Dynamic Optimization Of FX Reserves Under The Safety-first Criterion

FX reserves are the most important part of a country’s international reserves which can indicate its economic and financial strength. Thus management of foreign exchange reserves has always been a central issue of Economic studies. Since the reform of FX system in 1994, China’s FX reserves has experienced years of rapid growth because of surplus in both current and capital account. The total amount of China’s FX reserves has reached 3.82 trillion dollar by December 2013, higher than any other nations. On one hand, China’s huge amount of foreign exchange reserves is insurance against international financial crisis. On the other hand, because of the opportunity cost of holding reserves, there is a huge waste of resources, and also enormous pressure put on reserve management authorities. The primary guiding principle of FX reserve management is safety, and due to the much-higher-than-international-standards scale of China’s FX reserves, its asset allocation structure and profitability problems draw increasing attention.With the transformation of China’s economic structure and accelerating international capital flows, FX reserves face greater downside risk, which raise more requirements for dynamic management. Therefore, how to pursue greater gains in the premise of ensuring safety should be the basic goal of dynamic management of FX reserves and the size and structure of FX reserves become the most important two issues in its management decision making. The structure of FX reserves contains allocation between different currency and investment tools.Based on this goal, this paper introduces Roy’s safety-first criterion to describe the emphasis of a country’s FX reserves on safety, the specific utility function followed return movements if safety was assured.The optimal allocation of FX reserves derived from the model varies according to the scale ofFX reserves and necessary FX reserves, the disaster level, disaster tolerance and the size of exogenous shocks. It can help us analyze the optimal allocation strategy under different scenarios. According to the model, this paper attempts to provide policy recommendations for the management and investment of FX reserves.