According to a statement released by Bank Negara, it has an equivalent of USD97.3 billion in international reserves as of 29 July 2016.
That sounds like a lot of money!
What’s the rationale behind Bank Negara holding on to so much foreign reserves?
The Gold Standard
For the longest time in human history, countries have subjected their currencies to the gold standard. The gold standard is a monetary system that pegs the value of a currency to the amount of gold reserves a country has.
In other words, the gold standard makes sure that national currencies are backed by a proportionate amount of gold reserves, hence giving the currency “real” value.
The Function Of International Reserves
However, ever since President Nixon took the United States off the gold standard back in 1971, countries around the world have gradually moved away from the gold standard and onto a floating or controlled-float system that most countries adopt today.
At the same time, countries around the world gradually built up international reserves in the form of gold, US dollar and other foreign reserve currencies recognised by the International Monetary Fund (IMF) such as the Euro, Japanese Yen, British Pound Sterling and most recently, Chinese Yuan to back their currency.
The Controlled-Float System
With a floating exchange rate, a currency’s value is susceptible to huge fluctuations because it is directly influenced by market forces. In other words, the currency’s value would directly reflect the demand and supply of the currency.
Such huge fluctuations in a currency’s strength and exchange rate can cause severe instability in a country’s economy and affect trade as seen in the 1997 Asian financial crisis.
Balancing The Demand And Supply Of A Currency
For a country to be able to cushion any sudden and huge fluctuations in the strength and value of a currency in a controlled-float system, the country would need to have substantial international reserves to balance the demand and supply of a currency.
Influencing The Strength Of The Ringgit
If the ringgit is weakening due to strong selling pressure on the ringgit, Bank Negara could use our international reserves to buy more ringgit to artificially prop up the strength of the ringgit before gradually weakening it to reflect the shift in market forces.
On the contrary, if the ringgit is strengthening too quickly, Bank Negara could also sell more ringgit in exchange for more gold or reserve currencies such as the US dollar to prevent the ringgit from strengthening too quickly.
These cushions in the exchange rate of the ringgit are crucial for businesses and trade relations as it provides the stability and predictability required for trade to happen.
Cushioning Sudden Fluctuations In Currency Value
Without a stable currency with a predictable exchange rate, there would be chaos in the economy as importers and exporters would never be sure of the price they would have to pay for their goods or sell their goods at due to the uncertain exchange rates.
Can you imagine if imported electronic products and medicine cost half as much this month and twice as much the next month? Retailers and businesses would have trouble knowing how to price their goods in their inventories and predicting how much they could potentially make with each batch of goods.
Their budgets and financial projections would go haywire!
The Bedrock Behind The Ringgit
Hence, Bank Negara’s USD 97.3 billion worth of international reserves is crucial for our economy as it serves as the bedrock behind the ringgit and is the key to providing a relatively stable and predictable currency that allows trade to thrive.
It is also our first line of defence against sudden fluctuations in market forces and in preventing events like the 1997 asian financial crisis from re-occurring.
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DollarsAndSense Malaysia is a website that aims to help people make better financial decisions, one interesting, bite-sized article at a time. Like us on Facebook to stay in touch with our latest articles.