The foreign currency portion of international reserves (IRs) is held in "reserve currencies"—mostly US dollars (two-thirds of the total) but also euros (25%), UK pounds and Japanese yen. SDRs ("special drawing rights") are international reserve assets, created by the International Monetary Fund (IMF), that member countries can add to their foreign currency reserves (assets held in a currency other than the local currency) and gold reserves to use for payments requiring foreign exchange. The SDR's value is set daily using a basket of four major currencies: the euro, Japanese yen, pound sterling and US dollar.
Ample IRs allow a government to manipulate exchange rates—usually to stabilize rates to provide a more favorable economic environment or to purchase its domestic currency to protect the country from a capital crisis provoked by an attack on its currency by speculators. Central banks of several countries can cooperate in buying and selling official IRs to influence exchange rates. IRs are also an important indicator of a country's ability to repay foreign debt and are a factor in determining a country's credit rating.
During economically challenging times, countries whose private capital inflows do not cover their financing needs will often bridge the gap by drastically reducing their trade deficits (through reducing imports) or by drawing down IRs. However, other government liquid assets can be applied to liabilities in times of crisis, including sovereign wealth funds (SWFs). If SWFs were included, Norway and the Gulf States would rank higher on the list (the UAE would be second after China).
In the initial phases of the recent economic crisis, developing countries consumed US$362 billion worth of their IRs. About half of emerging market countries depleted their reserves as part of their adjustment to the global liquidity crisis. Developing countries sometimes try to increase their reserves to provide some insurance against future fluctuations in global financial conditions. The extent to which high reserves helped lessen the impact of the recent crisis is not clear; indeed, countries with large reserves suffered downturns almost as severe as did countries with small reserves.
At one time it was believed that reserves were "adequate" if they could cover approximately three months of a country's imports or all of the external debt maturing over the coming year. However, that measure became less relevant as countries—for example, Brazil, Russia and, in particular, China—accumulated reserves that far surpassed such levels. Very high reserves, while reassuring in the recent financial downturn, can have negative implications for the holder of the reserves and for the global monetary system. For one thing, by investing heavily in foreign reserves, a country invests less in its own economy—possibly spending less on education, healthcare and infrastructure—which may have otherwise offered a route to longer-term growth. For another, with most reserves held in US dollars, a stronger US dollar has been supported despite high current account deficits in the US, contributing to global economic imbalances.
In 2009 Zhou Xiaochuan, governor of the People's Bank of China, proposed a gradual move toward increased use of SDRs as a centrally managed global reserve currency, and also for the national currencies backing SDRs to be expanded to include the currencies of all major economies. This proposal was followed by some other countries suggesting that a "more diversified" monetary system, to reduce dependency on the US dollar, be considered.
However, starting in late 2009 and moving into the spring of 2010, a series of events brought increased confidence in the US dollar as a reserve currency: • Dubai's debt problems emerged (leading to a series of sovereign debt downgrades and a flight of capital from emerging markets);
• The sovereign risk crisis in Greece and other European Union countries worsened and put pressure on the euro (with some analysts even questioning the continued existence of the single currency);
• The US economy showed signs of recovery and growth.
Data is from the International Monetary Fund (IMF) and the World Bank, with additional information from IMFdirect and the University of California – Santa Cruz Economics Dept.
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