What are foreign currency reserves and can they help combat the global economic crisis?

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Stefan Ellerbeck, Senior Writer, Formative Content

• Sri Lanka’s foreign currency reserves have fallen by 99% since 2019, amid an economic crisis that has seen the country’s president overthrown.
• Foreign currency or exchange reserves, otherwise known as forex reserves, comprise cash and other assets like gold that are held by central banks.
• Other developing countries are looking to shore up their foreign currency reserves in the face of escalating energy prices and supply chain issues.
• The dollar has reached an almost two-decade high as investors look for a ‘safe haven’ currency prompted by the global economic crisis.

The economic and political crisis in Sri Lanka, which began in April 2022, has been playing out on TV screens around the world. Protests have swept the country, forcing the President to step down.

The country defaulted on its debt payments in May and currently owes creditors $51 billion, according to Visual Capitalist. Inflation is running at almost 40%, caused by an increasing inability to pay for fuel, food and medicine imports. Foreign currency reserves are estimated to have dwindled to around $50 million, plummeting 99% from $7.6bn in 2019.

What is a foreign currency reserve?

Foreign currency or exchange reserves, otherwise known as forex reserves, comprise cash and other assets like gold that are held by central banks and other financial institutions such as the International Monetary Fund (IMF), according to City Index, a financial services provider. It has listed 7 main reasons why central banks have reserves:

• To help keep the value of a domestic currency at a fixed rate. China pegs the value of the yuan to the US dollar. By stockpiling dollars it raises the dollar value versus the yuan thereby increasing sales by making Chinese exports cheaper than American-made goods.
• To keep a domestic currency lower than the dollar. Japan, which has a floating exchange rate system, buys US treasuries or bonds, to keep the yen lower than the dollar. This again helps keep its exports relatively cheaper.
• To maintain liquidity in case of an economic crisis. A central bank can step in and exchange its foreign currency for the local currency ensuring companies can continue to import and export competitively.
• To meet a country’s international finance obligations. These could include paying debts, financing imports and absorbing sudden capital movements.
• To fund internal projects. Infrastructure or industry programmes are sometimes financed this way.
• To reassure foreign investors. Wars or internal unrest can spook investors who may look to move their money out of the country. Holding forex reserves can project an air of confidence and calm investors’ fears.
• To diversify their portfolio. By holding different currencies and assets in reserve, a central bank can diversify its risk and provide protection should one investment decline.

Why the dollar is a safe haven in times of economic crisis

During volatile periods for the world economy, investors and currency traders often seek to convert cash holdings into so-called ‘safe haven’ currencies for protection. Currencies such as the Swiss franc and the Japanese yen, but especially the US dollar are considered safe-haven assets.

The dollar is particularly attractive, being the world’s reserve currency and the one used in many international business deals. It is also backed by the world’s largest gold reserves. The so-called ‘Greenback’ has recently been at its highest for two decades compared to major rival currencies. Investors have been flocking to it, encouraged by signs that the US Federal Reserve will increase interest rates faster than most.

“With US rates much higher and stocks way lower, the dollar is a safe-haven trade,” Brent Donnelly, President of Spectra FX Solutions, told Bloomberg. “The only safe haven left is the US dollar,” he added.

Could an alternative world reserve currency emerge?

President Vladimir Putin has said Russia is ready to develop a global reserve currency together with China and other members of the BRICS group of nations. It could be based on a basket of currencies from the organization’s members who also include Brazil, India and South Africa.

The move follows Russia being cut off from the world’s financial system following its invasion of Ukraine. This curtailed its access to dollars. According to Markets Insider, this could be an attractive option to a wider group of countries: “One possibility is that the BRICS basket currency could attract the reserves not just of the group’s members, but also countries already in their range of influence. These include nations in South Asia and the Middle East.”

Advocates of cryptocurrencies such as Bitcoin believe that digital assets could also challenge the dominance of the major currencies. Some central banks are looking at blockchain technology for sovereign crypto digital coins. China doesn’t recognise Bitcoin but is reportedly developing a digital yuan, reports City Index.