UPDATE 1-China says forex agency could be ready by year-end

KYOTO, Japan, May 6 (Reuters) - The deputy head of China's currency regulator, Wei Benhua, said on Sunday the country's new foreign exchange reserve investment agency could start operations by the end of the year.

He said state media had reported that such an agency could manage a maximum of $200 billion of the country's $1.2 trillion in reserves, adding this did not reflect his own judgement on how much the agency would handle.

"I'm sure it should be ready by the end of the year," Wei said at the annual meeting of the Asian Development Bank in Kyoto, western Japan.

He said one of the options to fund the new agency was to issue yuan-denominated bonds to buy foreign exchange reserves from the central bank.

China began setting up the agency earlier this year to help manage part of its vast reserves.

The official said that his office would improve the approach and method of capital management and strictly control the inflow of speculative short-term capitals.

Turning to global central bank reserves management, Wei said many central banks have been shifting more of their reserves to a wider range of asset classes, which also exposes them to challenges from both the changing economic climate and ongoing transformation in their management practices.

Current low interest rates in many countries make it difficult for central banks to achieve higher yields on their reserves, he added.

"With the flattening yield curve and increasing portfolios, central banks have to balance between long-term and short-term strategies to secure returns," he said.

Developing countries accounted for around 70 percent of the world's $5 trillion in foreign exchange reserves as of the end of 2006.

Wei said the adequate level of foreign exchange reserves was no longer confined to conventional needs arising from trade and currency intervention.

The level is increasingly related to combined economic factors such as the size and growth of the economy, the openness of the economy, development of foreign trade, the scale and structure of external debt as well as the vulnerability of financial system, he said.

Although some countries such as Japan, India, Russia and China have accumulated vast amounts of foreign reserves, they have not exceeded the adequate amount, he said.

He noted that it was necessary for developing nations to keep certain controls over their capital accounts to maintain a sufficient level of reserves to prevent risks from attacks by short-term cross-border capital flows and shield them from large volatility in exchange rate movements of major currencies.

China's foreign exchange reserves are mainly invested in high rate government bonds and notes as well as institutional and corporate bonds.

"Adhering to the objectives of security, liquidity and returns, our reserve portfolios will be managed under long-term strategies rather than orienting toward short-term returns or speculation in the foreign exchange market," Wei said.

Wei also repeated a long-standing official refrain that China would increase the yuan's flexibility but in a gradual and self-controlled approach, steadily open capital accounts and further nurture the foreign exchange market by introducing more instruments as well as continue to expand the so-called Qualified Foreign Institutional Investors scheme.