The fast pace of China's accumulation of foreign exchange reserves caught worldwide attention as the country recently became the world's largest reserve holder with more than US$1 trillion.

To many, such a stunning amount in foreign exchange reserves is not in China's interest as it will lead to losses in national welfare, increased financial risks and high prices if it continues. Therefore, they argued, part of the reserves should be used to establish strategic resource reserves, assist technological upgrades of State-owned enterprises, push reform of financial institutions, fill the gap in the social security fund or even finance the low-cost housing programme.

Those suggestions, as Wu Xiaoling, vice-governor of the People's Bank of China, the central bank, said, ignore the fact that the foreign exchange reserves are bought by the State by providing basic money and are not fortunes that can be poured freely into policy programmes.

In other words, foreign exchange reserves, unlike tax revenue, cannot be taken as a means to transfer payments. They are recorded as liabilities on the balance sheet of the central bank and if they were used for domestic expenditure, the bank's balance sheet would not change and the liabilities would remain.

If we do not consider issues such as the country's ability to make international payments or prevent financial risk, the large amount of reserves in itself would not be seen as a serious menace.

China has a population of 1.3 billion, which means a Chinese on average shoulders only less than US$1,000. But this meagre amount is nothing to worry about.

Moreover, China is a large, transitional economy and the risks and fluctuations that may possibly emerge during the process of transition are certainly more severe than those mature market economies or economies of smaller scale. In this sense, China's foreign exchange reserves, although as large as US$1 trillion, should not become a cause for concern, but rather they can provide an anchor for the country's economic transition.

As a large economy, China may experience something that seems unusual to other countries. No other countries have piled up so much in foreign exchange reserves, but it does not mean that a stockpile of such magnitude will become unaffordable for China.

What needs to be clarified now is which part of the reserves is normal trade surplus and which part is "hot money" that has flowed into China to take advantage of the defects of China's foreign exchange regime to speculate on the revaluation of the renminbi.

If such loopholes are found, foreign exchange regulators should seriously review the current regime to deal with the loopholes and prevent foreign capital from entering the country to push the revaluation of the renminbi.

What really counts is how to effectively manage foreign exchange reserves. Its scale does not matter.

Few would deny that "using money to make money" is the best and fastest way to accumulate wealth. If managers of the reserves can find proper investment channels, it would be more possible that the reserves would appreciate.

Technically, the cost of the reserves can be measured by the interest rate of the renminbi, while the returns can be measured by the interest rate of foreign exchange currencies. The interest rate of US treasury bonds that China holds is 5 per cent, while the base interest rate of the renminbi is 2.52 per cent. Given the interest rate gap it is worth holding foreign exchange reserves, whose rate of return is higher than the general rate of domestic financial markets.

If China can diversify its holdings and investment instruments, the return rate may be higher than that of US treasury bonds.

There are a good number of investment institutions in the international markets. China needs to make good use of those investors and form an effective and diversified investment mechanism so that the reserves can appreciate.

Scholars have put forward a slew of proposals on the management of the reserves. What is sure is that regulators will choose the best methods based on their professional knowledge and information to increase the value of the reserves.

More importantly, as China holds a colossal amount of foreign exchange reserves, any changes in the structure and quantity of the reserves would cause fluctuations in the international financial market, which in return would have a direct or indirect impact on the management and value of China's reserves. As a result, regulators must be cautious.

The United States remains the world's superpower and the long-term strength and security of the US dollar is hardly disputable. In this situation, it is better for China to continue to hold the dollar as its primary reserve asset.

It has been argued that part of the large pool of reserves can be used to push domestic reforms and upgrade industrial structure. For example, the State has used foreign exchange reserves to inject billions of dollars worth of capital into State banks since the end of 2003.

Admittedly it is an innovative option and has achieved some results as those banks have had their corporate governance improved to varying degrees. But it should be seen as a special case and should not be applied to other banks. Otherwise it will incur the problem of "moral hazard."

A diversified mode of investment is the ultimate way out for the excessive accumulation of reserves.

It is most important, of course, to keep the renminbi stable to reduce expectations of renminbi revaluation and stall speculation. In this way, the reserves would gradually scale down.

Meanwhile, a smooth channel should be created to ease the legal flow of currencies across the border so that excessive domestic capital can be diverted into the international markets. This will lead to a natural shrinking of the reserves.

It is fair to say that the large stockpile of foreign exchange reserves is a sign of China's powerful economy. We should not worry about its sheer scale, but figure out how to effectively manage the reserves to increase their value.

Source: China Daily