Definition: Foreign exchange reserves are the foreign currencies held by a country's central bank and its member banks. They are also referred to as foreign currency reserves or foreign reserves.
The country's exporters deposit foreign currencies into their local banks who then transfer them to the central bank. Exporters are paid by their trading partners in U.S. dollars, euros, or other currencies.
First, countries use their foreign exchange reserves to keep the value of their currencies at a fixed rate. A good example is China, which pegs the value of its currency, the yuan, to the dollar. When China stockpiles dollars, that raises its value when compared to the yuan.
That makes Chinese exports cheaper than American-made goods, increasing sales.Like China, this keeps Japan's exports relatively cheaper, boosting trade and economic growth. For more, see How Foreign Exchange Markets Work.
A third, and critical, function are to maintain liquidity in case of an economic crisis. For example, a flood or volcano might temporarily suspend local exporters' ability to produce goods. That cuts off their supply of foreign currency to pay for imports. In that case, the central bank can exchange its foreign currency for their local currency, allowing them to pay for and receive the imports.
Similarly, foreign investors will get spooked if a country has a war, military coup, or other blow to confidence. They withdraw their deposits from the country's banks, creating a severe shortage in foreign currency. This pushes down the value of the local currency since fewer people want it. That makes imports more expensive, creating inflation.
The central bank can supply foreign currency, to keep markets steady, and buy up the local currency, to support its value and prevent inflation. This reassures foreign investors, who return to the economy. A fourth reason is to provide confidence and assure foreign investors that the central bank is ready to take action to protect their investments, and prevent a sudden flight to safety and loss of capital for the country. In that way, a strong position in foreign currency reserves can prevent economic crises caused when an event triggers a flight to safety.
Fifth, reserves are always needed to make sure a country will meet its external obligations. These include international payment obligations, including sovereign and commercial debts, financing of imports, and to absorb any unexpected capital movements.
Sixth, some countries use their reserves to fund sectors, such as infrastructure. China, for instance, has used part of its forex reserves for recapitalizing some of its state-owned banks.
Seventh, most central banks want to boost returns without compromising safety. That's why they'll often hold gold and other safe, interest-bearing investments, to diversify their portfolios
How much are enough reserves? At a minimum, countries have enough to pay for three to six months of imports. Buy Forex Online: With Axis Forex online send money in 100+ currencies to any bank account in the world. Buy forex card and go cashless across the globe
Source : https://www.thebalance.com/foreign-exchange-reserves-3306258