What Happens When a Country Runs Out of Foreign Reserves?

Foreign reserves, also known as foreign exchange (forex) reserves, are assets held by a country’s central bank in various foreign currencies. These reserves are vital tools for maintaining economic stability, supporting the value of a country’s currency, and ensuring the country can meet its international obligations.

But what happens when these reserves are depleted?

The consequences are severe—ranging from currency collapse and import shortages to sovereign debt defaults and loss of investor confidence. In this article, we explore why foreign reserves matter, what happens when they run dry, and what countries can do to recover.

Why Are Foreign Reserves Important?

Foreign reserves are the backbone of a nation’s financial stability. Without them, a country becomes vulnerable to both internal and external economic shocks.

Stabilising the Exchange Rate

One of the primary uses of foreign reserves is to maintain the stability of a country’s currency. Central banks intervene in foreign exchange markets by buying or selling foreign currency to reduce volatility.

• If a currency is falling rapidly, the central bank can sell reserves to buy back its own currency and support its value.
• A country with insufficient reserves cannot protect its currency, resulting in rapid depreciation.

Paying for Imports

Foreign reserves allow countries to pay for essential imports, such as oil, food, medicine, and machinery.

• Without reserves, countries cannot fulfil import contracts.
• This leads to shortages of essential goods, often causing inflation and social unrest.

Example: If an oil-dependent country exhausts its reserves, it can no longer pay for fuel imports. This leads to supply disruptions, increased fuel prices, and inflation across the economy.

Servicing External Debt

Many countries borrow in foreign currencies, especially US dollars or euros. Foreign reserves are needed to repay these debts on time.

• Without reserves, countries risk defaulting on their obligations.
• A default can trigger credit rating downgrades, limit future borrowing, and raise interest rates on existing debt.

Consequence: Investor confidence collapses, and access to international capital markets dries up.

Preventing Economic Panic

Foreign reserves are a signal of a country’s economic strength. When reserves fall below critical levels:

• Investors lose trust and may pull out capital, worsening the situation.
• Citizens may convert their local currency into foreign currency, accelerating depreciation.
• Banks may face liquidity issues, triggering a banking crisis.

This creates a vicious cycle of falling reserves, currency collapse, and financial instability.

What Happens When a Country Runs Out of Foreign Reserves?

When a nation depletes its foreign exchange reserves, it loses one of its most crucial economic tools. The immediate and long-term consequences can be devastating—leading to a breakdown in currency stability, trade, debt repayment, and investor confidence.

Let’s examine the key consequences in more detail.

Sharp Currency Depreciation

Without adequate reserves, a country cannot defend its currency against market forces, and central banks cannot intervene in foreign exchange markets to stabilise the exchange rate.

• The domestic currency rapidly loses value against major currencies like the US dollar.
• A weaker currency makes imports more expensive, feeding into inflation and increasing the cost of living.
• Businesses that rely on imported goods face higher operational costs, leading to reduced output or closure.

Real-World Example
Sri Lanka (2022): As foreign reserves fell to critical levels, the Sri Lankan rupee depreciated by over 80% against the US dollar. The cost of importing fuel and essentials skyrocketed, fuelling an already dire economic situation.

Hyperinflation and Rising Cost of Living

Currency depreciation often leads to inflation, especially in import-dependent countries. Hyperinflation can occur when the central bank prints more money to fund government spending.

• Prices of essential goods rise uncontrollably.
• Wages fail to keep up with the cost of living, reducing purchasing power.
• Savings lose value, eroding household wealth and pushing more people into poverty.

Real-World Example
Venezuela (2016–2020): Plummeting reserves, poor fiscal management, and an overreliance on oil exports triggered one of the worst hyperinflation crises in history, with inflation exceeding 1,000,000%. Millions of citizens emigrated as food, healthcare, and jobs became scarce.

Import Shortages and Economic Slowdowns

Countries without foreign reserves cannot pay for imports, leading to severe shortages of essential goods such as:

• Fuel and electricity
• Medical supplies
• Raw materials for industry
• Staple foods

This results in:

• Industrial shutdowns and rising unemployment
• Lower consumer confidence and reduced economic activity
• A sharp contraction in GDP

Real-World Example
Lebanon (2019–2023): Depleting reserves left the country unable to afford critical imports. Fuel queues stretched for hours, medicines disappeared from shelves, and blackouts became routine. The crisis pushed over 80% of the population below the poverty line.

