What are foreign currency reserves and can they help combat the global economic crisis?

The economic and political crisis in Sri Lanka, which began in April 2022, has been playing out on TV screens around the world. Protests have swept the country, forcing the President to step down.

The country defaulted on its debt payments in May and currently owes creditors $51 billion, according to Visual Capitalist. Inflation is running at almost 40%, caused by an increasing inability to pay for fuel, food and medicine imports. Foreign currency reserves are estimated to have dwindled to around $50 million, plummeting 99% from $7.6bn in 2019.

Foreign currency or exchange reserves, otherwise known as forex reserves, comprise cash and other assets like gold that are held by central banks and other financial institutions such as the International Monetary Fund (IMF), according to City Index, a financial services provider. It has listed 7 main reasons why central banks have foreign currency reserves:

During volatile periods for the world economy, investors and currency traders often seek to convert cash holdings into so-called ‘safe haven’ currencies for protection. Currencies such as the Swiss franc and the Japanese yen, but especially the US dollar are considered safe-haven assets.

The dollar is particularly attractive, being the world’s reserve currency and the one used in many international business deals. It is also backed by the world’s largest gold reserves. The so-called ‘Greenback’ has recently been at its highest for two decades compared to major rival currencies. Investors have been flocking to it, encouraged by signs that the US Federal Reserve will increase interest rates faster than most.

“With US rates much higher and stocks way lower, the dollar is a safe-haven trade,” Brent Donnelly, President of Spectra FX Solutions, told Bloomberg. “The only safe haven left is the US dollar,” he added.

President Vladimir Putin has said Russia is ready to develop a global reserve currency together with China and other members of the BRICS group of nations. It could be based on a basket of currencies from the organization’s members who also include Brazil, India and South Africa.

The move follows Russia being cut off from the world’s financial system following its invasion of Ukraine. This curtailed its access to dollars. According to Markets Insider, this could be an attractive option to a wider group of countries: “One possibility is that the BRICS basket currency could attract the reserves not just of the group's members, but also countries already in their range of influence. These include nations in South Asia and the Middle East.”

Advocates of cryptocurrencies such as Bitcoin believe that digital assets could also challenge the dominance of the major currencies. Some central banks are looking at blockchain technology for sovereign crypto digital coins. China doesn’t recognise Bitcoin but is reportedly developing a digital yuan, reports City Index.