Many people raised eyebrows on the Bangko Sentral ng Pilipinas's (BSP) move to sell gold in its reserves while other countries did the opposite in the first half of the year. The Philippine central bank justified the move, saying it meant to take advantage of the rising gold prices in the market, but how exactly do foreign reserves work?

The gross international reserves (GIR) are often described as "buffer funds" in times of economic or financial shocks. That's only the gist of a more complicated mechanism surrounding the management of GIR, which amounted to roughly $107 billion as of August. For one, GIR does not work like savings which governments can dip into anytime to fund public projects. The BSP operates independently, and funds from the GIR enter the financial system mainly through investment channels (like investing in government bonds, etc.).

Gold, for one, is just a single component of it, and not even the largest at just about 9% of the total pile to date. Apart from the precious metal, GIR is composed of foreign investments by the BSP, holding the largest share of about 85%, together with a mix of money in various currencies, and required placements by the Philippines at the International Monetary Fund (IMF).

We break them down below.

At the heart of the issue now is gold. For a common person, reserves may sound like a pile of cash. But in reality, there's gold, which BSP, like other central banks, keep as a hedge against depreciating currencies.

Typically, currencies like the Philippine peso, and gold trade inversely: when one is up, the other is down and vice versa. And this mostly happens in times of heightened economic risks.

For example, during the height of the Covid-19 pandemic in 2020 when economies were put to a standstill by lockdowns, gold prices peaked, suggesting that investors— which included central banks— bought record amounts of the metal. At the time, currencies across the world fell as the lack of economic activity risked a stoppage on financial systems and therefore money flow.

It is for this reason that gold is considered a "safe haven" asset. This year, gold prices are climbing in the face of a weakening US dollar. The greenback has declined in value as the US Federal Reserve started a rate cutting cycle, which in turn, lowered returns for investment assets. Using a simple analogy, for investors seeking higher returns, they would rather invest in gold rather than in US dollar this time.

The big chunk of reserves is not actually liquid– that is, they are not in cash. They are investments abroad made by the BSP. The BSP has around $87 billion in foreign investments and because it's an investment, they generate returns. These returns, in turn, feed in to the GIR, thereby increasing or decreasing its value over time.

What exactly are these investments is kept under wraps because "there could be market sensitivity" to making it public, Diwa Guinigundo, former BSP deputy governor, explained. BSP, in particular, adheres to the guidelines by the International Monetary Fund (IMF) on how to properly report the GIR, which includes reporting the value lodged on foreign investments.

Guinigundo only went as far as saying that these investments are placements "in A class securities or bonds of sovereign or quasi-sovereigns" like international finance institutions. "A" class securities are bonds issued by countries with an A credit rating, classified as extremely safe for investors to pour money in with guarantee of payment and high returns. Examples of these include bonds issued by countries like the US and Australia.

The BSP, through a dedicated office and guided by the policies set out by its policymaking Monetary Board, make these investments, following the guidelines, Guinigundo said.

Now, let's go to the part that we like— money. Around $700 million of the GIR is composed of foreign currencies, and they are mostly the major ones like the dollar, euro, yen and the sterling. How much are exactly into what form of currency is unknown.

This cash is not just sitting idly in BSP coffers. It is sometimes used by the BSP to, in their own typical language, "smoothen foreign exchange volatility." That's just to say to manage the ups and downs, the appreciation and depreciation, of the peso.

There are many reasons why the BSP "enters the market," as it usually says. Strictly speaking, the peso is market-driven, meaning no specific player dictates how it goes up or down against another currency, say, the US dollar. But the BSP sometimes buy or sells currencies in the market in huge sums to try to manage the swings either way. Theoretically, a high demand for a currency makes it appreciate and vice versa.

When the BSP uses the dollar to buy the peso, it does so to support the peso's appreciation; when it does the opposite— meaning sell pesos to buy the dollar— it supports depreciation.

There are competing arguments for a strong (appreciating) or weak (depreciating) peso. On one hand, a strong currency makes our imports cheap, helping tame local prices of imported products once sold here. On the other, a strong peso cuts through the earnings of overseas Filipino families benefiting from salaries in foreign currencies of their loved ones so they might prefer a weaker currency. Finding the right balance to these factors is up to the BSP.

SDR stands for special drawing rights. These are assets in the IMF which corresponds to borrowing authority from a member country like the Philippines. Simply put, these assets, which is not a currency, can be exchanged for a specific amount if needed be.

Member countries also have IMF quotas. These are contributions to the Fund which are in their local currency, in our case the peso. Countries can also tap this if needed, and the IMF uses these on its lending programs. Since 2006, the Philippines has been a net external creditor of the IMF, which means we are now more of a lender to than a borrower from the IMF.

The Philippines has come a long way in beefing up its buffer stocks since the Asian financial crisis of 1997. But a $100 billion in reserves hardly mean anything if it doesn't catch up with a growing economy.

To this end, policymakers typically look at import cover to gauge the sufficiency of the GIR. This metric measures the GIR capacity to pay the country's imports over time.

As of August, the GIR is sufficient to fund 7.8 month's worth of imports. There is no strict standard to this, although after the global financial crisis of 2008, countries have informally attached a 6 month's worth of import cover as more than sufficient.

Sources:

Bangko Sentral ng Pilipinas, World Gold Council, International Monetary Fund

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