What foreign reserves are for and how a country can have negative reserves and still operate fine.

Question

I do understand the basic concept of foreign reserves but I never knew they could be negative until I saw headlines about Turkiye’s reserves going negative, does that denote bankruptcy or what? How does that work?

In: 4

Answer 1

It means that they can’t do things like prop up the Lira anymore. For Turkey specifically, they have been using foreign reserves to keep the value of the Lira up on foreign exchange markets to prevent inflation from worsening.

How are those related? In Turkey’s case the central bank spends their foreign reserves to buy Lira on the international market. This reduces supply of Lira, which increases the value relative to other currencies. As long as the central bank continues to buy Lira using foreign currencies like the USD. They’re basically in the situation Sri Lanka and Pakistan are in, although not as bad (yet) because Turkey does still have a decently diverse economy.

If you want an example of what happens when a central bank engages in currency manipulation like this, you can take a look at Russia. When they were sanctioned in 2022 the value of the Ruble collapsed. They propped it up by declaring that the Ruble would be pinned to the price of gold. They did this by buying Rubles from the market for gold at a fixed rate. The problem is that this only works as long as the bank has enough gold on hand to buy Rubles and keep the price up. They quickly found out that they would run out of gold very quickly and instead forbade Russian citizens from exchanging Rubles for gold. That move basically turned the market for Rubles into an artificial one where essentially the only participant is the Russian central bank. Russian oil companies that can still trade are required to hand over a certain amount of foreign currency to the central bank in exchange for Rubles. Turkey can’t do this because they’re not a sanctioned pariah state and their currency is still traded on the international markets.

This is also why countries like China hold so many us bonds. They build massive reserves of USD and Euro assets because if they reduced their holdings, they would inevitably increase the value of the CYN relative to the USD/Euro and hurt their key income stream, exports.