Introduction to Foreign Exchange Reserves
Assets which are held on reserve in foreign currencies by a central bank is known as Foreign Exchange Reserves. These reserves are used to support liabilities and to back the monetary policy. It includes any foreign money a central bank holds, such as the U.S. Federal Bank Reserve.
How Do They Function?
Foreign exchange reserves can comprise deposits, banknotes, treasury bills, shares, and other government-related securities. Such reserves serve many purposes but are most importantly kept to ensure that if their national currency quickly devalues or becomes insolvent all together, a central government entity has backup funds.
In countries around the world, holding a considerable amount of reserves in their foreign exchange is a common practice for their central bank. Most of those reserves are kept in the U.S. dollar because it is the world's most-traded currency.
Economists believe that it is a better move to hold foreign reserves in a currency that is not directly linked to the country's own currency to provide a barrier in the event of a market shock. Nevertheless, as currencies have become more intertwined as global trading has become easier, this practice has become more difficult.
Important Note
The largest current foreign exchange reserve holder in the world is China, a country that holds more than $3 trillion of its foreign currency assets. Most of China's reserves are held in the United States dollar. One reason for this is that it makes it easier to execute international trade, as most of the trading takes place via the U.S. dollar.
Saudi Arabia also has considerable foreign reserves, since the country relies primarily on the export of its vast oil reserves. If oil prices start to drop rapidly, their economy could suffer. They keep large amounts of foreign funds in reserves to act as a cushion should this happen, even though it is just a temporary fix.
