Analysis Of Chinas Foreign Exchange Reserve Finance Essay - Free Essay Example

China has accumulated substantial stock of foreign exchange reserves from different sources, for instance, foreign direct investment, export-oriented trade and maintenance of currency exchange rate. This has triggered a need to consider management of those reserves that is adequacy and optimality in order to determine the excessiveness and hence exposure to risk. Risk management frameworks would then be structured under informed bases. Error correction model following dynamic ordinary least squares will be employed in the assessment of adequacy and optimality while Value at Risk will measure risk exposure. Central banks accumulate foreign exchange reserves to facilitate international trade and as a means of financing exchange rate interventions in the foreign exchange market. Reserves can therefore be perceived as a buffer portfolio held for precautionary purposes (Borio, Ebbesen, Galati, Heath, 2008). The threshold of accumulating foreign exchange reserves is not clearly defined though (Park Estrada, 2009). Nonetheless, Disyaitat (2001) attempted to bridge this gap by formulating an optimizing model of currency crisis. Foreign exchange reserves consist of official public sector foreign assets that are readily available to and controlled by monetary authorities. Reserve asset portfolios have special characteristic that distinguish them from other foreign currency assets. Foreign exchange reserve assets do not only consist of liquid foreign currency assets, but they need to be held in the form of convertible foreign currency claims as well (Archana et al 2004). Henceforth, management of foreign exchange reserves portfolio is a crucial task given that foreign exchange reserves have potential to exert pressure unto the economy both internally and externally. The most common reserve currency globally is US dollar. Second to US dollar is euro. Euro as a reserve currency is gradually becoming an alternative reserve currency globally. There are speculations that Euro may be at par with or may even overtake US dollar as the main currency worldwide (Aristovnik Cec, (2009): Eichengreen Mathieson, (2000)). This is drawn from diversification of the currency composition of foreign exchange reserves point of view. In aggregate, due to diversification and other factors reserve assets denominated in US dollars have been slowly declining while at the same time reserve asset denominated in other curr encies are increasing  [CITATION Guj95 l 1033]  . Conversely, US dollar still claims the biggest share as a reserve currency (Pà ©tursson, 1995). 1.1.2 Chinas Economy brief review Post economic reform of 1978, China has been rapidly growing economically under export-led growth. Her openness to outside world with respect to trade has proven to be a great economic success which paved a way to rapid economic growth over almost three decades. In the process of international trade China managed to build a huge current and capital account surplus and hence accumulated enormous foreign exchange reserves. Chinese government implemented different strategies in order to attain rapid economic growth like encouraging inflow of foreign direct investment (FDI). In times of trade and current account deficit FDIs support is available to keep foreign exchange reserve rising. And hence the economy kept on growing lucratively. In 2006, China overtook Japan to the worlds largest holder of foreign exchange reserves. Chinas foreign exchange reserves are roughly three times as high as the reserves held by Japan, the country with the second largest holdings. Currently about 70% of Chinas foreign exchange reserves is held in US Dollars denominated assets, primarily US state bonds. At the end of the fourth quarter of 2009 the reported foreign exchange reserves stood at US$2, 3992 trillion. This is growth of foreign exchange reserves portrays strength of Chinas economy in aggregate. However, challenges both internally and externally that are brought by this success cannot be overlooked. Internally China is exposed to inflationary pressures while externally the pressure is on appreciation of her currency. During Chinas economic reform, foreign exchange reserves were handy in terms of facilitating foreign trade and investment. However, the recent rapid growth has tended to worsen the imbalance in Chinas balance of payments and created risks to Chinas financial system. Thus vigilant measures towards management of this foreign exchange reserves has to be taken. The critical policy decision of central bank should be how to allocate those reserves, noting that t his action have important implications for global markets. There should be clear definition of optimal foreign exchange reserve: maximizing yield and simultaneously minimizing risk. In short, foreign reserves should be sufficient to meet the future anticipated claims on these reserves. 