Foreign Exchange Reserves – Why all the Fuss?

As citizens of a small open economy, that imports the bulk of what it consumes, we can certainly appreciate the need to have foreign currency on hand to pay for those goods and services. In this regard, the tightening of the foreign exchange market in recent years (owing to the slump in domestic energy sector revenue), has imposed severe challenges on businesses and individuals alike. However, foreign exchange reserves are important for much more than just facilitating the purchase of imports and therefore, it is important to monitor trends in this valuable resource. This note will briefly discuss a few critical roles played by reserves and the need to maintain healthy levels.

1. Protects the value of domestic currency

One important use of reserves is to defend the value of the domestic currency. It is normally better for an economy if the value of its currency remains stable, with no major spikes or plunges in the short term. Additionally, policy makers may have a preferred rate or range within which they would like the domestic currency to be exchanged. This type of stability can enhance confidence and consequently the willingness to invest in an economy. A healthy level of reserves can greatly facilitate this goal. For instance, when the demand for foreign exchange exceeds the supply, the Central Bank can sell part of its reserves to authorised dealers, who in turn put this additional foreign currency on the market. In so doing, the Central Bank protects the domestic currency from significant depreciation, which will make imported goods more expensive, resulting in an increase in inflation. In times of excess supply, the Central Bank purchases foreign currency from the market, thereby preventing a major rise in the value of the domestic currency, which would make exports more expensive and reduce the export earnings of local businesses in the process.

2. Acts as a buffer in times of crisis

A strong foreign exchange position can act as a buffer in times of economic crisis. When natural disasters and wars occur, or when external shocks arise, a country’s ability to produce goods may be reduced, or the price of key exports may plunge. In such circumstances, the ability of firms to earn foreign exchange may be hindered, along with their ability to pay external suppliers. To provide relief, the Central Bank can sell some of its reserves to the affected businesses. This could help to limit the level of disruption throughout the economy, and as such preserve jobs. A country always needs reserves to satisfy international debt and other external obligations. A healthy stock of foreign currency can help to ensure that it continues to do so even in times of crisis (at least for a short period). As a result, it will be better equipped to weather external and domestic shocks, since, for instance, it would face a reduced risk of sovereign default on external debt and will be less likely to need the intervention of multi-lateral agencies such as the IMF.

3. Safeguards the stability of the economy

Reserves can also help to safeguard the stability of the economy when it faces a spike in capital flight. For instance, if domestic or international developments cause investors to lose confidence in the domestic market, they may decide to reduce their exposure to the market. This is likely to result in large outward, capital movements to other jurisdictions, which would increase the demand for foreign currency. The effect of this would be a fall in the demand for domestic currency and a slide in its value. To counteract this, the Central Bank can sell foreign currency to the market, removing excess quantities of domestic currency in the process and thereby protecting its value. This will limit the associated inflationary pressures.

4. Supports policy making

Having high levels of reserves allow policy makers to pursue key initiatives, such as providing support to systemically important sectors or fledgling industries that face challenges accessing sufficient quantities of foreign exchange. Such initiatives can foster the growth of industries, which will support the diversification and expansion of the economy. Considering the foregoing, one might ask what is a healthy level of foreign exchange? Well, a general rule of thumb is to not let the figure fall below the equivalent of three months of imports, at a minimum. However, consideration must also be given to the country's external debt payments and current account deficits (if any). There is no universal rule, since the reality each country faces would be different. As such, a healthy position would be one where a country can comfortably cover its external obligations. In this regard, Trinidad and Tobago’s reserve position remains strong, reaching US$7.6 billion in January 2019 (8.6 months of import cover). What is concerning though, is the fall since 2014, when reserves equaled US$11.5 billion or 12.9 months of import cover.