Wikipedia explains foreign exchange reserves.
(emphasis mine) [my comment]
Foreign exchange reserves
Foreign exchange reserves (also called Forex reserves) in a strict sense are only the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, SDRs and IMF reserve positions. This broader figure is more readily available, but it is more accurately termed official international reserves or international reserves. These are assets of the central bank held in different reserve currencies, such as the dollar, euro and yen, and used to back its liabilities, e.g. the local currency issued, and the various bank reserves deposited with the central bank, by the government or financial institutions.
Official international reserves, the means of official international payments, formerly consisted only of gold, and occasionally silver. But under the Bretton Woods system, the US dollar functioned as a reserve currency, so it too became part of a nation's official international reserve assets. From 1944-1968, the US dollar was convertible into gold through the Federal Reserve System, but after 1968 only central banks could convert dollars into gold from official gold reserves, and after 1973 no individual or institution could convert US dollars into gold from official gold reserves. Since 1973, all major currencies have not been convertible into gold from official gold reserves. Individuals and institutions must now buy gold in private markets, just like other commodities. Even though US dollars and other currencies are no longer convertible into gold from official gold reserves, they still can [and do] function as official international reserves.
Purpose [key point]
In a flexible exchange rate system, official international reserve assets allow a central bank to purchase the domestic currency, which is considered a liability for the central bank. This action can stabilize the value of the domestic currency. [foreign reserves main purpose is to defend the value of the domestic currency]
Central banks throughout the world have sometimes cooperated in buying and selling official international reserves to attempt to influence exchange rates.
Changes in reserves
The quantity of foreign exchange reserves can change as a central bank implements monetary policy. A central bank that implements a fixed exchange rate policy may face a situation where supply and demand would tend to push the value of the currency lower or higher (an increase in demand for the currency would tend to push its value higher, and a decrease lower). In a fixed exchange rate regime, these operations occur automatically, with the central bank clearing any excess demand or supply by purchasing or selling the foreign currency. Mixed exchange rate regimes ('dirty floats', target bands or similar variations) may require the use of foreign exchange operations (sterilized or unsterilized) to maintain the targeted exchange rate within the prescribed limits.
Foreign exchange operations that are unsterilized will cause an expansion or contraction in the amount of domestic currency in circulation, and hence directly affect monetary policy and inflation: An exchange rate target cannot be independent of an inflation target. Countries that do not target a specific exchange rate are said to have a floating exchange rate, and allow the market to set the exchange rate; for countries with floating exchange rates, other instruments of monetary policy are generally preferred and they may limit the type and amount of foreign exchange interventions. Even those central banks that strictly limit foreign exchange interventions, however, often recognize that currency markets can be volatile and may intervene to counter disruptive short-term movements.
To maintain the same exchange rate if there is increased demand, the central bank can issue more of the domestic currency and purchase the foreign currency [this is what China is doing], which will increase the sum of foreign reserves [this explains China's massive foreign reserves]. In this case, the currency's value is being held down; since (if there is no sterilization) the domestic money supply is increasing (money is being 'printed'), this may provoke domestic inflation (the value of the domestic currency falls relative to the value of goods and services).
Since the amount of foreign reserves available to defend a weak currency (a currency in low demand) is limited, a foreign exchange crisis or devaluation could be the end result. For a currency in very high and rising demand [ie: Chinese yuan], foreign exchange reserves can theoretically be continuously accumulated, although eventually the increased domestic money supply will result in inflation and reduce the demand for the domestic currency (as its value relative to goods and services falls) [in other words, currency pegs. In practice, some central banks, through open market operations aimed at preventing their currency from appreciating, can at the same time build substantial reserves.
In practice, few central banks or currency regimes operate on such a simplistic level, and numerous other factors (domestic demand, production and productivity, imports and exports, relative prices of goods and services, etc) will affect the eventual outcome. As certain impacts (such as inflation) can take many months or even years to become evident, changes in foreign reserves and currency values in the short term may be quite large as different markets react to imperfect data.
Costs, benefits, and criticisms
Large reserves of foreign currency allow a government to manipulate exchange rates - usually to stabilize the foreign exchange rates to provide a more favorable economic environment. In theory the manipulation of foreign currency exchange rates can provide the stability that a gold standard provides, but in practice this has not been the case.
