CONCEPTS · External Accounts

Foreign Exchange Reserves

The war chest is what a country falls back on when the world stops buying its money. It defends the exchange rate and covers foreign bills, and it is built through a purchase the central bank has to offset to keep domestic money from ballooning.

What it defends

Foreign exchange reserves are the foreign-currency assets held by a central bank, usually short-dated securities and deposits issued by other governments. They exist so the country can meet foreign-currency obligations and intervene in the currency market. A peg, a managed exchange rate and a large stock of external debt all need one.

Size is about adequacy, not ambition. The question reserves answer is whether the country can keep paying for imports and servicing foreign debt if foreign lenders and investors stop rolling their money over. Reserves buy time, and time is the difference between an adjustment and a crisis.

Sterilisation

Reserves are built by buying foreign currency, and that purchase has a side effect. The central bank pays with domestic money it creates, so buying reserves expands base money. Sterilisation is the offsetting step: the central bank sells domestic securities and drains the proceeds, removing the liquidity it just added. The reserve stock rises while domestic money does not.

What it is not

It is not a development fund and not a measure of national wealth. Much of the stock may be borrowed, it earns a low return by design, and it is only as useful as what it can buy. Defending a fixed rate against a persistent drain usually fails, because the market can sell far more of the currency than the central bank can absorb.

The checkable use is to ask where the reserves came from and what they are matched by. A stock built by borrowing in foreign currency is a buffer with a matching liability; a stock falling while the exchange rate is defended tells you the defence is being paid for. Growth in the stock is not the same thing as strength.

IF YOU REMEMBER ONE THING

DefinitionForeign-currency assets held by the central bank to defend the exchange rate and cover foreign-currency obligations.

SterilisationBuying reserves creates domestic money; selling domestic securities drains it back, so the purchase has no lasting effect.

CheckAsk where the reserves came from and what matches them. Borrowed reserves are a buffer with a liability attached.

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