1.1.3 Chinas Foreign exchange reserves review Beginning from 1950 to 1992, Chinas foreign exchange reserves have been steadily growing with few fluctuations. This may be explained by economic reforms which took place during that time. A call for rapid economic growth in 1992 was followed by reform initiatives which opened a door for inflow of foreign direct investment. As result of FDI inflows to China, the foreign exchange reserves have been growing rapidly. A starting point for this rapid growth in Chinas foreign exchange reserves can be traced from January 1993 until present. In January 1993 the size Chinas foreign exchange reserves was about US$ 20.138 bn, this amount gradually increased, by June 2010 the size was about US$2454.275 bn. This is a considerable accumulation and probably it will keep on growing larger and larger under the current exchange rate regime. The remaining question is how these reserves can be managed accordingly given that they have potential to impact financial system both in China and abroad. To manage the foreign exchange reserves, Chinese government under Peoples Bank of China has established State Administration Foreign Exchange (SAFE) institution. SAFE is the agency in charge of administering Chinas foreign exchange reserves. This institution has so far remained as one of the most secretive reserve managers in the world. Its investment strategy has been mainly in investing US government bonds. But recent trends show SAFE trying to reduce investment in the US treasury bonds and higher allocation to equities (Hu, 2010). In addition to SAFE, China Investment Corporation (CIC) was established solely for the purpose of reducing the size of foreign exchange reserves and increasing investment returns. Amongst its mandates CIC will pursue a variety of investments, primarily in overseas securities, including equities. SAFE and CIC operate within parameters of Peoples Bank of China (PBC). Chinas state sector as a whole including the central bank, public banks, and China Investme nt Corporation holds roughly US$3 trillion in foreign currency assets  [CITATION Guj95 l 1033]  . Meanwhile, US dollar is losing value over the long-term as measured by either exchange rates, Treasury notes or the amount of US dollars held by foreign countries (Kimberly, 2010). The rising current account deficit and external debt of the United States has created pressure on the dollar. As a result, confidence in the value of US dollar is reducing  [CITATION Guj95 l 1033]  and some countries are even shifting towards holding their reserves in Euro and other currencies. There is a concern that portfolio shifts from dollar denominated assets to those denominated in the euro and other main currencies by central banks, could result in sharp dollar depreciation (Elias et al (2006), Truman Wang, (2006)). This depreciation of US dollar translates into risk to the value of Chinas huge foreign reserves. Thus, any decline in the value of US dollar assets will amount to a decline in the value of Chinas foreign exchange reserves. Nevertheless, Chinas currency renminbi is pegged to US dollar (and basket of other foreign currencies). Consequently, China is compelled to increase her foreign exchange reserves holdings in US dollars to maintain the value of renminbi ( (Tatom, 2008): (Dooley, Folkerts-Landau, Garber, 2004)). In order to limit renminbi movement against the dollar, the PBC purchases and sells foreign exchange reserves on a daily basis. China continues to purchase large amounts of foreign exchange, adding to its reserves while resisting renminbi appreciation against US Dollar. If the domestic currency appreciates against all foreign currencies, the value of the governments foreign investments will decline. This may be one reason why the government resists currency appreciation. Generally, accumulating foreign exchange reserves is aimed at overcoming a balance of payments crisis. However, as Yongnian Jingtao, (2007) noted the huge foreign exchange r eserves can cause imbalances in the countrys economy. Sekine, (2009) noted that due to the capital inflows to China brought by its trade surplus and inward foreign direct investment and the fact that only the Peoples Bank of China is allowed to hold foreign exchange and intervenes in the foreign exchange market to sell renminbi for foreign currency to ensure that the renminbi does not appreciate, Chinas foreign exchange reserves are set to increase unless there is a sudden capital outflow. In other words, Chinas accumulation of foreign exchange reserve has been somehow closely related to the exchange rate regime as well. Intuitively, if the exchange rate regime changes the implication the foreign exchange reserves will reduce. The foreign exchange reserves of a country like China with a managed floating exchange rate regime are mainly used to pay off import bills and foreign debts, to maintain the bands within which the currency floats, and to invest in foreign assets. 1.2 Problem Statement Given the rapid accumulation of China foreign exchange reserves over past 20 years and the trend of continuing growth in the foreseeable future, the question of how to manage those reserves has become a very crucial issue for Chinese authorities. The concern is that, as much as foreign exchange reserves supports countrys financial system in times of economic shocks, they can as well invite pressure unto the countrys financial system. Sekine, (2007) pointed out that huge foreign exchange reserves of China have created excess liquidity in the country, which in turn creates the risk of inflation and investment overheating. Yongnian Jingtao, (2007) asked whether Chinese foreign exchange reserves are excessive. With consideration that accumulation of foreign exchange reserves earns credibility and maintains stability of the currency. On the other hand, excessive accumulation of foreign exchange reserves creates pressure for the currency to appreciate, and the appreciation would result in financial losses and instability of the currency. Even so, China manages its foreign exchange reserves in a stable manner and this is not going to change swiftly  [CITATION Guj95 l 1033]  . The foreign exchange reserves of China have created mix feelings concerning their magnitude. Some people feel