There are costs in maintaining large currency reserves. Fluctuations in exchange markets result in gains and losses in the purchasing power of reserves [every nation with dollar reserves is soon going to experience such a loss]. Even in the absence of a currency crisis, fluctuations can result in huge losses. For example, China holds huge U.S. dollar-denominated assets, but the U.S. dollar has been weakening on the exchange markets, resulting in a relative loss of wealth. In addition to fluctuations in exchange rates, the purchasing power of fiat money decreases constantly due to devaluation through inflation. Therefore, a central bank must continually increase the amount of its reserves to maintain the same power to manipulate exchange rates. Reserves of foreign currency provide a small return in interest. However, this may be less than the reduction in purchasing power of that currency over the same period of time due to inflation, effectively resulting in a negative return known as the "quasi-fiscal cost". In addition, large currency reserves could have been invested in higher yielding assets.
Foreign exchange reserves are important indicators of ability to repay foreign debt and for currency defense, and are used to determine credit ratings of nations, however, other government funds that are counted as liquid assets that can be applied to liabilities in times of crisis include stabilization funds, otherwise known as sovereign wealth funds. If those were included, Norway and Persian Gulf States would rank higher on these lists, and UAE's $1.3 trillion Abu Dhabi Investment Authority would be second after China. Singapore also has significant government funds including Temasek Holdings and GIC. India is also planning to create its own investment firm from its foreign exchange reserves.
Reserves of foreign exchange and gold in 2006
At the end of 2007, 63.90% of the identified official foreign exchange reserves in the world were held in United States dollars [losing its reserve status is going to be painful for the dollar] and 26.5% in euros.
Monetary Authorities with the largest foreign reserves in 2008.
These few holders account for more than 60% of total world foreign currency reserves. The adequacy of the foreign exchange reserves is more often expressed not as an absolute level, but as a percentage of short-term foreign debt, money supply, or average monthly imports.
My reaction: I thought it was time to do an entry on foreign reserves. Basically, the key point is that central banks can sell reserves to boost the value of their domestic currencies. Large forex reserves means a nation has a lot of ammunition to defend/appreciate its currency.
Some other observations about foreign reserves:
1) When a central bank selloff its reserves in exchange for its domestic currency, it accomplishes two things:
A) It decreases the price of whatever its selling. For example, if the fed sells gold, it reduces the price of gold. If the fed sells euro, it decreases the cost of buying euro (with dollars).
B) It shrinks the money supply by taking the proceeds from the sale out of circulation. If the fed sells gold, the dollars it receives in exchange for the gold are removed from the US money supply.
2) Theoretically, anything that the central bank can sell in exchange for its currency can be considered a foreign reserve. For example, the oil in the US Strategic Petroleum Reserve, like gold, could be sold to shrink the US money supply.
3) As of March 2008, US official gold reserves were worth $261.5 billion (on paper, much of the US' s gold has been leased out), foreign exchange reserves $63 billion, and the Strategic Petroleum Reserve $67 billion (at a Market Price of $104/barrel with a $15/barrel discount for sour crude).
4) A central bank can transfer their reserves around to different assets without affecting the value of its domestic currency. For example, China recently started selling its agency holdings (debt backed by Freddie/Fannie) in exchange for treasuries. So a central banks can transfer its reserves around different foreign assets (euro, gold, treasuries, wheat, etc) without impacting exchange rates with its local currency.
5) When central banks do transfer their reserves around, this has a big impact on whatever they are buying and selling. When china started selling agencies for treasuries, agencies crashed, and treasuries rallied. If China decides the transfer any of its reserves into gold or euros, the dollar would crash against whatever it starts buying.
6) If a central bank decides to appreciate its local currency, it doesn' t need to sell its reserve directly. Meaning China, if it decided to selloff its reserves, doesn' t need to sell dollars in exchange for yuan. China can instead buy food and gold with its dollar holdings and then sell that food/gold domestically.
7) A more valuable currency allows a nation to monopolize more global resources (ie: the overvalued dollar allows the US to consume 25% of the world's oil despite having only 4% of the world's population). If China were to selloff its US reserves, its enormous population would start sucking up the world' s food supply like the US has been doing with oil.
Understanding more about foreign reserves is important because I see a scenario developing where spiking food prices (due to global shortages and money printing) cause competitive currency appreciation. In other words, central banks around the world sell off their reserves (which are mostly dollars) to boost their currencies and slow their domestic food inflation.
This competitive currency appreciation could be kicked off by China selling its reserves in response to rising food prices (see: Hyperinflation will begin in China and destroy the dollar and Northern China hit by worst drought in 50 years). When china begins appreciating the yuan, food shortages and prices everywhere else will jump upwards. As there is nothing that breeds social unrest like soaring food prices, nations around the world, from Russia, to the EU, to Saudi Arabia, to India, will sell off their foreign reserves. In response to this, China will sell even more of its reserves and so on. The big loser in this war will be the US.
The US faces the prospect of having central banks worldwide competing to appreciate their currencies by selling off their US holdings. This will be very bad for the dollar.