'Foreign Exchange Reserves' is explained in detail and with examples in the Trading edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Foreign exchange reserves are comprised of any currency which is foreign to the central bank holding it. If the American Federal Reserve held British pounds, this would be an example of such reserves. These exchange reserves can include bank deposits, foreign banknotes, bonds, treasury bills, and various other kinds of government securities. The phrase also includes IMF SDR special drawing rights’ units and gold reserves.
Such foreign exchange reserves can be utilized for a range of purposes. The main one is to provide the central government with necessary resilience and flexibility in any sort of currency crisis. If several currencies were to crash or become severely undervalued, these central bank vaults contain assets in other currencies which they can fall back on in order to outlast temporary market fluctuations and currency crises.
Practically every nation on earth, irrespective of their economy’s relative size and strength, chooses to inventory substantial foreign exchange reserves. Over half of all such foreign reserves in the globe exist in the form of U.S. dollars. This is because dollars represent the most heavily traded global currency in the world. Other commonly found forms of foreign exchange currency reserves include the Euro zone’s euro (EUR), the British pound sterling (GBP), the Japanese yen (JPY), the Swiss Franc (CHF), and ever increasingly the Chinese yuan (CNY). The euro is hands down the second largest form of such international exchange reserves. The yuan is the fastest growing component of foreign reserves today.
A number of economists and currency analysts concur that it makes the most sense to keep significant foreign exchange reserves in currencies which are not closely related to the ones of the nation in question. This helps to hedge the central bank from possible currency shocks and devaluations. It has become an increasingly Herculaneum task to do so since the majority of currencies are now closely correlated.
These days the People’s Republic of China contains the most impressive array of international exchange reserves. This is due to their over 3.5 trillion dollars in foreign assets denominated in foreign currencies. The majority of these are based in the dollar and treasury securities proffered overseas by the U.S. Treasury.
Foreign exchange reserves serve the most common purpose of backing up the domestic currency of any country. This is necessary as currency by itself is inherently of no value. It is only an IOU from the government which issued it in the first place. The only assurance a receiver of this currency has that the currency value itself will be maintained is the good faith, trust in, and credit of the government and nation. This gives such foreign reserves great importance as a form of concretely backing up such assurance. Liquidity and security are critically important in defining what makes a reliable currency reserve investment.
Foreign exchange reserves are also utilized as an instrument in the tool kit of monetary policy these days. This is especially important for any country that is determined to use a fixed exchange rate. This helps a central bank to exercise control over its own currency value on the open market when they have other currencies to push into the markets against their own. Nations have opted to build up larger storehouses of foreign reserves since the untimely demise of the Bretton Woods system in 1971 over 45 years ago.
For example, China maintains simply enormous foreign exchange reserves so that it can control the exchange rates of its own currency the yuan. This helps it to foster beneficial international trading arrangements for its country and economy. They also keep such large dollar reserves because of the requirements of international trade which still mostly settles in U.S. dollars exclusively. Nations such as Saudi Arabia choose to keep huge foreign reserves because their entire economy depends on the one production and resource of oil to which their economy is almost entirely addicted. When oil prices plunge, their economy benefits at least temporarily from the flexibility provided by their heavy buildup of foreign exchange holdings.