The Study On Scale Of China’s Foreign Exchange Reserves Based On Maximum Utility

As of the end of June2012, the scale of China’s foreign exchange reserves has reached up to3.24trillion US dollars. The substantial and sustained, rapid growth of foreign exchange reserves is a "double-edged sword". It can not only increase China’s international liquidity and the ability to resist international financial risks, but also mitigate domestic financial shocks, strengthen macro-control ability, enhance the international status of the currency. Meanwhile, the rising stock of foreign exchange reserves would increase pressure on domestic inflation, weaken the independence and effectiveness of monetary policy, face high opportunity cost and risk of value shrink, and become an important issue to achieve internal and external equilibrium. Therefore, this issue attracts both academia and government’s extensive attention. What’s the motivation of hoarding reserves? Which scale is moderate size? How to maintain and incerese the value of extra reserves? After the global financial crisis, the answers to these questions become more urgent.The paper analyzes the motivation and optimal scale of China’s foreign exchange reserve through the combination of theoretical and empirical approaches, introduces the experience of international reserves management and forwards corresponding proposal for the authority. The basic framework is divided into six chapters. Chapter one introduces the background, methods, trends and possible innovations of the paper. Chapter two presents the current reserve scale of global and China through data and charts, and then summarizes the evolution and latest development of the optimal international reserve theory. Chapter three introduces the debates of mercantilist and precautionary motive for hoarding reserves and respective performance in China, and proved that the precautionary prudential motivation is the key factor by the establishment of a foreign exchange reserve accumulation motives model and annual data from1990to2011China. Chapter four introduces China’s foreign exchange reserve to GDP ratio, constructs representative consumer intertemporal utility fuction as the objective fuction via the maximization approach, and makes numerical simulation with dynamic panel data to find the optimal scale and analyze its results. Chapter five discussed the experiences and inspirations on the management of foreign exchange reserves. Chapter six is conlcutions and policy recommendations.As the foundation of the above study, based on the precautionary motivation, the paper adopts dynamic optimization approach to find the optimal scale of China’s foreign exchange reserves and makes sensitivity analysis about the variable’s influences on foreign exchange reserve to GDP ratio. It concluded that the precautionary motive is the critical factor for accumulation of reserves; the actual ratio of foreign exchange reserves to GDP is too high in China, the appropriate ratio should be maintained between16%and26%, this ratio could provide theoretical and policy support for the monetary authorities; China’s foreign exchange reserves is highly sensitive to the risk aversion coefficient, the likelihood of crisis, the opportunity cost and the scale of crisis.