| Decisions made at the Third Plenary Session of the 18th Central Committee of the Communist Party of China signal a new round of comprehensive reforms for the world's second largest economy, highlighted by further opening up. In the process, reform in the financial sector, particularly foreign exchange (forex) reserve management, is bound to unleash enormous growth potential.
China's forex reserves have reached $3.7 trillion, exerting a huge impact on the Chinese economy. Forex reserves have played a positive role in balancing international payments, improving China's external payment ability, stabilizing the exchange rate of domestic currency and offsetting the effects of the global financial crisis. However, too much in forex reserves could compromise the independence of monetary policies and result in low reserve investment yields. This has become one of the most important strategic issues concerning China's economic and financial safety. Therefore, China should change its traditional management mindset toward forex reserves and innovate.
According to estimations, the optimal forex reserves for China should be $800 billion to $1 trillion. With high liquidity, this should be used to pay off external debts, pay for imports in case of a trade deficit, to cope with unusual fluctuations in currency exchange rates and to respond to global and domestic financial turbulence. Forex reserves beyond the optimal amount should be used to support the real economy or for professional investment purposes.
First, China can set up platforms to use forex reserves to finance domestic companies' overseas expansions. By setting up a forex investment fund, China can push forward overseas direct investment, merging and acquisitions from Chinese companies. Such funds can also support the purchase and import of high value-added equipment and technologies and facilitate the establishment of domestic companies' overseas research and development bases. More technological innovation could help China's production move up the industrial value chain.
Second, China should establish a multi-layer overseas investment fund system to manage forex reserves by dividing investment destinations. Geographically, investment regions include the European market, the American, Asian and African markets. They can also be divided into the BRICS, APEC and OPEC markets. Meanwhile, a national investment organ should be established for targeting special markets. This will not only strengthen professional study of targeted markets and help manage investment risks, but will also achieve the highest returns on investment.
Third, China can offer financing to sectors that it wants to support via asset securitization. Securities can be issued using part of the country's forex reserves as collateral to finance strategic projects, such as affordable housing and infrastructure construction projects.
Finally, China should establish more sovereign wealth funds. Sovereign wealth funds, having gained popularity in recent years, have played an increasingly important role in the global economy. Sovereign wealth funds reached $5.2 trillion by the end of 2012, up 8 percent from 2011. They are expected to exceed $5.6 trillion this year and surpass the official total amount of global forex reserves in 2014. Compared to the flourishing of sovereign wealth funds in other countries, China only has one such funds company—China's Investment Corp. China should consider setting up new sovereign wealth funds to solve domestic problems pertaining to its aging society and energy deficit.
This is an edited excerpt of an article by Zhang Monan, an associate researcher with the State Information Center, previously published in China Securities Journal | 
