Financial security and optimal scale of foreign exchange reserve in China

Abstract

The study of how foreign exchange reserves maintain financial security is of vital significance. This paper provides simulations and estimations of the optimal scale of foreign exchange reserves under the background of possible shocks to China's economy due to the further opening of China's financial market and the sudden stop of capital inflows. Focused on the perspective of financial security, this article tentatively constructs an optimal scale analysis framework that is based on a utility maximization of the foreign exchange reserve, and selects relevant data to simulate the optimal scale of China's foreign exchange reserves. The results show that: (1) the main reason for the fast growth of the Chinese foreign exchange reserve scale is the structural trouble of its double international payment surplus, which creates long-term appreciation expectations for the exchange rate that make it difficult for international capital inflows and excess foreign exchange reserves to enter the real economic growth mechanism under the model of China's export-driven economy growth; (2) the average optimal scale of the foreign exchange reserve in case of the sudden stop of capital inflows was calculated through parameter estimation and numerical simulation to be 13.53% of China's gross domestic product (GDP) between 1994 and 2017; (3) with the function of the foreign exchange reserves changing from meeting basic transaction demands to meeting financial security demands, the effect of the foreign exchange reserve maintaining the state's financial security is becoming more and more obvious. Therefore, the structure of foreign exchange reserve assets should be optimized in China, and we will give full play to the special role of foreign exchange reserve in safeguarding a country's financial security.