Foreign exchange reserves are exactly that – stockpiles of foreign currencies held by governments. For many countries, especially in the emerging markets, the official foreign exchange reserves are both a major national asset and a crucial tool of monetary and exchange-rate policy, particularly in countries vulnerable to financial crises.
In many emerging markets, for example, a devaluation of a country’s currency raises the cost of imports (and hence causes inflation) and of paying back debt denominated in foreign currency. With a large stockpile of reserves, a country’s central bank can buy up its own currency in the foreign capital markets, helping to maintain its value. Large reserves are therefore considered to be an indication that a country’s economy is capable of relative stability.
There is some debate about how much a country should hold in its reserves. Critics say that holding a lot of reserves is costly – the money could be put to better use making real investments in the economy, such as building roads. Others point out that this cost is nothing compared to the cost of a currency crisis should reserves get depleted.