Foreign Exchange Reserves Demystified

What is Foreign Exchange Reserves?

By Jonny Andrew

Foreign Exchange Reserves are reserve assets held by the Central Bank (BPNG for PNGs case) in various currencies and sometimes in various countries around the world to back liabilities on their own currency.
Foreign exchange reserves come in several forms, which include foreign banknotes, bank deposits, bond, treasury bills, gold bullion, and other government securities and IMF funds.

For many years, gold served as the primary currency reserve for most countries. Gold was long considered the ideal reserve asset, often appreciating in value even during times of financial crisis, and believed to retain an almost-permanent value. However, all assets are only worth as much as buyers are willing to pay for them, and since the breakdown of the Bretton Woods system in 1971, gold has steadily declined in value.

 

Why do we hold Foreign Exchange Reserves?

There are 2 main reasons for holding a foreign exchange reserves while others some likely reasons;

  1. Tool for exchange rate or monetary policy
  2. Held to back the local currency
  3. Service foreign currency liabilities and debt obligations
  4. Source of funds to pay for government expenditure overseas
  5. Defense against emergencies or disaster
  6. Investment fund

Reserves are considered assets in a capital accounts but it is important to remember the liabilities associated with foreign reserves. They are borrowed, swapped with domestic currency on the international exchange market, or purchased outright with domestic currency – all of which incurs a debt. Exchange reserves are also as risky as any other investment; should a currency collapse, all foreign exchange reserves held in that currency around the world will become worthless.

 

How do we acquire Foreign Exchange Reserves?

Broadly speaking, authorities do not hold currencies other than their own, thus to fund the foreign reserve, there are 3 main reasons on how central bank achieves that;

  1. Borrow foreign currency formally
  2. Borrow foreign currency against local currency in a forex swap
  3. Buy foreign currencies outright with domestic currency

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Why do we need to manage our Foreign Exchange Reserves?

In most countries, the reserves are owned by the central bank; that is, they are on the central bank’s balance sheet and the ultimate decisions on reserves management are taken within the central bank’s management structure and its monetary policy.

Sound reserve management practices are important because they can increase a country’s or regions overall resilience to shocks. Through their interaction with financial markets, reserve managers gain access to valuable information that keeps policy makers informed of market developments and views on potential threats. The importance of sound practices has also been highlighted by experiences where weak or risky reserve management practices have restricted the ability of the authorities to respond effectively to financial crises, which may have accentuated the severity of these crises

According to the Bank of Papua New Guinea 2016 march quarterly report, the objective of the Monetary policy “is to achieve and maintain price stability. This entails low inflation supported by stable interest and exchange rates.”

Maintaining price stability leads to;

  • Confidence in the kina exchange rate and management of the economy;
  • A foundation for stable fiscal operations of the Government;
  • Certainty for businesses to plan for long-term investment; and
  • A stable macroeconomic environment conducive to economic growth.

 

Optimal Size of Foreign Exchange Reserves

In developing countries and small economies like Papua New Guinea, there are often debates on the foreign exchange reserves and the size. It is often pointed out that there are not enough foreign reserves, or claims that the sum of foreign exchange reserves should be higher. The public is lead to believe that “good foreign exchange reserves are good and the more foreign currency reserve is better”. There is however very complicated mathematical formulae suggested by the IMF to calculate a countries optimal foreign exchange reserves. But in a nutshell, Central Banks always strive to achieve very MINIMAL foreign reserves with no upper limits.

Finally, the question we should all be asking isn’t about having a high level of foreign exchange reserves rather should we develop as a country or not? Maintaining high foreign reserves are good, but should we sacrifice a countries social and economic development to just shore up reserves?

The way forward is highlighted in a research done by African Development Bank Group on ‘Holding Foreign Reserves versus Infrastructure Investment”

Investment Vehicle be created to complement the private, public and development partners objectives. It should focus on;

  1. Economic infrastructure projects that has regional impacts
  2. Innovative mechanism for cross-border infrastructure investments
  3. Deal with Political risk, credit risk and refinancing risk

Credit must be given to the Bank of Papua New Guinea for their prudent management of the Economy. Whilst the global commodity prices slumps, their management had shielded us from external shocks and imitate the associated risks.

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