China's foreign exchange reserves topped one trillion dollars at the end of October, making it the largest holder of foreign reserves in the world, something many noted economists are calling excessive. But it is foolish to use only this figure to understand the reserves held by the Central Bank of China.

First, China's capital accounts are still immature and the currency has not been floated. One cannot treat these reserves as they would a developed country's.  

Furthermore, the government still maintains several layers of control over domestic firms' and private individuals' overseas investing. In effect, these restrictions attempt to make every dollar flowing into China as part of direct investment or the trade surplus come through one channel- the Central Bank. In this sense, the official foreign reserves represent the sum total of foreign financial assets held by the Chinese economy. 

Recently, China's foreign reserves stood at 15 percent of all financial assets. From a risk diversification standpoint this is far from sufficient. For example, in 2005, Taiwan's ＄643 billion in foreign reserves comprised 30 percent of it's total assets. Unlike Taiwan, China is a country whose economy is going through a phase of rapid growth, with uncertainty still high. Although developed countries experience lower rates of returns, they are more stable, and so as part of diversifying this risk at least 25 percent of China's financial assets should be foreign. And looking beyond the ＄650 billion of accumulated foreign direct investment, China has ＄350 billion in foreign loans. 

Ten years from today this foreign debt will accompany China as it continues its 10 percent growth rates and its initiation into the international financial system. As a result, China must continue to expand its foreign investments and safeguard itself against a financial crisis. 

That said, China does not necessarily need to increase foreign assets via reserves held by the central bank. The optimal choice is for domestic firms and individuals to do this. Opening up overseas investment has a twofold benefit; first, if the 3 trillion yuan worth of savings deposits is invested overseas it will further help diversify risk. 

This April, the People's Bank of China passed a set of measures loosening control over capital account management. According to the new rules, more than ten banks and financial institutions can, in accordance with QDII quotas, partially invest clients' deposits into foreign bond markets. For what we estimate to be ＄400 billion worth of potential demand for overseas investments by Chinese citizens, this quota is just the tip of the iceberg. And if we turn this potential demand into real capital flows, the central bank needs to further broaden the scope of investable foreign assets beyond fixed-income assets to include capital markets and derivatives. 

The Chinese government has another choice-- it can consider the Government of Singapore Investment Corporation's model and establish an independent investment body that, by floating yuan-based bonds, can raise funds to buy foreign currencies in an actively profit-driven operation.  

When the forex reserves exceed ＄1 trillion, the key lies in increasing the channels of investment for Chinese citizens and slowing the rate of growth of the reserves. It's not as simple as deciding how to best utilize the already accumulated reserves.