continue borrowing abroad without causing instability domestically. High levels also create spending power, increasing exports which ultimately makes the country stronger.
Summary
Changes in Forex Reserves will always affect an economy one way or another, even if it just has enough money to pay back other debts on time. Countries with strong economies tend to have more foreign currency than others, making them perfect for keeping track of foreign debts and consequent interest payments. Learn more about foreign exchange reserve currency by contacting a reputable broker from Saxo Bank. Start your trading journey today.