that those reserves are excessive some feel otherwise. For instance, Li (2006) argues that Chinas foreign exchange reserves are not excessive because China needs sufficient reserves to maintain the stability of the renminbi and to maintain the confidence of international investors. He also argues that Chinas foreign exchange reserves have been rewarded by sufficient returns. Frankel (2005) emphasized the opportunity cost of huge foreign exchange reserves and argued that China was presumably paying foreign investors on their inward investment a higher return than it was earning from its investment in foreign exchange reserves. Xia (2006) estimated that approximately 22 percent of foreign exchange reserves accumulated in 2005 was induced by expectations of the Chinese currencys appreciation, mostly in terms of short-term capital inflows. He maintained that US$700bn in foreign exchange reserves should be sufficient. But the actual accumulation of reserves in 2005 was about US$819bn  [CITATION Guj95 l 1033]  . Liu (2007) maintains that Chinas holding of foreign exchange reserves exceeds the estimated adequate level. Moreover, much of Chinas foreign reserves are said to be invested in dollar-denominated assets, primarily US Treasury bonds. This investment of the worlds largest foreign reserves in mostly US dollar denominated assets also creates exposure to the risk of asset price declines resulting from dollar depreciation. Another risk to be considered is that if dollar-denominated assets were replaced with assets denominated in other currencies (e.g. Euro), the act of switching itself, depending on the scale and frequency, would also trigger a decline in the value of the US dollar. This would translate into news for China, since any decline in the value of US dollar assets will amount to a decline in the value of Chinas foreign exchange reserves. 1.3 Purpose of the Study Too much of anything in most cases turns out to be bad news. Countries accumulate foreign exchange reserves and maintain an optimal level where they are sufficient to meet countrys urgent needs in times of financial crisis. This is done to ensure stable financial environment. Likewise China as a large developing country needs to maintain a certain scale of foreign exchange reserves, in order to be in a better position to effectively fend off future crises. What happens when a country has accumulated foreign reserves beyond its needs (optimal level) is a different story. Liu (2007) and Yongnian Jingtao (2007) confirmed that China has accumulated reserve not only to its optimal level but also exceeds demand for liquidity and other economic needs. This act has a propensity to cause imbalance in the economy, though inflation and currency appreciation pressure. Much of the writings which touch foreign exchange reserve topic dwell much on the general discussions of determinants of th e demand for foreign exchange reserves or empirically analyzes countries holding compositions ( (Dooley, Lizondo, Mathieson, 1989), (Pà ©tursson, 1995), (Eichengreen Mathieson, 2000), (Aristovnik Tanja, 2010)). Little attention have been paid on the analysis of risk associate with Chinas foreign exchange reserves been held in US dollar denominated assets. Give the huge US current account deficit, the expectation is that eventually US dollar will depreciate in the long run. This suggests diversification of reserves away from US dollar denominated assets. Sudden move would likely harm both US dollar and those reserves. More besides, there is no super-sovereign reserve currency that can be used not only to eliminate the inherent risks of credit- based sovereign currency, but also to make it possible to manage global liquidity  [CITATION Guj95 l 1033]  . This paper considers Chinas Foreign exchange reserves as portfolio which is under control of Peoples Bank of China (The Cen tral Bank of China). Management of these reserves is a critical issue, which is why it is imperative to understand the risk involved in holdings. With reference to the size of Chinas foreign exchange reserves, the largest in the world, a policy decision lies with allocation. In particular, efficient allocation and management of the foreign reserves will promote the liquidity needed to fulfill policy mandates while at the same time minimizing the costs of holding reserves. Central bank foreign reserves risk management can contribute to these objectives by managing and controlling the exposure to financial and operational risks. Given that not only is a large amount of money at stake, but also significant elements of national economic policy. Generally foreign exchange reserves are accumulated to perform four major tasks; to pay for imports bill, maintain the value of currency, to pay for international debt and to be invested in foreign assets. Based on the ground that China has ex cessive foreign exchange reserves (Liu, 2007; Park Estrada, 2009), the purpose of this paper is to measure the risk exposure of those reserves using Value at Risk (VaR) technique. Being aware of extent to which foreign exchange reserves holdings are exposed to market risk play important task in the risk management. VaR is straightforward to estimate and interpret as a measure of risk exposure, and these advantages often appeal to asset managers (Culp, et al, 1998; Nocetti, 2006). VaR measures the worst expected loss under normal market conditions over a specific time interval at a given confidence level. In other words, VaR is the lowest quantile of the potential losses that can occur within a given portfolio during a specified time period. The basic time