Countries Only Accumulate Foreign Reserves Because They Decide To

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Friday, 21 December 2012 06:17

A Washington Post article on a report by the IMF's Independent Evaluation Office criticizing political influence by the United States on the Fund's policy may have misled readers on how countries accumulate foreign exchange reserves. The article told readers:

"A steady rise in foreign reserves — a country’s holdings of dollars, yen or other major world currencies — can be the result of large trade surpluses. But it can also stem from an undervalued exchange rate, something that the United States has long accused China of maintaining to give its products a more attractive price on world markets."

A rise in foreign exchange reserves can only result from a decision by a central bank to buy reserves. Its access to reserves is affected by the country's trade balance, but a central bank only ends up with reserves because it has decided to buy them. If the central bank of a country with large trade surpluses decided not to buy reserves, then its currency would rise in international markets as holders of foreign exchange (mostly dollars) dumped them on international markets to obtain more of their own country's currency.

This would cause the price of their own country's currency to rise and the foreign country's currency to fall. There is no real dispute that central bank intervention keeps the dollar high against the yuan and other currencies. The only questions can be the motivation and the implications of this intervention.