According to the release by the People's Bank of China on July 15, China's total foreign exchange reserve reached 2.132 trillion USD.  The number has attracted the world's attention.

In February 2006, China's foreign exchange reserve surpassed Japan and became the world's number one.  In October of the same year, China's total reserve reached 1 trillion USD for the first time.  Thereafter, China's total reserve had grown steadily until last October, when China's reserve experienced the first negative growth in many years, caused by the international financial crisis.  For the following several months, the growth rate flirted around the zero line.  Since March, however, the growth rate has stayed solidly in the positive territory (see charts below), especially in the second quarter, total reserve shoot up by 177.865 billion USD.

The reserve increase is caused by three factors.  One is the trade factor.  Even though total trade growth has stayed in the very negative territory, see chart below, output still remained higher than import.  Second, because of the devaluation of the USD, other currency reserves appreciated in value.  The reserve diversification policy implemented by the Chinese government last year got some payoff.  Finally, due to China's stimulus policies, China's economy showed signs of turning around in the first quarter and therefore attracted foreign capital inflow.  It is estimated that the net increase from trade surplus and foreign direct investment was 50 billion USD in the second quarter, much lower than the 177.865 billion total increase, indicating the strong influence of foreign capital inflow.

By the end of March, China's total reserve had already accounted for 29.9% of the world's total.  With additional 177.9 billion USD added in the second quarter, how to handle and manage the huge reserve has become a very big issue.

To stabilize the exchange rate of yuan, the central bank had to purchase excess foreign currencies from the open market, which means de facto additional money supply.  It is estimated that purchasing foreign currencies caused 97, 164, and 287 billions of domestic currency to be injected into the market in March, April, and May respectively, which may inflate the values of stock and property markets, even cause asset bubble.

Another issue is the risk of the USD devaluation.  Even though China has been trying to diversify its reserve, it is still heavily concentrated in USD.  Devaluation of the USD can cause China's total reserve value to evaporate.

The distribution of foreign currency has also become a concern.  Even though the government owns over 2 trillion USD of reserve, total foreign currency deposit by business and Chinese citizens is merely about 150 billion USD.  As a comparison, Japan's reserve was 1.1 trillion USD last year end, but its citizens owned more than 3.64 trillion USD of foreign currencies.  This indicates China still has a long way to go to reform and improve its currency management policies and market structure.

Realizing the issue, the Chinese government has taken actions recently.  A series of new policies have been released to encourage companies to invest abroad.  There are also some positive signs that the government's initiative might have shown some impact.  In the first quarter, China's trade surplus and foreign direct investment totaled 84.3 billion USD, but the reserve only increased 7.7 billion USD, indicating some outflow of foreign currency.