Defaulting on Foreign Debt

When reserves run dry, countries struggle to meet repayment schedules on foreign-denominated debt, particularly bonds and loans from international institutions.

• Sovereign default occurs when a country officially fails to meet its debt obligations.
• Credit ratings are downgraded, which increases the cost of future borrowing.
• International lenders become reluctant to extend new credit.

Real-World Example
Argentina (2020): Facing dwindling reserves and recession, Argentina defaulted on $65 billion of foreign debt—its ninth default. This further isolated the country from global capital markets and deepened the economic crisis.

Loss of Investor and Business Confidence

The depletion of reserves signals instability. As panic sets in:

• Foreign investors pull out capital, accelerating outflows.
• Stock markets experience sharp declines.
• Banking systems come under pressure, and depositors begin withdrawing funds.

This financial turmoil creates a feedback loop, worsening the economic situation and making recovery more difficult.

Real-World Example
Pakistan (2023): As reserves fell below critical levels, foreign investment dried up. The country faced rising bond yields, declining stock market indices, and mounting pressure on its banking system. Negotiations with the IMF became the only path to short-term relief.

Real-World Examples of Foreign Reserve Crises

Foreign reserve depletion is not a theoretical risk—it has happened in several countries with devastating economic and social consequences. Below are three major examples that illustrate how reserve crises unfold and the ripple effects they create.

Sri Lanka (2022): Economic Collapse and Social Unrest

The Reserve Drain

Between 2019 and 2022, Sri Lanka’s foreign reserves fell from $7.5 billion to just under $50 million. The collapse stemmed from a mix of unsustainable debt levels, over-reliance on tourism, tax cuts, and poor policy decisions, such as banning chemical fertilisers, which hurt agricultural exports.

Key Outcomes

• Debt Default: In May 2022, Sri Lanka defaulted on its external debt for the first time in its history, unable to make interest payments to international bondholders.
• Import Shortages: With no reserves to fund essential imports, the country experienced acute shortages of fuel, electricity, medicine, and food.
• Public Outrage: Rolling blackouts, inflation, and hunger triggered widespread protests that led to the resignation of President Gotabaya Rajapaksa and the fall of his government.
• International Assistance: The IMF approved a $2.9 billion bailout to help stabilise the economy and support fiscal reforms.

Lessons from Sri Lanka

Poor fiscal management and unsustainable borrowing can rapidly erode reserves. Without structural reforms, external aid may offer only temporary relief.

Venezuela (2016–2020): Hyperinflation and Economic Meltdown

The Fall from Oil Riches

Venezuela, once one of Latin America’s wealthiest nations due to oil exports, suffered a catastrophic economic decline after the 2014 oil price crash. Government mismanagement and heavy reliance on crude exports exposed the country to severe shocks.

Key Outcomes

• Reserve Depletion: Foreign reserves plummeted from over $30 billion in 2011 to less than $1 billion by 2020.
• Hyperinflation: The government resorted to printing money to cover spending. By 2018, inflation hit a staggering 1,000,000%, making the currency almost worthless.
• Import Collapse: With no reserves to fund trade, even basic goods like toilet paper, food, and medicine became inaccessible.
• Mass Migration: The economic crisis displaced more than 7 million people, many of whom sought refuge in neighbouring countries.

Lessons from Venezuela

A reserve crisis can escalate into systemic failure when compounded by policy missteps, corruption, and lack of diversification in the economy.

Lebanon (2019–2023): Banking Crisis and Currency Collapse

Years of Fiscal Mismanagement

Lebanon’s crisis stemmed from years of political dysfunction, unsustainable borrowing, and a Ponzi-like financial model. The central bank offered unsustainable interest rates to attract foreign deposits, but when inflows dried up, the reserves collapsed.

Key Outcomes

• Currency Crash: The Lebanese pound lost over 90% of its value on the parallel market, fuelling triple-digit inflation.
• Banking Paralysis: Banks limited withdrawals and dollar transfers, effectively freezing public access to personal savings.
• Import Shortages: With no dollars to pay for imports, medicine, fuel, and food became scarce. Power cuts lasted for hours daily.
• IMF Hesitation: Due to governance concerns and lack of political reform, international lenders were reluctant to approve bailouts, delaying recovery.

Lessons from Lebanon

When governance is weak, and reserves are used to artificially maintain economic illusions, a crisis is not only financial but also humanitarian.

