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Definition: Foreign exchange reserves
Foreign currency denominated assets and gold held by the central bank or monetary authority of a country is called foreign exchange reserve. Foreign exchange reserves are maintained to meet foreign payment obligations – both short and long term such as import requirements, sovereign debt etc. It also boosts confidence to investors in the ability of a country to meet its requirements and is also used to determine credit rating of a country.
Most of the countries possess assets in US dollar, Euro and Yen in their foreign exchange reserves. Foreign exchange reserves include foreign currency deposits, gold reserves, special drawing rights (SDR) and monetary reserves at the International Monetary Fund.
The main advantages of having high foreign exchange reserves are as follows: it helps finance imports; also they serve as precautionary holdings in case of economic crisis. The country however runs a risk of foreign currency depreciation when there are very high foreign reserves. The funds may also enjoy a higher rate of return had they been invested within the country/put for other uses. There is also a inflationary risk associated with foreign reserves.