period T and the confidence level (the quantile) q are the two major parameters that should be chosen in a way appropriate to the overall goal of risk measurement (Benninga Wiener, 1998). The two main focal points of this pape r are management and risk management of chinas foreign exchange reserves. Foreign exchange reserves can to certain extend be considered as major national asset since they account for significant percentage of GDP. From national asset preserving background, management of foreign exchange reserves is a vital task of central bank. This task trade off three objectives namely safety (capital preservation), liquidity and return. Reserves accumulation motives which are precautionary and transaction-related regard safety and liquidity. In the same manner, the investment of excess balances naturally places greater weight on return. The problem centers on allocation. Poor management of the reserves may put at risk other elements of national policy (e.g exchange rate) and this can cause severe economic damage out of all proportion to the financial loss suffered on the assets themselves. Reason for holding reserves plays a very important part in planning how those reserves should be managed and how they should be invested. Since the end objective a central bank in of its operations is usually the pursuit of a chosen policy for example, maintaining the exchange rate at a certain level, rather than merely financial gain. In this case, it may be unwilling or unable to withdraw from an operation, even if a simple financial cost-benefit analysis suggests that it is unfavorable. The very act of holding net foreign exchange reserves entails an unavoidable currency risk, as the liabilities that fund the net reserves will be denominated in domestic currency. This risk cannot be reduced without reducing the holdings of the reserves themselves. Similarly, other risks for example credit risk, liquidity risk, interest rate risk, currency risk and cross-country spread risks constitute an integral part of holding reserve assets, and cannot be wholly avoided. 2.0 Literature review The theoretical and empirical studies on the demand for international reserves have revealed that a countrys reserve demand is a function of certain variables, and such a functional relationship is relatively stable over a long-term period. Xu, (1992) shows that a countrys demand for international reserves is not only determined by economic variables but is also affected by the institutional as well as structural conditions in the economy. Ito Cheung, (2009) groups the determinants of international reserves into three categories: traditional macro variables, financial variables, and institutional variables. They notice that this classification scheme is mainly determined for the sake of convenience and should not be interpreted too strictly. These three categories are formulated from framework of analysis on reserve adequacy and optimality which could be classified by the methodologies used into two categories: ratios as tools of analysis and regression analysis. As Liu, (2007) listed them, the ratios are: reserves to imports, reserves to domestic money supply, reserves to short-term debt and opportunity cost of capital. According to Wyplosz (2001) the choice of the reserve holdings of developing countries is influenced by the exchange rate and financial and trade ties to the countries of the reserve currencies. Aristovnik Cec (2009) and Papaioannou, et al, (2006) made a list of factors which determine foreign currency reserve composition. In managing of international reserve, the objective of a central bank is to protect the value of those reserves against high-risk events and imported inflation. Hence a need to diversify foreign exchange reserves holdings into different currencies. A study by Ramaswamy, (1999) presumes that a representative central bank would only want to invest in four leading global currencies: the dollar, the euro, the yen and the pound sterling. For these currencies, a central bank can specify the acceptable share of a given cur rency that can make up the reserve holdings and base its requisites on the depth and liquidity of an individual currency in the global foreign exchange market. Truman Wang,( 2006) and Chiou, et la, ( 2008) mentions the priorities reserves managers are faced with. Firstly, protection of the value of the countrys foreign exchange reserves, including their safe investment in impeccable assets or claims on first-class institutions. The reserve manager may be concerned about the potential appreciation or depreciation of his own currency. That concern creates incentives to intervene, which adds to or reduces reserve holdings, but those concerns are not immediately relevant to the choice of the currency in which to hold the stock of the countrys foreign exchange reserves once acquired. Secondly, protection of liquidity of the countrys foreign exchange reserves. This motive dictates concentrating holdings in short-dated instruments in deep markets and thereby to minimize transaction cos ts, including costs associated with converting from the countrys intervention currency to another currency and potentially back again. And lastly the return on the countrys foreign exchange reserves. Everything else being equal in terms of value preservation and liquidity preference is that the countrys reserves generate a higher, rather than a lower, return. In a comparative study of currency composition of foreign exchange reserves, Soesmanto (2008) finds that both the mean-variance theory and the transaction theory are important in