How Countries Try to Recover from a Reserve Crisis

When a country’s foreign exchange reserves deplete, urgent corrective measures must be taken to stabilise its currency, restore investor confidence, and reboot economic activity. While the path to recovery can be difficult, several strategies—ranging from international support to structural reforms—are commonly employed.

A. Seeking IMF or International Bailouts

One of the first responses to a reserve crisis is turning to global institutions like the International Monetary Fund (IMF), World Bank, or regional financial bodies for financial aid.

Why it matters: These organisations provide emergency loans to replenish reserves and support basic imports, including fuel, medicine, and food. However, these funds are typically contingent upon the implementation of strict economic reforms such as spending cuts, tax hikes, or market liberalisation.

Real-world example:
In 2023, Sri Lanka secured a $2.9 billion IMF bailout to stabilise its collapsing economy after its reserves plummeted to critical levels. The bailout required the country to restructure debt, tighten fiscal policies, and increase transparency in public finance.

B. Imposing Capital Controls

Capital controls are measures that limit the flow of money into or out of a country. These restrictions are meant to prevent further outflows of foreign reserves during a crisis.

How it works: Governments may limit foreign exchange transactions, restrict ATM withdrawals in foreign currency, or prevent businesses and individuals from converting local currency into dollars or euros.

Real-world example:
Argentina has implemented capital controls multiple times to prevent the rapid depletion of its foreign reserves, especially during election cycles or economic downturns.

C. Cutting Imports and Promoting Local Production

Reducing reliance on imported goods is another way to curb the outflow of foreign currency.

Policy measures include:

• Import tariffs or quotas on non-essential goods.
• Subsidies and incentives for domestic industries.
• Campaigns promoting the consumption of locally made products.

Real-world example:
Turkey has pursued import substitution strategies by boosting domestic production of consumer goods and intermediate industrial inputs to ease pressure on its current account and reduce foreign currency outflows.

D. Currency Devaluation to Boost Exports

Governments aim to make exports cheaper and more attractive in the global market by devaluing the national currency.

How this helps: Increased exports bring in foreign currency, replenishing reserves and narrowing the trade deficit. However, devaluation can also raise the cost of imports and contribute to inflation if not managed carefully.

Real-world example:
China has adjusted the yuan’s value strategically to ensure its exports remain competitive, especially in times of external economic pressure or tariff-related slowdowns.

E. Raising Interest Rates

Higher interest rates are used to attract foreign capital by offering better returns on investments in local assets.

Impact: An increase in interest rates can lead to more foreign deposits and investments in government bonds, which in turn supports the domestic currency and stabilises reserves.

Real-world example:
In 2023, Pakistan raised its key interest rate to a record 22% to combat inflation and attract foreign exchange inflows. While this move helped strengthen the rupee in the short term, it also raised the cost of borrowing domestically, affecting growth.

How Countries Manage Currency Exchange Rate Risk Through Foreign Reserves

Foreign reserves are a vital tool for central banks to manage currency exchange rate volatility and protect economic stability. Here’s how they help:

1. Direct Market Intervention

Central banks buy or sell foreign currencies from their reserves to influence the value of their domestic currency.

• To strengthen the domestic currency, they sell foreign reserves and buy their own currency.
• To weaken the currency (to boost exports), they buy foreign currency and sell the local one.

This helps smooth out excessive volatility and maintain orderly forex markets.

2. Building Confidence and Deterrence

A strong reserve position reassures investors and currency traders that the central bank has enough resources to defend the currency. This discourages speculation and sudden capital outflows.

3. Maintaining Import and Debt Coverage

By holding sufficient reserves, countries ensure they can continue paying for essential imports and external debt even during economic shocks. This helps maintain currency stability and reduces the risk of sudden devaluation.

4. Currency Peg and Exchange Rate Regimes

Countries with fixed or managed exchange rate regimes use reserves to maintain their peg. For example, if a currency is pegged to the US dollar, the central bank must use reserves to keep the exchange rate within the target range.

Final Thoughts: The Dangers of Running Out of Reserves

Foreign reserves are essential for economic stability, currency stability, and investor confidence. When a country runs out of reserves, it faces a currency crisis, hyperinflation, trade disruptions, and social unrest.

To prevent such crises, governments must manage reserves wisely, reduce excessive borrowing, and promote exports. Countries with strong fiscal discipline, diversified economies, and prudent monetary policies are less likely to experience a foreign reserve crisis.

In today’s globalised world, a country’s economic stability depends heavily on maintaining healthy foreign reserves—making sound economic policies more crucial than ever.