Foreign-exchange reserves also called forex reserves or FX reserves is money or other assets held by a central bank or other monetary authority so that it can pay if need be its liabilities , such as the currency issued by the central bank, as well as the various bank reserves deposited with the central bank by the government and other financial institutions.
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. This broader figure is more readily available, but it is more accurately termed official international reserves or international reserves. Foreign-exchange reserves are called reserve assets in the balance of payments and are located in the capital account.
Hence, they are usually an important part of the international investment position of a country. The reserves are labeled as reserve assets under assets by functional category. In terms of financial assets classifications, the reserve assets can be classified as Gold bullion, Unallocated gold accounts, Special drawing rights, currency, Reserve position in the IMF, interbank position, other transferable deposits, other deposits, debt securities , loans , equity listed and unlisted , investment fund shares and financial derivatives , such as forward contracts and options.
There is no counterpart for reserve assets in liabilities of the International Investment Position. Usually, when the monetary authority of a country has some kind of liability, this will be included in other categories, such as Other Investments.
Official international reserves assets allow a central bank to purchase the domestic currency, which is considered a liability for the central bank since it prints the money or fiat currency as IOUs. Thus, the quantity of foreign exchange reserves can change as a central bank implements monetary policy ,  but this dynamic should be analyzed generally in the context of the level of capital mobility, the exchange rate regime and other factors.
This is known as Trilemma or Impossible trinity. Hence, in a world of perfect capital mobility, a country with fixed exchange rate would not be able to execute an independent monetary policy.
A central bank that implements a fixed exchange rate policy may face a situation where supply and demand would tend to push the value of the currency lower or higher an increase in demand for the currency would tend to push its value higher, and a decrease lower and thus the central bank would have to use reserves to maintain its fixed exchange rate.
Under perfect capital mobility, the change in reserves is a temporary measure, since the fixed exchange rate attaches the domestic monetary policy to that of the country of the base currency. Hence, in the long term, the monetary policy has to be adjusted in order to be compatible with that of the country of the base currency.
Without that, the country will experience outflows or inflows of capital. Fixed pegs were usually used as a form of monetary policy, since attaching the domestic currency to a currency of a country with lower levels of inflation should usually assure convergence of prices.
In a pure flexible exchange rate regime or floating exchange rate regime, the central bank does not intervene in the exchange rate dynamics; hence the exchange rate is determined by the market.
Theoretically, in this case reserves are not necessary. Other instruments of monetary policy are generally used, such as interest rates in the context of an inflation targeting regime. Milton Friedman was a strong advocate of flexible exchange rates, since he considered that independent monetary and in some cases fiscal policy and openness of the capital account are more valuable than a fixed exchange rate.
Also, he valued the role of exchange rate as a price. As a matter of fact, he believed that sometimes it could be less painful and thus desirable to adjust only one price the exchange rate than the whole set of prices of goods and wages of the economy, that are less flexible. Mixed exchange rate regimes 'dirty floats' , target bands or similar variations may require the use of foreign exchange operations to maintain the targeted exchange rate within the prescribed limits, such as fixed exchange rate regimes.
As seen above, there is an intimate relation between exchange rate policy and hence reserves accumulation and monetary policy. Foreign exchange operations can be sterilized have their effect on the money supply negated via other financial transactions or unsterilized.
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. Since if there is no sterilization the domestic money supply is increasing money is being 'printed' , this may provoke domestic inflation.
Also, some central banks may let the exchange rate appreciate to control inflation, usually by the channel of cheapening tradable goods. Since the amount of foreign reserves available to defend a weak currency a currency in low demand is limited, a currency crisis or devaluation could be the end result.
For a currency in very high and rising demand, foreign exchange reserves can theoretically be continuously accumulated, if the intervention is sterilized through open market operations to prevent inflation from rising.
On the other hand, this is costly, since the sterilization is usually done by public debt instruments in some countries Central Banks are not allowed to emit debt by themselves. In practice, few central banks or currency regimes operate on such a simplistic level, and numerous other factors domestic demand, production and productivity , imports and exports, relative prices of goods and services, etc.
