Academic journal article International Management Review

A Study on Foreign Reserve Management of China: Optimal Currency Shares in Reserve Assets

Academic journal article International Management Review

A Study on Foreign Reserve Management of China: Optimal Currency Shares in Reserve Assets

Article excerpt

[Abstract]

The foreign reserve accumulation in China has increased rapidly in recent years, which raises the question how the Central Bank of China manages the huge amount of foreign reserve effectively. It seems that optimizing the currency shares of reserve assets is one of the solutions to it. This paper introduces a dynamic mean-variance optimization framework with rebalancing costs, performs simulations for the optimal currency allocations of China's foreign reserve from 1999 to 2007, and adds constraints that reflect desires of the Central Bank of China to hold a sizable currency portion of its peg, its foreign debt and its international trade. The main study results include: 1) as for the reference currency, the optimal share of the US dollar is 47%-58%; 2) The optimal share of the Japanese Yen is 13%-18%; and 3) The optimal share of the Euro is 8%-10%.

This research is supported by National Natural Science Foundation of China (Code: 70573025, 70741010).

[Keywords] Foreign reserve; international currencies; optimal currency share

Introduction

The foreign reserve accumulation of China has increased rapidly in recent years, which has augmented to 1.3326 trillion dollars in June 2007. On the one hand, the huge foreign reserves reduce the effect of the monetary policy (I). On the other hand, there are 70% dollar-denominated assets in China's foreign reserve, but the rising current account deficits of USA and the potential risk of U.S. dollar depreciation will decrease its value of reserve assets and result in a negative impact on the safety and return of China's huge amount of foreign reserves. For these reasons, how to manage the huge foreign reserves effectively should be taken into consideration by the Central Bank of China.

To insure the safety, keep the liquidity, and maintain the profitability of China's foreign reserves, the Central Bank of China mainly concentrates on two issues. 1) The size: Sufficient foreign exchange reserves help stabilize foreign exchange rates, ensure payment for import and debt, and reduce vulnerability to financial crises. 2) Reserve currency composition. The Central Bank of China should decide the currencies composition and their shares in order to maximize the return of foreign reserves when diversifying away from the U.S. dollar.

The traditional theories said that the modest size of foreign reserves should maintain the payment needs of three-month imports. However, it makes no sense now due to the financial globalization and the international capital movements. Thereby, the study by Heller (1966) suggested that the Central Bank should maximize the reserve assets' return when choosing the reasonable size of foreign reserves, and Agarwal (1971) introduced the reserve assets' marginal return and marginal cost into this file. Since 1980, more and more advanced econometrics models have been widely used to determine the reasonable size of foreign reserves, such as Partial Adjustment Model (Frenkel, 1978, 1981; Malixi, 1990) and Error Correction Model (Huang, 1994; Huang & She, 1999).

However, China has accumulated huge foreign exchange reserves way above the optimal level and it cannot decrease in a short time, so the Central Bank has to pay more attention to improve the reserve currency structure, which means the currencies composition and their shares. Several factors explain the determination of foreign reserves currencies composition. Eichengreen (2005) suggested that the primary considerations for the composition of reserves have been market liquidity (which in turn depends on Central Banks' willingness to ensure it, currency convertibility, financial stability, and the underlying development of financial markets) and a dominant position in international trade. Yet, besides these economic reasons, geopolitical factors are also important. The studies by Dooley, Lizondo and Mathieson (1989), Eichengreen and Mathieson (2000), Naameh (2003) and Pringle and Carver (2003, 2005) said that the currency pegs, the direction of trade, and the currency of foreign debt were the significant factors when determining the composition of reserves. …

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