Foreign exchange reserves

Foreign exchange reserves (also called forex reserves or FX reserves) are cash and other reserve assets such as gold and silver held by a central bank or other monetary authority that are primarily available to balance payments of the country, influence the foreign exchange rate of its currency, and to maintain confidence in financial markets. Reserves are held in one or more reserve currencies, nowadays mostly the United States dollar and to a lesser extent the euro.

Foreign exchange reserves assets can comprise banknotes, bank deposits, and government securities of the reserve currency, such as bonds and treasury bills. Some countries hold a part of their reserves in gold, and special drawing rights are also considered reserve assets. Often, for convenience, the cash or securities are retained by the central bank of the reserve or other currency and the "holdings" of the foreign country are tagged or otherwise identified as belonging to the other country without them actually leaving the vault of that central bank. From time to time they may be physically moved to the home or another country.^{[citation needed]}

Normally, interest is not paid on foreign cash reserves, nor on gold holdings, but the central bank usually earns interest on government securities. The central bank may, however, profit from a depreciation of the foreign currency or incur a loss on its appreciation. The central bank also incurs opportunity costs from holding the reserve assets (especially cash holdings) and from their storage, security costs, etc.

Foreign exchange reserves are also known as reserve assets and include foreign banknotes, foreign bank deposits, foreign treasury bills, and short and long-term foreign government securities, as well as gold reserves, special drawing rights (SDRs), and International Monetary Fund (IMF) reserve positions.

In a central bank's accounts, foreign exchange reserves are called reserve assets in the capital account of the balance of payments, and may be labeled as reserve assets under assets by functional category. In terms of financial assets classifications, 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, company shares (listed and unlisted), investment fund shares and other financial contracts. 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". On a central bank's balance sheet, foreign exchange reserves are assets, along with domestic credit.

Typically, one of the critical functions of a country's central bank is reserve management, to ensure that the central bank has control over adequate foreign assets to meet national objectives. These objectives may include:

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 which chooses to implement 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.