What are Reserve Assets?
Reserve assets are financial assets denominated in foreign currencies, held by central banks, that are primarily used to balance payments. A reserve asset must be readily available to monetary authorities, must be an external physical asset that is, in some measure, controlled by policymakers, and must be easily transferable.
Understanding Reserve Assets
Reserve assets include currency, commodities, or other financial capital held by monetary authorities, such as central banks, to finance trade imbalances, check the impact of foreign exchange fluctuations, and address other issues under the purview of the central bank. They can also be used to restore confidence in financial markets. The U.S. Dollar (USD) is widely considered to be the predominant reserve asset and, because of this, most global central banks will hold a substantial amount of U.S. Dollars.
Reserve assets, as per the International Monetary Fund's (IMF) balance of payments manual, must, at a minimum, comprise the following financial assets:
- Foreign Exchange: by far the most important official reserve and must be tradeable (can buy/sell anywhere), such as USD, EUR.
- Special Drawing Rights (SDRs): represent unconditional rights to obtain foreign exchange or other reserve assets from other IMF members.
- Reserve position with the IMF: reserves that the country has given to the IMF that is readily available to the member country.
Before the Bretton Woods agreement ended in 1971, most central banks used gold as their reserve asset. Today, central banks may still hold gold in reserve, but this has been supplanted by reserves of tradable foreign currencies. Currencies held by central banks have to be readily convertible, meaning that the currency should have high enough stable demand (and low controls) to allow the bank to use them.
Reserve assets can be used to fund currency manipulation activities by the central bank. In general, it is easier to push the value of a currency down than to prop it up, since propping the currency up involves selling off reserves to buy domestic assets. This can burn through reserves quickly. The central bank can put downward pressure on the currency by adding more money into the system and using that money to buy foreign assets. The downside to this strategy is the potential for increased inflation.