A study on foreign reserve management of China: Optimal currency shares in reserve assets

The foreign reserve accumulation in China has increased rapidly in recent years, which raises the question how the Central Bank of China manages the huge amount of foreign reserve effectively. It seems that optimizing the currency shares of reserve assets is one of the solutions to it. This paper introduces a dynamic mean-variance optimization framework with rebalancing costs, performs simulations for the optimal currency allocations of China's foreign reserve from 1999 to 2007, and adds constraints that reflect desires of the Central Bank of China to hold a sizable currency portion of its peg, its foreign debt and its international trade. The main study results include: 1) as for the reference currency, the optimal share of the US dollar is 47%-58%; 2) The optimal share of the Japanese Yen is 13%-18%; and 3) The optimal share of the Euro is 8%-10%. This research is supported by National Natural Science Foundation of China (Code: 70573025, 70741010).