Explainer: Foreign Exchange Reserves

Introduction

The politicization of the foreign exchange reserves, with both sides of the aisle attempting to skew data in their favour, is adding to the perplexity of the concept. Even more than that, these faux value judgments make it difficult to discern the historical trends and understand the policies that have a real-time impact on the foreign exchange reserves.

In other words, it has become difficult to separate the wheat from the chaff. To get out of this labyrinth of fabrications and deliberate confusion, the basics of the concept offer the best shot. 

What Do We Mean by Foreign Exchange Reserves?

Foreign exchange reserves simply constitute the reserves of foreign currency held by a country’s central bank. Investopedia defines foreign exchange reserves as, “assets held on reserve by a central bank in foreign currencies. These reserves are used to back liabilities and influence 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.”

So, at its core, the foreign exchange reserves are the backup fund of a country which can be used to offset external and internal shock events. Foreign exchange reserves are also required to pay for the imports. These imports can range from consumer goods to raw materials for different industries.

For instance, if import-substituted industrialization is the goal, then, an array of cutting-edge technologies and machinery has to be imported which is paid for with the foreign exchange reserves. Keeping all other variables constant, this imported technology and machinery can help the country in expanding and/or diversifying its industrial base.

The industry produces goods which can be imported thereby adding to the foreign exchange reserves. On the other hand, if imports outstrip exports or constitute mainly consumer goods, then it has a negative impact on forex supply.  Pakistan serves as an example in this regard.