Besides that, the hypothesis that the world economy operates under perfect capital mobility is clearly flawed. As a consequence, even those central banks that strictly limit foreign exchange interventions often recognize that currency markets can be volatile and may intervene to counter disruptive short-term movements that may include speculative attacks. Thus, intervention does not mean that they are defending a specific exchange rate level. Hence, the higher the reserves, the higher is the capacity of the central bank to smooth the volatility of the Balance of Payments and assure consumption smoothing in the long term.
After the end of the Bretton Woods system in the early s, many countries adopted flexible exchange rates. In theory reserves are not needed under this type of exchange rate arrangement; thus the expected trend should be a decline in foreign exchange reserves. However, the opposite happened and foreign reserves present a strong upward trend. Reserves grew more than gross domestic product GDP and imports in many countries. The only ratio that is relatively stable is foreign reserves over M2.
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. For example, Article IV of  uses total external debt to gross international reserves, gross international reserves in months of prospective goods and nonfactor services imports to broad money , broad money to short-term external debt, and short-term external debt to short-term external debt on residual maturity basis plus current account deficit.
Therefore, countries with similar characteristics accumulate reserves to avoid negative assessment by the financial market, especially when compared to members of a peer group. 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. If a specific country is suffering from a balance of payments crisis, it would be able to borrow from the IMF.
However, the process of obtaining resources from the Fund is not automatic, which can cause problematic delays especially when markets are stressed. Therefore, the fund only serves as a provider of resources for longer term adjustments. Also, when the crisis is generalized, the resources of the IMF could prove insufficient.
After the crisis, the members of the Fund had to approve a capital increase, since its resources were strained. 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.
Also, an increase in reserves occurred when commercial openness increased part of the process known as globalization. Reserve accumulation was faster than that which would be explained by trade, since the ratio has increased to several months of imports.
Furthermore, the external trade factor explains why the ratio of reserves in months of imports is closely watched by credit risk agencies. 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. Usually financial flows are more volatile that enforce the necessity of higher reserves. Moreover, holding reserves, as a consequence of the increasing of financial flows, is known as Guidotti—Greenspan rule that states a country should hold liquid reserves equal to their foreign liabilities coming due within a year.
Reserve accumulation can be an instrument to interfere with the exchange rate. Hence, commercial distortions such as subsidies and taxes are strongly discouraged. However, there is no global framework to regulate financial flows. As an example of regional framework, members of the European Union are prohibited from introducing capital controls , except in an extraordinary situation. Some economists are trying to explain this behavior.
Usually, the explanation is based on a sophisticated variation of mercantilism , such as to protect the take-off in the tradable sector of an economy, by avoiding the real exchange rate appreciation that would naturally arise from this process. One attempt  uses a standard model of open economy intertemporal consumption to show that it is possible to replicate a tariff on imports or a subsidy on exports by closing the current account and accumulating reserves.
Another  is more related to the economic growth literature. The argument is that the tradable sector of an economy is more capital intense than the non-tradable sector. The private sector invests too little in capital, since it fails to understand the social gains of a higher capital ratio given by externalities like improvements in human capital, higher competition, technological spillovers and increasing returns to scale.
The government could improve the equilibrium by imposing subsidies and tariffs , but the hypothesis is that the government is unable to distinguish between good investment opportunities and rent seeking schemes. Thus, reserves accumulation would correspond to a loan to foreigners to purchase a quantity of tradable goods from the economy. In this case, the real exchange rate would depreciate and the growth rate would increase. In some cases, this could improve welfare, since the higher growth rate would compensate the loss of the tradable goods that could be consumed or invested.
In this context, foreigners have the role to choose only the useful tradable goods sectors. 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.
Sovereign wealth funds are examples of governments that try to save the windfall of booming exports as long-term assets to be used when the source of the windfall is extinguished. 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.
Therefore, a central bank must continually increase the amount of its reserves to maintain the same power to manipulate exchange rates. Reserves of foreign currency provide a small return in interest.
However, this may be less than the reduction in purchasing power of that currency over the same period of time due to inflation, effectively resulting in a negative return known as the "quasi-fiscal cost". In addition, large currency reserves could have been invested in higher yielding assets. 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. One interesting  measure tries to compare the spread between short term foreign borrowing of the private sector and yields on reserves, recognizing that reserves can correspond to a transfer between the private and the public sectors.
In the context of theoretical economic models it is possible to simulate economies with different policies accumulate reserves or not and directly compare the welfare in terms of consumption.
Results are mixed, since they depend on specific features of the models. 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.More...