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China's foreign exchange reserves look set to hit the US$1 trillion mark at the end of this month or beginning of November. But as the figure rises, so does the debate over how to best manage it.

 

The reserves, already the world's biggest, surged to US$987.9 billion at the end of September, largely driven by a burgeoning foreign trade surplus and massive inflow of foreign direct investment (FDI).

 

In the first nine months of the year, FDI stood at US$42.59 billion, although this represented a 1.52 percent drop year-on-year.

 

Reserves grew an average US$18.8 billion a month from January to September, statistics from the central bank show.

 

"How to manage such a huge reserve is a big challenge," said Yi Xianrong, a research fellow at the Institute of Finance Research under the Chinese Academy of Social Sciences.

 

"The crux of the problem is that you have to keep the value stable or increasing," Yi said.

 

The country's ballooning foreign reserves, many economists say, is a major reason behind the increased money supply. This is because the central bank has to issue additional currency to mop up excess US dollars in the market, resulting in excessive liquidity in the banking system.

 

Further, the fluctuating foreign exchange rate also poses a huge risk, economists say.

 

In a bid to minimize such risks, the central bank should diversify its existing US dollar-dominated foreign reserves structure, and increase its holdings of euros or other major international currencies, said Li Yongsen, a finance professor at Renmin University of China.

 

The central bank, he said, could also buy more state bonds issued by other major economies and decrease holdings of US Treasury bills.

 

"It's better to spread the risks, and not put all your eggs in one basket," Li said.

 

Li also suggested that China could consider using the huge foreign reserves to purchase some strategic resource reserves such as oil.

 

But such a plan should be implemented with caution, both Li and Yi warned, citing the huge risks involved due to changing resource prices.

 

In the short term, increasing imports is an effective way to decelerate foreign reserves, economists said. This would also reduce trade frictions with some countries that have a high trade deficit with China.

 

Experts also said the country should further relax controls on capital outflow, in order to create a better balance of international payments.

 

In a bid to ease foreign reserves and broaden investment channels, China introduced the Qualified Domestic Institutional Investor (QDII) scheme, allowing qualified companies to invest overseas.

 

By October 10, the foreign exchanges regulator had granted quotas worth US$11.6 billion to QDIIs.

 

"This is the right approach for creating a two-way capital corridor," said Yi. "We used to put too much emphasis on attracting foreign investment and feared capital outflow."

 

China is also shifting from a long-held policy of stockpiling foreign reserves in state coffers, and instead encouraging households and businesses to hold more foreign currency.

 

Individuals, for example, are now allowed to buy up to US$20,000 in foreign exchange a year, up from US$8,000 previously.

 

The practice before was that some foreign exchange reserves were invested in banks.

 

Central Huijin Investment Company, an investment arm of the central bank, injected a total of US$45 billion in foreign exchange reserves into China Construction Bank and Bank of China in 2003.

 

It poured another US$15 billion into the Industrial and Commercial Bank of China in 2005.

 

(China Daily October 30, 2006)