Foreign exchange reserve can be defined as deposits of a foreign currency held by the central bank of a country. Here are some of the reasons why it is important for a country to have good amount of foreign exchange reserves –
1. It increases the confidence in the monetary and exchange rate policies of the government.
2. It enhances the capacity of the central bank of the country to intervene in the foreign exchange market and control any adverse movement and stabilize the foreign exchange rates to provide a more favorable economic environment for the progress of the country.
3. During time of any crisis foreign exchange reserves come to the rescue of any country so as to absorb the distress related to such crisis.
4. It also adds to the comfort of market participants that domestic currency is backed by external assets and hence it also helps the equity markets of the country, because due to strong reserves many people from foreign countries are willing to invest in the country having strong foreign exchange reserves.
However holding too much foreign exchange reserves is also not advisable because it involves the opportunity cost of money tied in reserves rather than investing somewhere else which could have earn higher return on the invested amount.