Foreign exchange reserves are liquid assets in foreign currency units maintained by the central bank or government for future use. It includes reserves in hard currencies (such as dollars, euros, and Yen), government securities (domestic and foreign), special drawing rights , etc.
They are useful for fulfilling financial obligations in international transactions. Central banks may also use them for monetary operations, such as intervening in foreign exchange markets.
The influence of foreign exchange reserves on the economy
Foreign exchange reserves affect the credibility of central bank interventions in exchange rate markets, especially under controlled fixed or floating exchange rates. Its insufficiency will result in the exchange rate moving uncontrollably when speculative attacks occur.
The exchange rate ultimately influences other macroeconomic variables such as exports, imports, international investment, foreign debt, interest rates, economic growth and inflation. A sharp appreciation of the exchange rate, for example, makes export products less competitive because they are more expensive. This could disrupt domestic production, especially if producers rely on export sales. On the other hand, imported raw materials and capital goods are cheaper, thereby reducing imported inflationary pressures ( imported inflation ).
Long story short, drastic changes in exchange rates disrupt macroeconomic stability. That prompted the central bank to intervene using foreign exchange reserves.
The accumulation of foreign exchange reserves also affects a country’s credibility in fulfilling international obligations such as foreign debt. When a global crisis occurs, sovereign risk increases. Countries with large debts must be forced to allow their currencies to depreciate. Or, they withdraw their foreign currency reserves to refinance their debt.