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. Unfortunately, this is a lot more difficult than it sounds. China has already attempted to diversify, notably by buying US corporate and agency debt instead of just Treasury bonds. However, those purchases helped push up prices and drive down yields. As a result, China now holds riskier assets for relatively little extra return. Over the last few years, China has also shifted a small proportion of its reserves into other currencies, mostly euros. Once again, however, there has been a market impact. Beijing's buying has helped push the euro up and the dollar down, forcing China to intervene even more heavily to maintain the yuan's stability against the dollar, thereby accumulating even more dollar reserves. Other suggestions involve stockpiling strategic commodities. China has already begun filling a petroleum reserve. However, accumulating a 1.2 billion barrel, six-month store would take years and would still only use 7 per cent of the existing reserves at current prices. Diversifying into gold is even less feasible. A more radical idea is for China to set up a state investment fund to buy up higher-yielding foreign assets, including Chinese equities listed in Hong Kong. That would be a self-defeating exercise after all the trouble Beijing went to float them in the first place. Buying overseas equities would meet heavy political resistance, as last year's attempted acquisition of US oil company Unocal by CNOOC demonstrated. In any case, investing in equities would risk a growing mismatch between the central bank's assets - its foreign reserves - and its liabilities, the cash and debt it has issued on the domestic market. Calls to invest the money at home on infrastructure or poverty alleviation are even less viable. That would mean converting a portion of the reserves into yuan, which would simply raise the currency's value. Preventing that from happening is why China built up the reserves in the first place. Moreover, China has a problem with overinvestment as it is. Like it or not, most of that US$1 trillion is just going to have to stay where it is, at least for now.
