(Yahoo, Nov 29, 2006) China's best alternative for diversifying its foreign exchange reserves could be to move them into higher-yielding assets denominated in the currencies they are already invested in, a prominent economist said on Wednesday.

Li Yang, a senior researcher with the Chinese Academy of Social Sciences, said that neither shifting some of the more than $1 trillion in reserves away from dollars nor using them to buy strategic resources -- two suggestions put forward by a number of other analysts -- were very attractive options. First, the cost of any move away from dollars was likely to outweigh the benefit, Li said. Second, spending them on oil and other resources would account for just $50-60 billion, he cited relevant calculations as showing -- just a fraction of the total.

"Previously we mainly invested in Treasuries, but now we could invest in corporate bonds, equities, junk bonds and even derivatives," Li, a former central bank adviser, told a forum.

The composition of China's reserves is a state secret, but bankers and academics assume that at least two-thirds is invested in dollar assets, primarily U.S. government debt.

A shift to higher-yielding assets would mark a departure from China's long-held position that it put security and liquidity before returns in managing the reserves.

On monetary policy, Li said he thought the central bank would probably start to use increases in banks' reserve requirement ratios more frequently -- not so much as a tightening tool, but as a more efficient way of mopping up liquidity than issuing bills.

The central bank has raised the ratio three times this year as part of a drive to cool a liquidity-driven investment boom, and a number of economists have said they expect another 0.5 percentage point rise in the next few months.

To give the central bank more independence in conducting monetary policy, China could also consider creating a separate institution for managing part of its forex reserves, Li said, echoing a suggestion other analysts have previously made.

Many economists have said that the swelling reserves were making it difficult for the central bank to control liquidity, because it had to print yuan to pay for the new forex assets it was amassing as a result of exports and investment inflows.

"The foreign exchange reserves could be managed by the Ministry of Finance or a special vehicle," Li said, explaining that such an entity could issue financial bills to buy forex assets from the central bank.

Source:Yahoo