Forex reserves denote all the foreign currency deposits and foreign currency assets held by the central bank of any country. The form of reserves can be any of the followings
Foreign currency in cash form
Foreign currency assets, which denote all the assets held in different foreign currencies.
Special Drawing Rights, which are the supplementary foreign currency reserves maintained by the IMF for the member countries. Countries can claim the rights during crisis situation.
IMF reserve, which is the forex reserves held with IMF.
As forex reserves are mainly held in different foreign currencies, the total reserve value differs with the change in exchange rates. That’s why RBI re-evaluates the total value of its forex reserves every week based on the current exchange rates and current value of Gold.
As we all know, holding a huge forex reserves definitely cost a lot for a central bank. So there should be some important benefit for the central bank of any country to do so. Now we will check for the benefits of holding forex reserves. To do that we will also consider what the central banks (RBI forIndia) do and what they can do with such forex reserves.
Central Banks use forex reserves to stabilize the exchange rate during very high volatility.
Helps to keep currency exchange rate stable during financial crisis times, where foreign fund outflows increase significantly.
Acts as a self-insurer to the country which provides the supports in terms of foreign liquidity crisis.
Increases confidence to pay all the external obligations and debt, which in turn improves the credit rating of the sovereign debt.
Increases foreign investor confidence to get more FDI inflow.
Helps to pay the import bill during the crisis times. As per the Rangarajan Committee, 1993, the forex reserves should be sufficient to fund three months of import bills.
These are the main reasons countries, especially the developing countries hold for high forex reserves in spite of high holding cost. High forex reserves give them the main support to grow at much faster pace compared to other developed economies.