China's foreign exchange reserves have become a thorny issue for the government. Experts around the world have suggested ways in which China might address the surplus of foreign exchange reserves. However, many of these simply involve consuming the excess which could easily lead to inflation. Any attempt to address the excess of foreign exchange reserves should incorporate a fundamental economic restructuring and an adjustment of the RMB exchange rate formation mechanism, which will be a long and slow process. In the process the government can pursue some complementary policies to reduce its huge foreign currency reserves. The author believes that raising gold holdings should be one of government's strategic choices.

Gold has played a very important role in the international monetary system. With the Demonetization of Gold, decided at a meeting in Jamaica in 1976 after the breakdown of the Bretton Woods system, the function of gold as a currency has been weakened and its status in the international reserve system fallen. As a result, many countries and regions reduced their gold holdings. However, following the Asian financial crisis, the US' economic downturn and the depreciation of the dollar, gold once again has risen in importance. Many countries have restored or even raised their gold holdings and adjusted the proportion of gold in their reserves, seeking a better role for gold in the modern economy.

Gold has several functions. It can be a tool in a diversified investment portfolio and can spread investment risks. Gold has high liquidity, high security and low profitability. With a high liquidity, it can realize any market price freely. This is compatible with the ability of reserve assets to deal with any unexpected economic difficulties. Despite low profitability gold can have a very important hedging function. It can be combined with some asset portfolios that are high risk but also high benefit, increasing investment benefits at the same level as risks.

Gold is also important in helping prevent inflation. For emerging countries and markets, low interest rates, high oil prices and rampant fund speculation has increased the extent of inflation. To curb the bubble economy that could arise from inflation, countries usually adopt macroeconomic controls such as increasing the interest rate. Gold is another effective means of preventing inflation. History shows that gold prices increase in sync with the rise of the inflation index and often in a higher range. During deflation, the price of gold does not necessarily fall in line with the index, or by a lower margin.

In addition, holders of gold are able to meet their temporary funding needs in emergencies. During its 1998 financial crisis in 1998, Russia sold off 33 percent of its gold reserves. In 2001, to deal with a series of natural disasters that had befallen the country, it sold more of its gold holdings and invested the money into the reconstruction of Siberia. During the Asian Financial Crisis, Malaysia, South Korea and Thailand all appealed to residents to convert their gold into local government bonds or to turn the gold they had collected directly into holdings or into dollars either to pay for the debt or to reduce risks. This helped stabilize the local currencies.

Gold assets have unique features. Gold holdings is an issue that concerns national sovereignty. Every country has autonomous control of its gold. Gold does not involve a liability, nor is it subject to any country's economic policies, including the direct impact of monetary and fiscal policies.

China's Central Bank says that China has 600 tons of gold holdings, equal to about 19.29 million ounces. This figure has not changed since December 2002. China's gold reserves account for only 1.3 percent of its total foreign exchange reserves, far lower than the 3 percent that is standard in other countries. With the rapid growth of foreign exchange reserves, which now exceed US$1 trillion, the ratio of gold in China's foreign exchange reserves is even lower. In the long term, China should raise its gold holdings. The price of gold has rebounded since April 2001 and a record high was set in May 2006 ï¿½C US$725 per ounce. Currently an ounce of gold sells for approximately US$625. The price of gold has fluctuated but overall it remains high. If China adopts a long-term strategic approach, accurately predict the market price of gold and purchase gold in a timely and reasonable manner, it can preserve and increase the value of gold, improve the reserve structure, and create a solid foundation for the internationalization of the RMB in the future.

By People's Daily Online; The author, Gao Jie, is an Associate Professor at the School of Finance in the University of International Business and Economics