Central banks and sometimes other banks and large corporations, hold reserves in foreign currencies as a hedge against exchange rate risk and perhaps to satisfy the liquidity needs of positions they may have in Forex derivatives.
Central banks and large institutions which engage in international trade and Forex transactions will find it prudent and sometimes necessary to hold substantial reserves in a foreign currency. Central banks frequently engage in various types of Forex transactions to balance their exposure to trends, risks, and other effects in the currency market.
They may hold more reserves of a foreign currency in a situation where they worry it will gain too much value over their own, and they can mitigate some of these effects by flooding the market with some of their supply. The United States dollar is the primary reserve currency of foreign central banks. This is the most liquid currency and many other currencies are pegged to it or are highly correlated to it.
This gives the central banks of various countries chips to play at the international table. China and Japan have built up large reserves in USD as a means of artificially lowering the value of their own currency relative to it, to make their exports a little more affordable for international buyers, to help grow their economy and create jobs. China and Japan are heavily dependent on their exports, and it is detrimental to them for their currency to appreciate.
There is actually a word, Endaka, for the state of the Yen being strong relative to other currencies. For the US, a strong export economy in those nations means that the US can export less, and the US has had a trade deficit for a while now, although it’s not really the fault of China or Japan. The American dollar has strengthened relative to other currencies, which can be advantageous for a country doing a lot of importing, which it is.
But, the effects of a sudden sell-off in US currency from China or Japan, even with only a part of their holdings, could be a scary situation for America, as it would suddenly devalue the dollar significantly. This can be seen as a strategic advantage for China and Japan in the political sphere.
What is Foreign Exchange Risk?
What is Currency Convertibility?
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