playing a combined role in the determination of currency composition of foreign exchange reserves in the country. Transaction theory asserts market transaction activities as a drive behind holding reserves assets denominated in a certain currency rather than optimal distribution of net wealth across currencies (Dooley, et al, 1989). That is governments purchases and sales of foreign exchange are closely related to accumulation of reserves asset deno minated in a particular currency. On the hand mean-variance theory dwells on the issue of trade off between risk and returns of an optimal portfolio (Markowtiz, 1952). That is the distributions of net wealth, which include the risks and returns associated with holding reserve assets denominated in different currencies, are important in determining the composition of foreign exchange reserves. Henceforth, central bank must consider optimal composition of foreign exchange reserves that minimize risk for a given level of return on the reserves, or vice versa, maximize the return on the reserves for a given level of risk. History suggests that the primary considerations for the composition of reserves have been market liquidity (which in turn depends on central banks willingness to ensure it, currency convertibility, financial stability, and the underlying development of financial markets) and a dominant position in international trade. Heller Knight, (1978) provided evidence in sup port of the view that transaction needs played a major role in determining the currency composition of reserves. This study explained variations in the proportions of a countrys foreign exchange reserves held as assets denominated in the U.S. dollar, pound sterling, deutsche mark, French franc, and other reserve currencies as a function of the countrys exchange rate arrangements, which influenced both the foreign currencies bought and sold to defend such arrangements and the share of its trade with a particular reserve-currency country. Their results indicated that countries increased the proportion of their foreign exchange reserves held as a given reserve currency if they pegged their exchange rate to that currency or if the reserve center was an important trading partner. Eichengreen Mathieson, (2000) replicates Dooley, et la, (1989) in utilizing confidential IMF data on shares of the major international currencies in reserve holdings in a large number of industrial and devel oping countries to investigate the persistence. They found stability over time not only the reserves currency composition but also of the relationship between demand for reserves denominated in different currecies and its principal determinants: currency pegs, the direction of trade, and the currency of foreign debt. These factors are highly significant and robust determinants of the currency composition of reserve holdings. Much of the relevant literature on foreign exchange reserves investigation focus on the determinant in foreign reserves management. This is the case due to the difficulty of accessing truthful data. A countrys actual reserves are usually confidential, not only retrieving truthful data becomes difficult, but also the relative literatures are rare. The above cited papers mention liquidity, currency pegs, the direction of trade, and the currency of foreign debt as the key determinants in reserves management decision. When it comes to risk management, Hallerbach, (1999) decomposes the portfolio total risks into separated Value-at-Risks in parts. The study on central bank foreign reserves risk management appears in Blejer Schumacher, (1998) who theoretically construct a central banks investment portfolio VaR evaluation model and then analyze the associates policies implications, but unfortunately no empirical examinations were made. 3.0 Methodology 3.1 Model and Data The data in this paper will be sourced from World Economic Outlooks and International Financial Statistics of IMF and Peoples Bank of China SAFE. The considered duration will be monthly data from 1993 to 2010. The rationale behind this duration is to look at chinas foreign exchange reserves starting from the time they begun to accumulate rapidly. Estimation will be broken into three different time periods namely: whole sample period from 1993-1 to 2010-6; pre crisis 1993-1 to 1997-11 and post-crisis 1998-3 to 2010-6. The variables of interest are: foreign exchange reserves (Rt); imports (IMt); gross domestic product (GDPt); variance of current account balance (ÃÆ' Ãƒâ€ Ã¢â‚¬â„¢t) and it is proxied by ratio of reserves to imports; opportunity cost of holdings (rt) is proxied spread of domestic bond yield and US Treasury bond yield; Average propensity to import (APIt), which is ratio of import to GDP, is a proxy to adjustment cost: it indicates Chinas degree of exposure to the i nternational economy, and the potential risk involved therein. Either GDPt or IMt can be used as scaling variable  [CITATION Guj95 l 1033]  . This paper uses GDPt as a scale variable following the conventional method. All absolute values will be in U.S. million dollars, average market exchange rate will be used if necessary. If some or all of the variables follow non-stationary processes, then estimation in levels may not be meaningful because of the spurious regression problem. If the variables are cointegrated, the long-run relationship would be captured through cointegrating relationships in levels, and an appropriate dynamic model can be estimated in an error correction setting. Cointegration estimation method called dynamic ordinary least squares method will be considered to examine the