China faces growing challenges in managing its foreign exchange reserves -- the world's largest at $2.85 trillion, the country's foreign exchange regulator said in remarks published on Tuesday.

The comments by Yi Gang, head of the State Administration of Foreign Exchange (SAFE), highlighted official concerns over the rapid build-up in the country's foreign currency reserves, which jumped by a record $199 billion in the fourth quarter.

The management of large foreign exchange reserves is restricted not only by market sizes but also the attitude of invested countries, Yi said in comments published on the regulator's website:

China has been working for years to diversify its official currency reserves to reduce the dominance of U.S. Treasuries in its holdings of foreign assets.

But the diversification has not been smooth.

Investment of euro assets has been overshadowed by the debt crisis, and volatility in the value of the euro, while the attention China drew last year for buying Japanese and South Korean debt underscored the difficulties in investing in other smaller government debt markets.

The rise in China's reserves was fuelled by hot money inflows into the world's second-largest economy due to expectations for a stronger yuan, Yi said.

As China's economy has recovered with growing macro-economic strength, together with an interest rate gap, yuan appreciation expectations and other factors, small 'hot money' inflows through trade and investment should not be ruled out.

Economists suspect that much of the increase in FX reserves could not be explained by trade or direct foreign investment, implying that speculative inflows had picked up towards the end of the year.

China will gradually push ahead the free convertibility of the yuan on the capital account under its 12th five-year plan, but it will continue to clamp down on cross-boarder abnormal capital inflows in the coming five years, Yi said.

We will further improve the risk-alert system in tackling abnormal cross-boarder capital inflows and stand firmly to safeguard the national financial security, he said.