Official reserve – definition and meaning

The official reserve is a country’s holdings of gold reserves, special drawing rights, and tradable foreign currency. ‘Reserve account,’ ‘officials reserves‘ (plural), ‘official reserve assets,’ and ‘international reserves‘ mean the same as ‘official reserve.’

A tradable foreign currency is one we can purchase directly or legally outside the country that issues that currency. For example, the euro, US dollar, and pound sterling are tradable currencies. In other words, you can buy and sell them outside the eurozone, US, or UK.

The Malaysian ringgit has been non-tradable since 1998, i.e., you can only buy it in Malaysia.

Official reserve – central banks

A country’s central bank usually holds that nation’s official reserves. The Federal Reserve (Fed) and Bank of England are the central banks of the US and UK respectively.

Central banks use their official reserves to balance their payments from year to year. When there is a trade surplus, for example, the official reserve increases. However, it shrinks when there is a trade deficit.

Official reserve - image with explanation and examples
The official reserve acts as a buffer. The central bank uses it to protect the economy and currency from steep fluctuations.

Official reserve – exchange rates

Sometimes, central banks use their official reserves to intervene in the foreign exchange market. If the dollar is too strong, for example, the Fed might sell dollars to bring down its value.

If a currency is too weak, the central bank will purchase its own currency. This increases demand for that currency, which subsequently raises its value compared to others.

However, exchange rate interventions are only temporary fixes. Market forces are continually influencing exchange rates. Therefore, the market equilibrium will soon resume after the central bank’s intervention.

Since the beginning of this century, the official reserve assets of the United States have fluctuated. In 2000, they stood at $128.4 billion. They reached a peak of $527.37 billion in 2012 and then dropped to $407.22 in 2016.

According to the Bank of England:

“The UK’s official holdings of international reserves comprise gold, foreign currency assets, IMF Special Drawing Rights, and the UK’s Reserve Tranche Position at the IMF.”

The special drawing rights (SDR) were created by the IMF. SDR is an international reserve asset to supplement a country’s reserve assets.

The Statistical Data Warehouse of the European Central Bank says:

“SDR holdings represent unconditional rights to obtain foreign exchange or other reserve assets from other IMF members. SDRs are not claims on the IMF. Rather, the membership of the SDR Department of the IMF incurs the asset or liability position.”

China has the world’s largest foreign exchange reserves, followed by Japan, Switzerland, and Saudi Arabia.

In August 2017, China had $3.091 trillion in foreign exchange reserves. In September 2017, the United States had $123.377 billion, while the UK’s had $179.192 billion.

Video – Official reserve

This Khan Academy video explains why and how a country’s central bank would build foreign currency reserves.