A State Administration of Foreign Exchange spokesman was quoted as saying that this year the currency and asset structure of China's foreign exchange reserve will be optimized and the scope of investment using foreign exchange reserves will be expanded.

The market has generally interpreted talk of such a move as a signal China will adjust its massive foreign exchange assets and sell its US dollar holdings.

On Tuesday last week a central bank spokesman told overseas reporters he had not heard of such a plan, and pointed out that since China's foreign exchange reserve has exceeded US$800 billion, the central bank does not want to put the reserve in a single-currency basket. However, he said it was not likely China will sell off its US dollar holdings to diversify the country's foreign exchange reserves.

The incident has once again posed the question: What is the appropriate level for foreign exchange reserves?

It is generally accepted that four principles should be abided by when making a judgement. First, the reserve should satisfy the demand for imports for a certain period of time. Experiences elsewhere show the duration of this period should be three to four months, or the reserve should account for about 20 per cent of the country's gross domestic product (GDP).

Second, the reserve should satisfy the need for debt repayment, at least for short-term debts. Third, the reserve should ensure the smooth flow of short-term capital. Lastly, the reserve should help keep monetary policy stable to promote macroeconomic development.

China's foreign exchange reserve has gone way over the line in terms of these principles. By the end of 2004 the country's foreign exchange reserve satisfied its imports for 13 months and accounted for 38 per cent of its GDP. It was also 5.85 times China's short-term debts.

The rapid expansion of the foreign exchange reserve means a loss of investment opportunities and heralds great risks.

Given the US dollar's depreciation and inflation in the United States, China's foreign exchange reserve will depreciate. Since 2001, the US dollar has depreciated by 12 per cent against the euro. As a result, from November 2002 to August 2004, if 60 per cent of Chinese holdings were in US dollars, China would have suffered a loss of US$53 billion.

Finding ways to improve the returns on foreign exchange investment is another difficult task for managers of the reserve. Once the reserve has satisfied the needs of imports, fluidity of capital and security, managers should pay more attention to investment returns.

The majority of China's foreign exchange reserve is invested in foreign government bonds, semi-governmental bonds and bank deposits, which are not particularly risky.

But the rate of returns on China's foreign exchange investments is very low. The bonds in which China has invested its reserves mostly have a fixed nominal return rate of 4 to 5 per cent. If inflation and depreciation of the US dollar is taken into consideration, the real rate of return may be just 0.7 to 1.7 per cent. At the same time the rate of return on domestic investments may exceed 10 per cent.

Therefore foreign exchange reserve management bodies must urgently improve the investment returns of the reserve.

China also needs to stem the rapid expansion of the reserve. Although unfavourable factors make it difficult to regulate the scale of the reserve, such as the strong propensity of the public to save money and weak domestic demand, policy-makers should nevertheless be able to influence its size.

First of all they should, at least temporarily, stop taking the growth of the reserve as a criterion for career assessment among relevant departments  a major driving force behind the rapid growth of the reserve.

China can levy export taxes on products that require large amounts of resources and cause heavy pollution when they are manufactured. It can also encourage the import of resources, energy, key technologies and large-scale equipment, which are crucial for economic development.

The channels for the outflow of foreign exchange should be made easier to navigate. Possible policy choices include flexible short-term interest rate adjustments and open-market operation to facilitate the flow of short-term capital and change the scale of the foreign exchange reserve.

Channels should be expanded for residents to transfer their legally accumulated wealth overseas. Regulation on purchasing foreign currencies by those that are going abroad to study, work or travel should be loosened.

The exchange settlement and sales system should be reformed and people should be allowed to legally hold foreign currencies as they choose. The renminbi exchange rate formation mechanism should be improved so the rate can ultimately be decided by the market.

The structure of the reserve needs to be optimized to allocate resources more efficiently.

A limit should be set within which the reserve should be used to purchase foreign bonds and deposited in foreign banks to satisfy the needs of debt repayment and imports. Beyond that limit, the reserve should be put through multiple investment channels to maximize returns.

The investment channels for the foreign exchange reserve should be chosen carefully. Currently, part of the reserve can be used to purchase strategic resources and imports of energy. Some of the money can be used to establish a fund to stabilize raw material prices and hedge against price fluctuations on the international market. The fund could be invested in holdings of major raw material producers so domestic enterprises have access to stable imports of raw materials.

The reserve can also be invested in domestic enterprises, especially financial institutions that have bright prospects. China has injected US$60 billion of its foreign exchange reserve into two of its major State commercial banks. More key institutions should enjoy such support to maximize returns.

The reserve should also be used to improve public welfare. It could be poured into the cultural sector, education, medical care, poverty reduction, the construction of infrastructure and the tackling of emergencies, such as the prevention of epidemics and natural disasters.

Finally, the reserve can play a role in China's foreign aid programmes to promote a harmonious world.

The author is a researcher at Beijing-based China Association of International Trade.