While this sounds like a workable solution, it comes with two major caveats.

The first being that, generally, only central banks which intervene in the currency market to manage their domestic currency’s value versus the USD will have foreign reserves.

After all, if they aren’t actively buying or selling Dollars in the market, then the central bank probably won’t have Dollars on its balance sheet; at least not in the large amounts needed.

The second caveat is more difficult to grasp. While intuitively it might seem as if having more foreign reserves is desirable, since it means that a central bank can provide more USDs to its domestic banking system in times of crisis, the inverse is true.

Having more foreign reserves is not a good position to be in, simply because it means the country’s economy is extremely reliant on USD inflows.

Think about it for a minute – a foreign central bank can only amass large amounts of foreign reserves if it keeps intervening in the currency market.

Since most of these interventions involve them purchasing Dollars (hence their large pile of them), it means that the central bank has been very active in taking in USDs, in exchange for domestic currency at a rate they deem is beneficial for their economies. (Central banks who do this tend to intervene to keep their currencies weaker versus the Dollar.)

This in turn implies that the domestic economy is bringing a lot of USDs back home, and/or a lot of foreign investors are exchanging their USDs for domestic currency in order to invest in the country. When USD inflows from these two sources dry up, the domestic economy suffers.

The first scenario would come about due to falling foreign demand for whatever products domestic companies export. And the second from foreigners no longer investing their capital in the country due to domestic or global economic uncertainty.

Good examples of these include Southeast Asian economies in the lead up to 1997’s crisis, and China just before 2008. It is important to note that Southeast Asia, China, and Emerging Markets more broadly are still mostly oriented towards exports and attracting foreign direct investment today, but to a lesser degree than they were prior to those two crises.

Even so, as March 2020 so clearly showed, economies all around the world, even those considered to be “developed” markets, are vulnerable to USD funding markets drying up.

Dollar liquidity matters greatly to the global economy, and a country can be more or less reliant on USD inflows to drive economic growth. But, no country can really avoid using, and therefore being exposed to, the Dollar.

Consequently, the more foreign reserves a country has, the more its economy is reliant on USD inflows and funding.

When sources of these inflows and funding dry up overnight, such a country will find itself not only unable to pay its USD liabilities, but also deprived of the foreign USD based investment that was driving its growth.

Put simply – its economy collapses.      

To be continued…