Most countries use foreign reserves as a cushion when hit by monetary policy shocks

Foreign exchange reserves are assets that are denominated in a foreign currency held by a central bank. These reserves are used to back liabilities and influence the country’s monetary policy.

Foreign exchange reserves can include banknotes, deposits, bonds, treasury bills, and other government securities. These assets serve many purposes but are most significantly held to ensure that a central government agency has backup funds if their national currency rapidly devalues or becomes entirely insolvent.

There are three primary motives for central banks to hoard reserves. First, a stock of reserves provides self-insurance against runs on domestic financial markets and institutions by foreign and domestic asset-holders. Reserves can be held as a precautionary measure against sudden capital outflows related to global financial or domestic shocks. Second, reserves are used for intervention in the foreign exchange market to reduce short-term exchange rate volatility. A third motive seeks to maintain export competitiveness through systematic purchases of reserves aimed at undervaluing the exchange rate.

Reserves provide international liquidity to central banks to intervene readily in times of financial turbulence to maintain stability. Financially open economies face the risk of sudden reversals of foreign capital inflows or capital flight by domestic residents.

Foreign reserves can also provide central bank liquidity against purely domestic runs when confidence in home currency collateral assets fails. A financially closed economy is not subject to runs but can be short of trade credit to pay for imports – India faced this situation in 1991 prompting a concerted effort by the Reserve Bank of India (RBI) to build up foreign exchange reserves.

Determining the appropriate size of reserves to hold as a precaution against extreme capital outflows is an important concern for monetary policy. The adequacy of precautionary reserves is typically defined in terms of the potential demand for reserve currency in the short run.

The International Monetary Fund (IMF) assesses reserve adequacy using a metric based on rule-of-thumb ratios of reserves to a country’s exposure to sudden capital outflows or shortfalls of inflows. These include a threshold of one year of external debt amortisation (that is, periodically reduce the value of debt), the conventional threshold of three months of imports, and the ratio of reserves to broad money. Adequacy metrics, however, are ad hoc measures of the national economy’s exposure to global financial shocks and sudden stops.

The benefits of having reserves must be weighed against the opportunity costs of holding them. These costs are associated with the difference between the RBI’s earnings on reserve assets held in foreign government debt and the yield on the alternative asset, domestic government debt. These quasi-fiscal costs of holding reserves are largely estimated by the interest differential between domestic government debt and US Treasury debt, although not entirely.

Global financial turbulence and foreign monetary policy shocks are significant drivers of foreign capital outflows from India.

Monetary shocks affect foreign portfolio debt and equity flows differently. An increase in reserves significantly reduces the volatility of portfolio debt flows. Reserves reduce capital outflows following a rise in the federal funds rate and lower capital inflows with US monetary easing. While reserves have a stabilising effect on foreign debt flows, they do not significantly affect equity flows, as expected.

The effects of reserves on foreign portfolio capital inflows found by the analysis, suggest that reserve accumulation may continue to provide a precautionary reserve benefit to India. The results shows that additional reserves continue to reduce gross outflows against adverse global financial shocks and interest rate shocks, suggesting that there are positive marginal benefits to accumulating reserves for financial stability functions. This point to the stabilising effect of reserves in the case of monetary policy shocks. The estimated reduction in the sovereign interest spread implies that the opportunity cost of reserves for the RBI may be substantially less than the simple spread, net of valuation costs.

According to an analysis of foreign exchange reserves, China has the largest foreign exchange reserve in the world, holding over $3.6 trillion. Japan came in second, holding $1.3 trillion and Switzerland followed with $890 billion.

Saudi Arabia also holds considerable foreign exchange reserves, as the country relies mainly on the export of its vast oil reserves. If oil prices begin to rapidly drop, the country's economy could suffer. It keeps large amounts of foreign funds in reserves to act as a cushion should this happen.

U.S. foreign exchange reserves totaled over $244 billion in July.