Updated from original posting: 03 December 2006 Earlier this week, I told you that the IMF was looking to add the AUD and CAD as part of its official currency reserves list. Today, it's time to re-educate ourselves on the basics of foreign currency reserves!

What exactly are central bank reserves?

If you guessed acorns, you're wrong.

That squirrel from the Ice Age franchise stores acorns. Central banks store money.

Most of the money that is saved up is in the form of foreign currencies. After all, if you run out of your own domestic currency, you can always print more. No need to waste space storing them.

Why stash away foreign currencies?

A country accumulating big foreign currency reserves is the equivalent of that buff dude in your gym ripping off his shirt and flexing his big guns.

Having big muscles implies you can protect yourself which attracts the ladies because then they feel protected as well. The same analogy is applicable to economies. Having big foreign currency reserves implies that the country's economy is strong and can protect its own currency which attracts foreign investors.

elmo.jpg

Foreign reserves also allow central banks to limit the exchange rate volatility of its stored foreign currencies.

For example, let's pretend "Tickle Me Elmos" is a currency and you are Ben Bernanke, the head honcho of the U.S. Federal Reserve.

Let's say one Tickle Me Elmo is worth 30 USD. This is the exchange rate. You want the exchange rate is to be constant as much as possible. Unfortunately, Christmas is just around the corner and Tickle Me Elmos are being bought and sold all over the place. Today, one Tickle Me Elmo is worth 50 USD. The next day, one Tickle Me Elmo is worth 80 USD. The exchange rate becomes too erratic.

So what do you do? You control the supply. You buy as many Tickle Me Elmos as you can and you sit on them. The people who still own Tickle Me Elmos actually wish to keep them and don't wish to sell, so the flurry of buying and selling activity decreases which stabilizes the exchange rate.

What is the most popular foreign currency reserve?

Which currencies do the world's countries stash underneath their central bank's mattress? Here's a chart showing what makes up the world's foreign exchange reserves:

global-currency-reserves2.png
Source: IMF Statistics Department COFER database

You'll notice that the USD is still the most popular currency reserve, but this figure has been dropping steadily. After representing as much as 66% of global reserves, the USD now only takes up 62.16%. Meanwhile, the percentage of other currencies has risen from less than 1% to 5.35%.

Who is King of Foreign Reserves?

Which country stores the most moolah? The chart below displays eight countries (as well as the euro zone) that hold the biggest foreign reserves. It's pretty much a one-man show nowadays, as China has reportedly more than THREE TRILLION USD worth of currency reserves.

country-currency-reserves2.png

Over the next decade, it'll be interesting to see how this composition changes. Will currencies like the AUD and CAD continued to be added the vaults of central banks around the world? Will the dollar continue to lose its luster? And what about the yuan? I'm sure there are more than a few fellas out there who wanna park their cash in the reminbi!

If you were a central bank, which currency would you buy as reserves?
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