Foreign Exchange Reserves: FCAs and Gold

• A country's foreign exchange reserves are the foreign currencies held by its central bank.
• Foreign exchange reserves are also called foreign reserves or foreign currency reserves.
• Managing a currency's value is one of the most important reasons for holding reserves.
• Foreign Exchange reserves consist of: Foreign Currency Assets, Gold, Special Drawing Rights (SDR) holdings of the government, and Reserve Tranche.

Foreign Currency Assets (FCAs)

• The currencies of various countries held in foreign exchange reserves are called foreign currency assets.
• Examples of FCAs include reserves held in US Dollars, Euro, Japanese Yen, etc.
• FCAs include foreign bank deposits, foreign treasury bills and short-term and long-term foreign government securities, besides currencies.
• Deposit agreements with IMF trust are part of FCAs and readily available to meet a Balance of Payment (BOP) financing need.

Gold

• The RBI uses its gold stock as a back up to issue currency.
• The RBI uses its gold stock to meet unexpected Balance of Payment problems.

Special Drawing Rights (SDRs)

• The Special Drawing Right (SDR) is an international reserve asset, created by the IMF, to supplement official reserves of its member countries
• The SDR helps countries meet Balance of Payment problems.
• The IMF created the SDR in 1969.
• Member countries contribute to this account to avail of this benefit, in proportion to their IMF quota (membership fee).
• Special Drawing Rights can be exchanged for freely usable currencies.
• The value of the SDR is based on a basket of five major currencies: the US dollar, the Euro, the Japanese yen, the British Pound Sterling, and the Chinese renminbi (RMB).
• The SDR is a potential claim on the freely usable currencies of IMF members, rather than a claim on the IMF or a currency.
• Holders of SDRs can obtain freely usable currencies in exchange for their SDRs through: voluntary exchanges between members, and IMF designating members with strong external positions to purchase SDRs from those with weaker external positions.

Reserve Tranche

• It is the portion of the required quota of currency that each IMF member country must contribute to the IMF, but can designate for its own use.
• The reserve tranche portion of the quota can be accessed by the member at any time, whereas the rest of the member’s quota is typically inaccessible.
• Money lent over and above the quota to the IMF’s General Resource Account becomes part of the Reserve Tranche.

Purchasing Power Parity (PPP)

• Purchasing Power Parity (PPP) is an economic concept that compares currencies of different countries through a market “basket of goods” approach.
• Two currencies are in equilibrium or at parity when a market basket of goods, adjusted for the rate of exchange, costs the same in both countries.
• Using PPPs is an alternative to using market exchange rates.
• The actual purchasing power of a currency is the amount of that currency required to purchase a specific unit of a good or a basket of common goods and services.
• Purchasing power parity ultimately means equalising the purchasing power of two currencies by accounting for differences in the cost of living and inflation rates.
• PPP (Purchasing Power Parity) is determined in each country based on its relative cost of living and inflation rates.
• The purchasing power parity is one of the most important macroeconomic metrics used by economists in determining the economic productivity and living standards of a country.
• PPP is based on the law of one price, which states that identical goods will have the same price.
• The purchasing power parity formula: S = P1/P2, where S = Rate of Exchange of currency 1 in terms of currency 2, P1 = Cost of a good in currency 1, P2 = Cost of the same good in currency 2.

Explanation of foreign exchange reserves, which are foreign currencies held by a country's central bank. It describes the composition of reserves, including Foreign Currency Assets (FCAs) such as reserves held in US Dollars, Euro, and Japanese Yen. It also highlights the role of gold reserves.