Plans for spending China's reserves are just pie in the sky

At some point in the next few days, China is expected to unveil just how much money it held in foreign exchange reserves at the end of last month. Barring some clever conjuring act, such as a new bank bailout, the amount looks certain to exceed US$1 trillion, the largest sum ever held by any country.

Most of the money - probably about three-quarters - is parked in US-dollar-denominated assets, chiefly US Treasury bonds, which at present yield an annual return of 4.7 per cent.

This concentration of China's official reserves in US dollar assets, coupled with the relatively low returns they earn, has prompted a growing chorus of calls for Beijing to manage its foreign exchange assets more actively for the good of the country.

Over recent months, a series of apparently serious officials and academic economists have proposed an array of solutions ranging from diversification into different currencies or asset classes to spending the money at home on rural development. Most of their suggestions reveal a frightening ignorance both of what foreign reserves are and of how financial markets work.

They are right that China has a surfeit of reserves. Conventional wisdom holds that a developing country should have enough foreign exchange on hand to cover three months worth of imports and any short-term currency borrowings.

At the moment, China is importing about US$65 billion worth of goods and services each month and has US$166 billion of short-term foreign debt. That implies reserves of US$360 billion would be sufficient. Even the most conservative analysts agree that China holds US$600 billion more foreign currency than it really needs.

There is no shortage of ideas on how to put the money to work. The most obvious is that China should diversify its holdings into other currencies and assets, both to spread risk and earn higher returns.