Testing times for China's foreign exchange reserves

China's foreign exchange reserves, the largest in the world, reached a record $3.82 trillion last year.

Since China's reserves started accumulating more than a decade ago, the increase has been widely regarded as an encouraging and beneficial development. With China gradually becoming the "world's factory" and posting an increasing trade surplus in the past decade, Chinese reserves ballooned. During that period, the Chinese felt positive about growing reserves. But now they are feeling increasingly nervous about the situation.

With the rolling out of the three stages of quantitative easing, the Chinese realized with great disappointment that the real value of their reserves had depreciated considerably due to the United States' monetary policy, which is beyond the Chinese government's control.

The US government budget limit problem last October once again highlighted the possibility of a US default, which would not only affect its creditworthiness and the cost of US government financing but also the value of China's reserves and the confidence of the country, which is the largest investor in US government securities.

Not only would China lose due to the reduced value of its investment in US Treasury notes and related assets, but it also could be criticized for allowing the US government to maintain low interest rates and release unprecedented amounts of liquidity into the global economy.

As finance textbooks would preach in any investment context, to diversify is probably the most effective way to hedge against risks coming from a specific country or asset. Consequently, China should diversify its reserve assets.

China has been trying to diversify those assets during the past few years. According to US Treasury statistics, US dollar-denominated assets make up about 49 percent of Chinese reserves, down from 69 percent about three years ago.

China's foreign exchange reserve administrators have realized the risks associated with concentrated holdings in US dollar-denominated assets.

China has increased the proportion of Treasury bills in its US dollar-denominated assets, primarily due to its heightened risk of exposure in US government agency securities from the subprime mortgage crisis.

Yet, given their relatively high correlation with US T-bills in the grand scheme of things, such diversification within US assets may not offer China a big enough hedge against fluctuations in US economic growth, the budget dilemma or a possible default.

This situation is closely tied to the crux of the problem surrounding China's reserves: The country intends to diversify its reserves into other sovereign treasuries or assets, but it can find few alternatives.

The European sovereign debt crisis has shaken investors' confidence in such assets and "Abenomics" has cast doubts over the sustainability of Japan's government and fiscal situation.

Ignoring the economic situation of these regions for a moment, one would find the markets for such securities are small compared with those for US T-bills and agency securities.

Given the massive size of China's reserves, withdrawing from such a market would have profound effects and would inevitably damage the value of China's reserves.

One very important function of reserves is to serve as "ballast assets" that can be used to stabilize the value of a country's currency.

As a result, liquidity, immediacy and stability are crucial to reserve investments, and in this regard, US Treasury bills serve as a near-perfect choice.

However, many experts, including some Chinese central bank officials, believe that China's reserves are too large and a big chunk of them could be invested not for stability but for higher returns. If this is true, the real question becomes what the optimal size of China's reserves should be.

Although China has been trying hard to diversify into non-US-denominated assets over the past few years, the ballooning size of its reserves increases rather than decreases China's exposure to risk, and that seems to be the cause of Chinese anxiety over US fiscal problems.

If this is the problem, China should deepen its financial reforms, letting market forces determine its domestic interest rates and international exchange rate. Once China stops its passive "sterilization" of the inflows of dollars into its reserves, China's reserve investment challenges - along with many other challenges, such as domestic inflation and high housing prices - may be resolved once and for all.

The author Zhu Ning is deputy director of the Shanghai Advanced Institute of Finance, Shanghai Jiaotong University.