Term Foreign-exchange reserves under GST

Meaning of term Foreign-exchange reserves under GST

 

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Foreign exchange reserves

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.

[1] Reserves are held in one or more reserve currency, mostly the United States dollar and to a lesser extent the Japanese yen.

Definition

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.[2] However, the term in popular usage commonly also adds gold reserves, special drawing rights (SDRs), and International Monetary Fund (IMF) reserve positions. 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.[3] In the Central Bank’s Balance Sheet, foreign exchange reserves are assets, along with domestic credit.

 

Purpose

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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,[4] 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.

 

Precautionary aspect

The traditional use of reserves is as savings for potential times of crises, especially balance of payments crises. As we will see below, originally those fears were related to the current account, but this gradually changed to include financial account needs as well.[8] Originally, the creation of the IMF was viewed as a response to the need of countries to accumulate reserves. If a specific country is suffering from a balance of payments crisis, it would be able to borrow from the IMF, as this would be a pool of resources, and so the need to accumulate reserves would be lowered. However, the process of obtaining resources from the Fund is not automatic, which can cause problematic delays especially when markets are stressed. Hence, the fund never fulfilled completely its role, serving more as provider of resources for longer term adjustments. Another caveat of the project is the fact that when the crisis is generalized, the resources of the IMF could prove insufficient. After the 2008 crisis, the members of the Fund had to approve a capital increase, since its resources were strained.[9] Some critics point out that the increase in reserves in Asian countries after the 1997 Asia crisis was a consequence of disappointment of the countries of the region with the IMF.[10] During the 2008 crisis, the Federal Reserve instituted currency swap lines with several countries, alleviating liquidity pressures in dollars, thus reducing the need to use reserves.

 

External trade

As most countries engage in international trade, reserves would be important to assure that trade would not be interrupted in the event of a stop of the inflow of foreign exchange to the country, what could happen during a financial crisis for example. A rule of thumb usually followed by central banks is to at least hold an amount of foreign currency equivalent to three months of imports. As commercial openness increased in the last years (part of the process known as globalization), this factor alone could be responsible for the increase of reserves in the same period. As imports grew, reserves should grow as well to maintain the ratio. Nonetheless, evidence suggests that reserve accumulation was faster than what would be explained by trade, since the ratio has increased to several months of imports. The external trade factor also explains why the ratio of reserves in months of imports is closely watched by credit risk agencies.

Financial openness

Besides external trade, the other important trend of the last decades is the opening of the financial account of the balance of payments. Hence, financial flows, such as direct investment and portfolio investment became more important. Usually financial flows are more volatile, which enforces the necessity of higher reserves. The rule of thumb for holding reserves as a consequence of the increasing of financial flows is known as Guidotti–Greenspan rule and it states that a country should hold liquid reserves equal to their foreign liabilities coming due within a year. An example of the importance of this ratio can be found in the aftermath of the crisis of 2008, when the Korean Won depreciated strongly. Because of the reliance of Korean banks on international wholesale financing, the ratio of short-term external debt to reserves was close to 100%, which exacerbated the perception of vulnerability.[11]

 

Exchange rate policy

Reserve accumulation can be an instrument to interfere with the exchange rate. Since the first General Agreement on Tariffs and Trade (GATT) of 1948 to the foundation of the World Trade Organization (WTO) in 1995, the regulation of trade is a major concern for most countries throughout the world. 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. The dynamics of China’s trade balance and reserve accumulation during the first decade of the 2000 was one of the main reasons for the interest in this topic. 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[12] 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[13] 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.

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