What is a Foreign Currency Reserve and why do we need one?
What is a Foreign Currency Reserve?
A Foreign Currency Reserve is basically financial savings a nation holds in the currency of other nation (mainly major currencies like the Dollar, Euro, Yen and Yuan). It means that in a financial emergency a government can always buy things from abroad. But one of its most important uses is to manage the value of a domestic currency. If you want to push the value of your currency up you can buy up some of your own currency using another nation's currency and if you want to bring the value of your currency down you can sell your own currency and build up your reserve. You can also spend it if there is a domestic emergency and you can invest it and get interest from it.
How would you use it?
It entirely depends on the strategy you are taking to your currency. For example if you 'pegged' a currency to Sterling (kept them at the same value) you would need to use your reserve if your own currency increased or decreased in value. If you let your currency 'float' (rise and fall in value in relation to Sterling) you may want to smooth the natural increases and decreases. And you might want to affect your currency value for other policy reasons such as to encourage exports.
Doesn't this create risks?
Yes, if not used carefully. A speculative attack is when currency speculators think your currency has a current value 'wrong enough' to profit from it by 'betting against' the currency. They then try to destabilise your currency by doing the same thing you're doing – buying it or selling it and effectively betting on the outcome. But most speculative attacks fail either because they are successfully defended (the national government does the opposite of the speculator and the speculator gives up) or because the national government doesn't bother and lets the currency reach a new value (which may well be good for the economy if the currency is overvalued). But this isn't a risk in the early years of independence because speculators won't hold enough of the new Scottish currency to be able to mount an effective attack.
Is this the only option for managing the value of a currency?
No – that is the purpose of monetary policy as a whole and a foreign currency reserve is only a part of that. Interest rates are an example of another crucial tool.
So how much do we need and how do we get it?
If Scotland wanted to back a new currency and peg it to Sterling in the early years of independence then it would need a Foreign Currency Reserve of about £25 billion. About £15 billion of this would be inherited from the UK or come from other sources that don't 'cost' anything. The remaining £10 billion would be borrowed and added to the national debt. But this would actually work out about half a million pounds cheaper for Scotland than the current cost of maintaining the UK's currency reserve.