Foreign Exchange

Generally speaking, foreign exchange is a collective definition for financial instruments allowing a particular country to calculate how much it owes to other countries. For instance before 1999, when the Bulgarian national currency, Lev, was pegged to the Deutsche Mark (DM) and subsequently to the common European currency, Euro, the country used to settle the amounts that were owed to its trade partners in foreign exchange, most commonly in US dollars.

Undeniably, export and foreign investments are among the main motors of a country’s economy, as well as major sources of foreign exchange. On the other hand, when a country imports goods and services, the government may use foreign exchange to pay for these imports.

Basically, foreign exchange becomes necessary when a country’s national currency is not strong enough, i.e. the currency is constantly loosing its value as a result of, say, deteriorating economy, to guarantee the payments on its foreign debts, as well as the payments to its trade partners.

As a result of international sanctions, Zimbabwe suffered hyperinflation, which practically killed the Zimbodollar. At one point, Zimbabweans had to pay for bus tickets with trillions of their national currency. In such severe cases, the remedy of foreign exchange is just not strong enough, so the government has opted for a multi-currency system, in which payments are executed with three foreign currencies – the US dollar, the South African rand, and the Botswana pula.

To be able to react adequately to internal or external factors threatening the stability of the national currency, the national banks hold foreign exchange reserves. Other reasons for maintaining foreign exchange reserves include the above mentioned payments on maturing foreign debts and import/export management. Foreign exchange reserves also serve as buffer against financial shocks and this is why the economies, holding significant foreign exchange reserves, are doing better in the current conditions of widening economic crisis.

Essentially, the central banks hold gold reserves to guarantee the value of their national currencies. According to official reports at the beginning of 2005, the central banks were holding 19.5 percent of the available gold in reserve. One of the world’s largest lenders, the International Monetary Fund, holds a gold reserve of over three thousand tonnes of gold.

In their report for 2009, the experts of World Gold Holding have calculated that the Eurozone is holding the largest gold reserve – over ten thousand tonnes of gold, followed by the Unites States with a reserve of slightly over eight thousand tonnes of gold. However, the gold reserve of the United States accounts for up to eighty-seven percent of their total foreign exchange reserves.

So as to achieve an effective and efficient management of their foreign exchange and gold reserves, the central banks take into consideration several factors. First and foremost, these reserves should be held in appropriate composition or, in other words, the central banks should choose financial instruments that are likely to preserve their value in the long run. So as to prevent devaluation of their official reserves, the central banks invest them in various sub-portfolios. To monitor this process, the governments rely on adequate information systems, which are assessing financial risks, such as external shocks and liquidity. Some countries use external managers of their reserves. For instance, the currency board may keep the national currency pegged to the euro and guarantees the stability of the national currency. This process entails setting benchmarks of budget surplus to be achieved by the government. This was the case before the outbreak of the global financial crisis, but it also limits some of the central bank’s fiscal operations.

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