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    By the end of the first quarter of 2011, Chinese foreign exchange reserve reached USD 3 trillion. As the scale of Chinese foreign exchange reserve has already surpassed the optimal level, the costs and risks of holding such a huge reserve pool are becoming more and more prominent. The inflation in United States and the debasement of US dollar tend to be the major risks.

    According to our estimation, almost two thirds of Chinese foreign exchange reserve is investing in US dollar denominating assets, and Chinese central bank now holds over USD 1.3-1.5 trillion U.S. government bonds. China is the largest overseas creditor to U.S. government.

    After the burst of U.S. subprime mortgage crisis, the Fed adopted a very loose monetary policy. First, from August 2007 to December 2008, the federal fund rate had been cut down from 5.25% to 0-0.25%. Second, when there is no further space to decrease interest rate, the Fed took two rounds of quantitative easing (QE) policies, which meant the Fed kept injecting money into the market through the purchase of government bonds, MBSs and ABSs.

    The QE had effectively improved the liquidity shortage in US’s financial market, therefore it helped US government to stabilize financial market and stimulate real economy. However, the QE buried new risks. As the result of two QE, the total liability of the Fed expanded nearly 3 times to reach USD 2 trillion. That means, if the Fed could not execute a perfect exiting strategy in the future to withdraw the liquidity from the market, there will be unavoidable high inflation and significant depreciation of US dollar. Both the inflation and the US dollar deprecation will definitely hurt the interest of U.S. government’s creditors. The real value of U.S. government bonds will shrink significantly and Chinese government will suffer a huge capital loss.

    Besides the monetary policy, U.S. government also took a very loose fiscal policy since 2008. As the result, the federal fiscal deficit to GDP ratio in United States will be nearly 10% in 2011, and the government debt to GDP ratio will be over 90%. The healthy of U.S. fiscal position is not better even if you compare it with Greece, Ireland or Portugal. No wonder the Standard & Poor’s tuned down the prospect of U.S. sovereign debts to negative in April, the first time in the past 60 years.

    As for U.S. government, there is a strong incentive for it to decrease the real burden of its liabilities. There are several ways to achieve that objective. One way is creating an inflation to eat up the real value of government bonds, which will hurt both domestic and overseas creditors. Another way is pushing down the exchange rate of US dollar intentionally, which will made overseas creditors suffer from it. Although President Obama and Fed Governor Bernanke emphasized once and again that U.S. government will push for a strong US dollar, the incentive to reduce the real debt burden through US dollar depreciation is too strong to resist.

    Therefore, as a major form of Chinese national wealth, China’s foreign exchange reserve is in real danger now. For example, If US dollar depreciated again RMB for 20%, Chinese central bank will suffer a USD 390 billion capital loss, almost 8% of China’s GDP in 2010.

    What should Chinese government do to mitigate the above negative impacts? First, Chinese government should further diversify its investment portfolios of foreign exchange reserve. In currency composition, the weights of US dollar denominating assets should decline, and more reserve should be invested in euro or JPY denominating assets. In asset composition, Chinese government should purchase more gold, energy, commodities, equities and corporate bonds, decreasing the over reliance on government bonds.

    Second, Chinese government should take a comprehensive set of structural adjustment measures to change the twin surplus in its balance of payment, which could restrict or even stop the further accumulation of foreign exchange reserve. The most important measures include liberalizing the interest rate and commodity prices, decreasing or even stopping the official intervention on the foreign exchange market, abolishing the distorting preferential policies to stimulate export or attract foreign direct investment, etc.

    (The author is the deputy director of Department of International Finance, Institute of World Economics and Politics, Chinese Academy of Social Science)