What Are Reserve Assets?
Reserve assets are financial assets denominated in foreign currencies and held by central banks that are primarily used to balance payments.
- Reserve assets are currencies or other assets, such as gold, that can be readily transferable and are used to balance international transactions and payments.
- A reserve asset must be readily available, physical, controlled by policymakers, and easily transferable.
- The U.S. dollar is a reserve currency, meaning it is widely held as a reserve asset around the world.
Understanding Reserve Assets
A reserve asset must be readily available to monetary authorities and be an external physical asset that is, in some measure, controlled by policymakers and easily transferable. 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 USD.
Reserve assets include currencies, commodities, or other financial capital held by monetary authorities 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.
Reserve assets, as per the International Monetary Fund's (IMF) balance of payments manual, must, at a minimum, comprise the following financial assets:
- Foreign currencies: By far the most important official reserve. The currencies must be tradable (can buy/sell anywhere), such as the USD or euro (EUR).
- Special drawing rights (SDRs): Represent 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 are 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 central 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.
If a currency is too weak, this is usually a sign of deteriorating economic conditions, which the central bank will try to correct using internal credit or money supply controls, or possibly selling foreign reserves to prop up (buy) the currency.
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.
Reserve Assets Usage Example
Between 2011 and 2015, the Swiss National Bank (SNB) introduced and implemented an exchange-rate ceiling. The central bank wanted to cap the price of the Swiss franc (CHF), which is viewed as a safe haven, against the euro. A rising franc could hurt Swiss exporters since it becomes more expensive for other European countries to buy their goods.
Manipulating the price of a currency, to cap it in this case, requires a number of tools. The SNB opted to print francs, which in itself creates more supply for francs and helps lower the price. The SNB then sold those francs to buy the euro and other foreign currencies. This helped pushed the franc down, and other currencies up. At the end of 2014, the SNB's reserves increased by 64 billion francs versus the prior year.
The SNB also dropped interest rates to 0% at the end of 2011. By 2015, rates were dropped further, to -0.75%. These drops further dissuaded the buying of francs.
In January 2015, the SNB abandoned the ceiling on the franc. The SNB could no longer keep printing francs and increasing their reserve assets. The immediate result was a sharp rise in the franc. At the start of 2015, the EUR/CHF was trading just above 1.2, where the ceiling had been set. After the ceiling was abandoned, the rate immediately dropped below 0.98, which means the EUR fell dramatically, and the CHF increased dramatically.
Following the sharp rise, between 2015 and mid-2018 the CHF gave back most of its gains, briefly touching 1.2 in April of 2018. As of May 2021, interest rates in Switzerland remain at -0.75% and the EUR/CHF exchange rate is near 1.10.