This section needs additional citations citations Forex verification. In a strict sense, foreign-exchange reserves should only include foreign banknotes, foreign bank deposits, foreign treasury bills, and short and long-term foreign government securities. Foreign-exchange reserves are called reserve assets in the balance of payments and are located in the capital account. Theoretically, in this case reserves are not necessary.
Non-sterilization will cause an expansion or contraction in the amount of domestic currency in circulation, and hence directly affect inflation and monetary policy. For example, to maintain the same exchange rate if there is increased demand, the central bank can issue more of the domestic currency and purchase foreign currency, which will increase the sum of foreign reserves. Thus, intervention does not mean that they are defending a specific exchange rate level. After the end of the Bretton Woods system in the early 1970s, many countries adopted flexible exchange rates. However, the opposite happened and foreign reserves present a strong upward trend. Ratios relating reserves to other external sector variables are popular among credit risk agencies and international organizations to assess the external vulnerability of a country.
Reserves are used as savings for potential times of crises, especially balance of payments crises. Original fears were related to the current account, but this gradually changed to also include financial account needs. Furthermore, the creation of the IMF was viewed as a response to the need of countries to accumulate reserves. Most countries engage in international trade, so to ensure no interruption, reserves are important. A rule usually followed by central banks is to hold the equivalency of at least three months of imports in foreign currency. The opening of a financial account of the balance of payments has been important during the last decade. Hence, financial flows such as direct investment and portfolio investment became more important.
Reserve accumulation can be an instrument to interfere with the exchange rate. 1995, the regulation of trade is a major concern for most countries throughout the world. Reserve accumulation can be seen as a way of “forced savings”. The government, by closing the financial account, would force the private sector to buy domestic debt in the lack of better alternatives. With these resources, the government buys foreign assets. Thus, the government coordinates the savings accumulation in the form of reserves. There are costs in maintaining large currency reserves.
Price fluctuations in exchange markets result in gains and losses in the purchasing power of reserves. In addition to fluctuations in exchange rates, the purchasing power of fiat money decreases constantly due to devaluation through inflation. Several calculations have been attempted to measure the cost of reserves. The traditional one is the spread between government debt and the yield on reserves. The caveat is that higher reserves can decrease the perception of risk and thus the government bond interest rate, so this measures can overstate the cost.