cointegrating vectors. An error correction model is adopted to include the long-run equilibrium process in the short-run dynamics. The one of the objectives of this paper is to draw a con clusion on whether Chinas holding of foreign exchange reserves is larger than the desired amount. Under management of international reserves, it is important to explore both the adequate level of holding and an optimal level. Adequacy is defined as a sufficient level of holding to meet the general liquidity and security needs. On the other hand, optimality takes into account the risk/return characteristics of international reserves holding. The concept of excess reserves follows from the concept of optimal reserves, which, in turn, reflects the fact that countries not only obtain benefits from holding reserves but also incur costs. In determining the optimal level of reserves, the monetary authority will seek to balance the macroeconomic adjustment costs incurred if reserves are exhausted (crisis-prevention motive) with the opportunity cost of holding reserves. 3.1.1 Ordinary least squares regression To assess Adequacy and optimality of foreign exchange reserves the following regression will be adopted. (1) The scaling variable measures the size of international transactions and is generally represented by real GDP, real GDP per capita, or population size. It should have a positive coefficient. In empirical work, the average propensity to import was used instead of the marginal propensity and in most cases its coefficient is positive. The positive coefficient suggested that the demand for reserves increases as the economy faces greater external vulnerability. Opportunity cost of holding reserves should enter with a negative coefficient. Since opportunity cost of holding reduces a countrys national income which can be used for domestic consumption and investment. Current account balance variance should have positive coefficient. Serving as a buffer stock accommodating fluctuations in external transactions, the desired amount of reserves is expected to be positively proport ional to the variability of external net receipts. 3.1.2 Error correction model Dynamic ordinary least squares model will be utilized to examine the adjustment process of foreign exchange reserve changes. If two variables x and y, have a proportional long-run equilibrium relationship then the simplest error correction form would be given by: (2) Where. Equation (2) indicates that the change in one variable is related to the change in another variable, as well as the gap between the variables in the previous period. is the error correction. It can be argued that there is a long run, would be stationany random variable, even though or exhibits unit root  [1]  . Thus an error correction model would be an appropriate specification if the variables are cointegrated. Due to cointegration relations built into the specifications, error correction model restricts the long-run behavior of the cointegrated variables to converge on their cointegrating relationships. The error correction term captures gradual adjustment of the model to the long-run equilibrium th rough a series of partial short-run adjustments. The coefficient of the error correction term measures the speed of adjustment of the variables towards equilibrium (Hamilton, 1994). Thus the error correction model will be used to capture both the short-term dynamics and the long-term relationship among the variables (Ra, 2007). Let be a vector of exogenous variables then under cointegration, the following equation will be estimated using the dynamic ordinary least squares (DOLS) method developed by Saikkonen (1991), and generalized by Stock and Watson (1993), because of relatively small sample size. The DOLS procedure provides unbiased and asymptotically efficient estimates of the long-run relation, even in the presence of endogenous regressors. Thus, the endogeneity of any of the regressors has no effect, asymptotically, on the robustness of the estimates. Furthermore, statistical inference on the parameters of the cointegrating vector is facilitated by the fact that the t- stat istics of the estimated coefficients have an asymptotic normal distribution, even with endogenous regressors (Stock Watson, 1993). Another advantage of DOLS is that it allows for direct estimation of a mixture of I(1) and I(0) variables. Moreover, it performs well in small samples. The inclusion of lags and leads of the first differences of the I(1) variables solves potential endogeneity biases among regressors. The estimation equation is given as: (3) Where is a vector of long run coefficients and the inclusion of the lead and lag difference terms takes care of possible endogenity of. The dependent variable at time t is regressed upon the independent variables at time t plus an appropriate number of lead and lag differences of the independent variables including the contemporaneous difference. The estimate for the parameter vector, typically the main parameters of interest, is super-consistent if the system of I(1) variables are cointegrated. The equation is estimated in most cases with p=1, but then a general to specific procedure (Campos, et al, 2005) is applied to reduce the model to a more parsimonious specification where only significant variables are retained, therefore no need to worry about autocorrelation. After cointegrating relationship has been estimated, the following error correction model is constructed and estimated to investigate the short-run impact of the explanatory variables on the reserve demand. (4) Where is an error correction mechanism and it is estimated from the data. The conventionally the error correction is given by. Once the EC term has been computed, equation (4) will be estimated first and then engage in general to specific search for parsimonious equation. 