China's foreign exchange reserves have been growing rapidly. At the end of 1996, China's foreign exchange reserves for the first time exceeded US$100 billion. In the following five years, foreign exchange reserves grew stably. From 2001 to present, the country's strong economic growth has promoted an increase of reserves. In 2003, the annual increase of foreign exchange reserves exceeded $100 billion, amounting to $136.8 billion. In 2004, the annual growth of reserves reached $206.7 billion. The year 2006 will be the third consecutive year foreign exchange reserves have grown by more than $200 billion.

In accordance with the current trend, the total amount of foreign exchange reserves will exceed $1,500 billion in the second quarter of 2008 and $2,000 billion by the end of 2010. If the peak of reserve growth is foreseeable, then there would be not a great need to worry about the size and management of foreign exchange reserves.

However, the plain fact is that it is still hard to determine how just how great China's foreign exchange reserves may be in the next three to five years.

Soaring foreign exchange reserves have created a series of new challenges for the country. Undeniably, the high level of foreign exchange reserves implies a strong external payment capacity. But the challenges to the country's ability to guard against financial crisis are more noteworthy.

As a developing country, China needs to set up a new management system for foreign exchange reserves. This framework should encompass some important considerations

The new management system should dynamically define the modest scale of China's foreign exchange reserves, thus determining an appropriate level of surplus. There are at least three factors that have to be taken into consideration to determine this. The first is the benchmark scale of reserves. Currently there are several elements working in concert with the benchmark scale: foreign reserves spent on imports over 5-6 months; foreign reserves spent on payment of short-term external debt; foreign reserves spent on medium and long-term external debt; profits that have been made by foreign enterprises but have not been wired outside China; scale of direct investment by Chinese enterprises in overseas markets; and scale of investment in securities market. The second consideration is the scale of safety of China's foreign exchange reserves, and the third is the dynamic scale of slight growth in the balance of international payments. Taking into account the rapid growth of China's GDP and the scale of the external economy, the modest scale of reserves will also increase. A generally accepted dynamic growth rate would be between 2 and 3 percent of GDP, which means that in the next three to five years, the scale of reserves would increase by between $50 and 60 billion each year. The remaining amount of foreign exchange reserves could be included in surplus reserves. If this was done, the current dynamic benchmark scale of foreign exchange reserves would not generally exceed $800 billion. The rest would be regarded as surplus reserves.

The new framework should also make use of surplus reserves in diversified channels from a strategic perspective. The focus is currently on five different areas: investing surplus reserves to obtain the bulk of strategic resources important for sustaining national economic development, particularly energy resources and ferrous and nonferrous metals; investing surplus reserves in the technological transformation of state-owned enterprises; using surplus reserves to push forward the reform of state-owned financial institutions; using surplus reserves to bring a group of high quality Chinese scientists from overseas; and investing surplus reserves in filling the huge gap in social security funds.

The new management system should establish the framework for decision-making policies and day-to-day management institutions. Currently the central bank of China is responsible for the management of foreign exchange reserves in accordance with Central Bank Law. The State Administration of Foreign Exchange (SAFE) is authorized to conduct day-to-day management. Obviously, such a simplistic mechanism will be insufficient for the management of such a huge amount of reserves.

In-depth discussions are still to be conducted on this issue. It appears though that there are several things to be done. Considering the coordination of the benefits of multiple institutions involved in defining the modest scale of reserves and the level of surplus reserves, China needs to establish a financial coordination committee to formulate a policy on foreign exchange reserves management. China also needs to manage modest reserves and surplus reserves separately. Since the modest scale of reserves still functions, China could maintain its current management model and SAFE could maintain its authority. As surplus reserves are not directly involved in the financial market and surplus investment is made only as part of specific strategies, another government department needs to take the lead in operation. Based on international experience, money supply is divided into two categories: supply of high liquidity and average liquidity. The Central Bank and Ministry of Finance are responsible for the management of these two categories, and usually the Ministry of Finance is in charge of policy-making. Either for modest reserves or surplus reserves, China needs to try to introduce market-oriented private sectors so as to improve the performance of management.

It is by no means a normal phenomenon for a developing country like China to hold over one trillion US dollars of foreign exchange reserves. If China's leaders do not apply a broad strategy on this issue, they not only forfeit the benefits of ongoing reform, but actually sacrifice some of the gains made in the development of the export-oriented economy in the past three decades. Where to channel foreign exchange reserves is a very important issue requiring serious consideration.

By People's Daily Online; The author, Zhong Wei, is a professor at the Financial Research Center in Beijing Normal University

Editor: Yan