Governments hold enormous quantities of foreign currency earning modest returns, when the same funds could be spent domestically. The holdings are insurance against obligations that cannot be met with the national currency.
Some bills can only be paid in someone else's money
Imported oil, aircraft, medicines and machinery are usually priced in a small number of widely accepted currencies, chiefly the dollar.
A country that runs out of those currencies cannot buy essential imports regardless of how much of its own money it holds.
Reserves are commonly measured against months of import cover for exactly this reason, since the relevant question is how long the country could keep buying if inflows stopped.
External debt has the same requirement
Governments and companies frequently borrow in foreign currency because it lowers the interest rate demanded by lenders.
Repayment must then be made in that currency, and revenue collected domestically has to be converted first.
If the exchange rate moves against the borrower, the domestic cost of the same repayment rises, which is how currency weakness turns into a debt problem.
Reserves are the tool for defending an exchange rate
A central bank that wants to support its currency does so by selling foreign currency and buying its own, which raises demand for the domestic unit.
This works only while reserves last, and markets watch the level closely because a falling stock signals how long a defence can continue.
Countries with floating currencies intervene less often, and most still hold reserves to smooth disorderly movement rather than to fix a rate.
Holding reserves is expensive
Reserves are typically invested in highly liquid, low-yielding assets such as short-term government securities of the issuing country.
A country whose own borrowing costs are higher than the yield it earns on reserves is paying a real price for the insurance.
That cost is why the appropriate level is contested, since reserves that sit idle could instead fund domestic investment.
Composition reflects who a country trades with
Reserve portfolios are weighted toward the currencies a country actually needs, which usually means its trade invoicing and its debt.
The dollar dominates because commodities, shipping and much international lending are priced in it, and that dominance is self-reinforcing.
Gold occupies a separate role as an asset that is nobody else's liability, which is why central banks retain it despite it paying no interest at all.