What is Forex Reserves?

By : Neha Dhyani

Updated : Jun 14, 2022, 13:15

Forex Reserves, short for Foreign Exchange Reserves, are the assets that the central bank or monetary authority owns in the form of foreign currencies, deposits, gold reserves, etc. They play a crucial role in influencing a country's domestic and international monetary policy. To understand this concept further, let us look at how Forex Reserves perform their functions.

Functioning of Foreign Exchange Reserves

Forex Reserves serve many different roles for the country that holds them. The primary and most significant function they do is that they are held to ensure that the central government agency has backup funds of value if their national currency becomes insolvent or devalues exceptionally quickly. Therefore, Forex Reserves are used to back the central bank's liabilities (i.e., their national cash, bank deposits, government deposits, etc.)

Importance of Forex Reserves

Since it is such a crucial resource, it is common to see countries all over hold a large store of reserves in their foreign exchange. As the US $ (Dollar) is the most popularly traded currency globally, it is the most common form of the reserve for most countries. The British Pound, Chinese Yuan, and Japanese Yen are also ubiquitously used as Forex Reserves.

Gold is another commonly used asset by countries like Russia, India, etc., for Forex Reserves. Still, it can be somewhat risky to hold as it is an asset with an underlying value.

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Objectives of Forex Reserves

Countries use Forex Reserves to stabilize and fix the value of their currency. For example, China pegs the value of the yuan to the dollar. I.e., they maintain a large stock of US dollars as Forex Reserves, thus increasing its value. This manipulates the value of the Chinese yuan and makes their goods cheaper than American goods, thus increasing sales.

Similarly, countries with the floating exchange rate system utilize Forex Reserves to keep their currency's value low, so more of their exports can be sold, and their economy and foreign trade are boosted.

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The Purpose of Foreign Exchange Reserves

Foreign Exchange Reserves have several functions. Let us briefly look at some of these purposes -

  • Countries use Forex Reserves always to pay off their external obligations. Import financing, international debts, etc., are some examples of these obligations.
  • One of the most critical functions of Forex Reserves is that they allow countries to maintain liquid reserves in economic crises. When the country's citizens cannot pay for imports with foreign currency, these reserves give them the cash they need.
  • The Central Bank also uses Forex Reserves to prevent inflation by supplying this foreign currency to keep the market steady.
  • Forex Reserves provide confidence to foreign investors, giving them confidence in their investments and preventing the sudden loss of capital for countries.

To conclude, in the globalized economy we live in today, countries need to take careful steps to protect their economy and keep their local currency solid and valuable. In this regard, Forex Reserves are an excellent means for them to achieve this goal, as it allows countries to protect their currencies from economic crises, control their value to a specific rate and maintain a balance of liquid cash to use as and when required.

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FAQs on Forex Reserves

Q 1. What is the most held form of Forex Reserves?

Ans. The most held form of Forex Reserves is US Dollars.

Q 2. Which country has the largest store of Forex Reserves?

Ans. China has the largest store of Forex Reserves, with over 3 trillion dollars.

Q 3. What is the most significant component of Forex Reserves?

Ans. Foreign Currency assets are the most significant component of Forex Reserves.

Q 4. With regards to the Forex Reserves, what are the sources of Foreign Exchange?

Ans. The most common sources of Foreign Exchange are Foreign Direct Investments(FDI) and the export of goods in foreign currency.