Tuesday, January 03, 2012

How to Accumulate Foreign Exchange Reserves

Many states have accumulated foreign exchange reserves and hold them in sovereign wealth funds. Most of these funds are denominated in dollars, because that's the "safe," albeit under-performing, asset. However, by mixing in a bit of currency risk, foreign exchange reserves could be much more profitable and moderate the impact of mercantilism via currency manipulation.

What a nation would do is base their foreign currency holdings on the foreign-currency denominated value of their imports. So you would add up your foreign reserves and allot them proportionately to the countries from whom you imported the most. For example, if, in the last three years, 40% of imports came from country A, 30% from country B, and 10% from country C, 40% of the foreign reserves would be in A's currency, 30% in B's, and 10% in C's. As trade flows shifted and proportions changed, these numbers would shift as well.

This arrangement would provide several benefits:

First, your reserves would be in the appropriate currency to pay for your imports, should your own currency fall into question (which is, after all, the reason for having reserves).

Second, imports from a country rise as that country's currency's value falls. Contrariwise, if another currency's value is rising, imports from that country will fall. If you reallocate the foreign exchange reserve portfolio based on imports, you will be buying currency when it is cheap, and selling it when it is expensive. In other words, profit.*

Third, if a country is manipulating its currency to make it artificially cheap to support an import policy, this policy would actively counter it.


* If you're wondering why funds don't do this, it's just like trading oil futures. Eventually, someone has to take a delivery. The investors usually don't want the actual oil, they're profiting by smoothing out the variation in demand. You can still profit from long-term trends, if you can take your profits in the form of oil. The foreign exchange reserve would be in a similar position, as accumulating reserves is the goal.

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