Foreign Exchange Reserves

In our last article we went over the inner workings of the foreign exchange markets and how exchange rates between currencies are affected by a variety of competing factors. The forex markets deal with currencies, and maintaining a robust currency (or “sound money”) is crucial for a strong economy. That’s where official reserves come in — stashes of foreign currency kept by central banks that keep the international financial system up and running.

Also called foreign exchange reserves, these are simply assets (banknotes, bonds, treasury bills, etc) held by the central bank but in foreign currencies.The People’s Bank of China (China’s central bank), for example, is the world’s largest foreign exchange reserve holder, stockpiling more than $3 trillion in assets, not in the Chinese yuan but in various currencies (mostly the USD).

Balance of Payments

The main purpose of keeping foreign reserves is to manage a country’s balance of payments, specifically in the cases of surplus or deficits. If a country has a deficit in its balance of payments, that means that it has imported more goods, services, and capital than it has exported. All those imports need to somehow be paid for in the currency of the country from which they were imported, and the only real way this can be achieved is if the central bank has those foreign currencies on reserve that are ready to be converted.

Say that the US’s Federal Reserve has £100 in reserves and that America is importing £50 but exporting £40, creating a balance of payments deficit of £10. This means that the Federal Reserve can finance the deficit for 10 years (£10 each year), but how does a country’s central bank “finance” a deficit? American importers need to pay British exporters £10 in order to close the deficit, but this can only be done by American firms converting their US dollars into £10. But who’s simply going to give up £10 in exchange for the equivalent in USD (let’s assume for that to be $10)? That’s where the Fed comes in — they serve as a reliable currency converter that American importers can turn to when they need to convert their US dollars into a foreign currency (ATMs you’d find at a bank usually aren’t viable options when dealing with large sums of money).

If the US has a balance of payments surplus (exported more goods, services, and capital than it has imported), the Fed’s foreign reserves aren’t really touched. How? Let’s go back to our US-UK example: America is importing £40 and exporting £50, creating a surplus of £10. Similar to how the US had to pay the UK £10, American exporters need to acquire $10 USD (again, assuming a 1:1 exchange rate between the USD and the GBP). If we suppose all goes well, that’s basically the end of it — American exporters are paid their extra money in their currency and the surplus has been neutralized.

On the other hand, British importers are doing exactly what the American importers did when the US had a deficit with the UK: the Bank of England (UK’s central bank) has $100 in reserves and the country is importing £50 USD and exporting £40, creating a balance of payments deficit of £10. British importers exchange their pounds for $10 USD, which they then pay to American exporters to close the deficit.

The International Role of the USD

This is part of the reason most countries’ foreign reserves are in the USD — the United States is the world’s biggest importer, bringing in roughly $2.6 trillion worth of imports as of 2020. So when other countries sell their currencies and buy dollars in the open market, it makes their exports cheaper in terms of US dollars, as there are now more units of that country’s currency in circulation (higher supply, ceteris paribus, lower price).

Think about countries such as China, wherein the US is responsible for a huge portion of their exports and so the Chinese central bank therefore has a strong incentive to keep an eye on the USD-CNY exchange rate. If the yuan appreciates too much too quickly, China’s biggest customer will be looking for other suppliers. China wants the opposite of that — they want to be America’s cheapest option in terms of USD.

So in order to depreciate their currency and thus promote their exports, the People’s Bank of China exchanged a bunch of yuan for a bunch of dollars, flooding international markets with yuan.

There are other reasons the USD is the world’s foreign reserve. As we explained in our last article, when 2 countries want to trade, they generally stick to the exporter’s currency. There are, however, cases when that simply isn’t a feasible option. Say Nigeria and Indonesia decide to trade with each other; Nigeria’s currency is the Naira (NGN) and Indonesia’s currency is the Rupiah (IDR). It just so happens that these are both among the worst currencies in the world — it’s difficult to acquire large quantities of either of them outside of their respective countries, and the NGN is particularly volatile, throwing in a whole extra layer of complexity when it comes to pricing goods between the 2 countries.

So what’s the solution? Just use the USD — it has a history of being the world’s most widely traded currency, and as we mentioned before, the US is the world’s biggest importer so pricing your goods in their currency certainly isn’t the worst idea. For a situation as precarious as the Nigaria-Indonesia one, simply playing along with the currency that the entire world has been using since the aftermath of WW2 (remember the Bretton Woods system from our last article) might be your best bet.

It would save a ton of time, energy, and money if Nigerian importers pay Indonesian exporters in USD and then have them convert the dollars into IDR, as opposed to the Nigerian importers trying to pay the Indonesian exporters by converting their NGN to IDR. Like that would literally be easier.

Foreign Reserves as Backup Funds

Asides from managing trade, central banks have forex reserves as backup funds so to speak

that can be utilized in case of an economic crisis, especially when the value of a country’s currency is threatened. Say that a bunch of the US’s exporting factories must temporarily cease operations due to a natural disaster and so for the time being, the US doesn’t export much.

Because the US isn’t exporting much, no one is going to be importing from the US, which results in a decrease in demand for the USD, which in turn results in the devaluation of the USD. But why is this bad exactly? If the dollar is devalued just enough, then American importers won’t be able to import essential supplies from other countries.

Suppose a 1:1 conversion ratio between the USD and GBP (British pound). The US suffers a natural disaster which prevents American exporters from being able to sell stuff to the UK. As such, British importers are no longer looking to get their hands on the USD as they can no longer buy anything with it — the value of the dollar goes down. Now say things get really bad with a 100:1 conversion ratio between the USD and GBP — even if American importers were desperate for British supplies, they’d only acquire a fraction of what they were previously able to since to purchase just £1 of stuff, they’d need $100 USD.

So, how would the Fed address this? Well, seeing as how the Fed does indeed have British pounds on reserve, all they need to do is “sell” a bunch of them on the open market, thereby increasing the supply of GBP in circulation. An increased supply, ceteris paribus, results in a depreciated value of the currency. The exchange rate between the USD and GBP should therefore eventually stabilize.

Econ IRL

Urban flooding is an interesting issue for economists as it dies directly with urban planning and therefore, the question of investing in flood adaptation mechanisms, be that on the part of individual households (i.e. avoid living in increasingly risky areas) or on the part of municipal governments. But making wise flood protection investments in a given area requires information regarding the damage that floods do there as well as the overall risk the vicinity in question is at being hit with a flood.

The authors of this week’s paper seeks to not only address the problem above but also test a variety of flood adaptation hypotheses by putting together a global city data set covering nearly 9,500 cities. There are 3 key findings to report:

• Cities in high-income countries that experienced higher frequency of extreme events in the past still experienced fewer deaths per disaster. But low-income countries that also had a higher number of extreme events in the past saw higher deaths per disaster, indicating a severe lack of flood adaptation systems in low-income cities
• Risky cities see a lower impact of floods relative to cities that had no such prior experience; public officials and citizens with prior experience will be able to take more effective courses of action if they know what to expect
• Do dams help mitigate the negative impacts of floods? The first thing to keep in mind is that cities with dams face a higher number of floods, which makes sense seeing as how dams are more likely to be placed in areas at greater risk. Cities with dams experience a lesser decline in the use of night lights during floods by approximately 1.7% (the use of night lights is used as a proxy for economic activity — the higher the use, the higher the level of economic activity and thus, the less the economic damage the flood caused)

‘Till next time,

SoBasically