3.2 Risk assessment Reserves management is one of the few areas of central bank operations where extra risk is voluntarily taken on in order to achieve a policy objective. This section considers risk management in the reserves management operation from a narrow financial risk control perspective. As Blejer Schumacher (1998) noted central bank portfolio may be too involved to be analyzed and updated with sufficeint frequency required more besides information may not even be readily available. In addition, for central bank reserves managers portfolio management returns and risk parameters are most commonly defined by reference to a benchmark (Dwyer Nugà ©e, 2004). In this case Ex post tracing error can be employed. Ex post tracking error is defined as the standard deviation of the difference in the return on a portfolio and the return on the benchmark. However, Ex post tracing error is concerned with what occurred in the past rather than what might happen in the future. As such a model that looks int o the future may be more appropriete like Value at Risk (VaR). VaR technique focuses attention on risk as pertain to monetary authority. It provides a better risk assessment of central banks specific macroeceonomic policy. Since, VaR estimates the exposure of a portfolio to market risk, that is changes in prices such as interest rate, foreign exchange rate and commodities. Given normal circumstances of the market, VaR tries to identify the possible lose of a portfolio. Therefore, knowing VaR is imparetive in risk management. However, the normal VaR is criticized firstly for its strong normality assumption, since financial variables usually violate this assumption. Financial returns distribution functions are characterized by both flat tails and Kurtosis excess. The normal VaR is also criticized for its inadaptability to nonlinear financial instruments such as derivatives. Generally, there are two procedures that can be used to compute VaR, viz historic simulation and Factor ap proach. Factor approach includes delta-normal method or variance-covariance method, and Monte Carlo Simulation. Historic Simulation procedure pretends that the change in market parameters from today to tomorrow will be the same as it was some time ago. Delta-normal method is based on the assumption that the short term changes in the market parameters and in the value of the portfolio are normal. And lastly Monte Carlo Simulation is based on the assumption that we have some information about the joint distribution of market changes. Then using this distribution we can draw randomly a large number of scenarios and price the portfolio for each scenario. The applicability of these approaches depends heavily on the availability of data and the distribution assumptions of the underlying returns of the portfolio. For historic simulation accurate data is a prerequisite to attain meaningful results. On the other hand, central to the assumptions contained in the factor approach to VaR is the use of the normal curve for the distribution of market movements. In aggregate, the understanding of assumptions underlying any risk model helps in ensuring realistic sense of control and security (Dwyer Nugà ©e, 2004). The normality assumption has the great advantage to simplify the VaR calculation since only the mean and the variance-covariance matrix are to be calculated for the different asset price fluctuations. Hence, for the purpose of this analysis delta-normal method will be employed to compute VaR, the reasons being simplicity and normal distribution assumption asset prices changes. This means portfolio return is a linear combination of normal variables and it is normally distributed as well. When a portfolio consists of financial instruments with linear behavior toward risks, portfolio volatility is directly calculated via the variance-covariance matrix of the risk factors. Following portfolio selection conception of weighted sum (linear combination), variance of a p ortfolio is given by: (5) Where: is variance of the portfoliois the proportion invested in asset ; is the variance of changes in asset prices ( return on asset ), let return on asset be ; is covariance between and , is correlation coefficient are standard deviations of and prices respectively. Square root of is standard diviation. Equation (5) can be used to construct the VaR of a portfolio positions which is given by (6) Where is the amount of the position multiplied by the worst move in the relevant price in the horizon. Let be the amount of the position and , the volatility of the position , or , then is the VaR of  [CITATION Guj95 l 1033] The worst loss to which a portfolio composed by normally distributed assets returns is exposed at 95% (respectively 99%) confidence level, is determined by calculating negative (unfavorable) fluctuations of prices corresponding to 1.65 (respectively 2.33) standard deviation away from the mean. 4.0 Conclusion The objective of this paper is not to debate the excessiveness of Chinas foreign exchange reserves rather to analyze their exposure to risk, ie financial risk perspective. Risk is the probable variability of returns which is not always possible or desirable to eliminate. But understanding it is an important step in determining how to manage it. Identifying exposures and risks forms the basis for an appropriate financial risk management strategy.