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Sovereign wealth funds can help stabilize global financial system

By Lou Jiwei (chinadaily.com.cn)
Updated: 2009-04-01 16:07

Lou Jiwei

I would like to take this opportunity to talk about my understanding of the current global economic crisis, and the positive role Sovereign Wealth Funds can play as an important stabilizing force in the global financial system. I would also like to take this opportunity to elaborate on some basic information about China Investment Corp (CIC).

In November 2007, delegates from the CIC attended the First Annual Roundtable of Sovereign Asset and Reserve Managers organized by the IMF. In the past year, the financial turmoil stemming from the subprime mortgage markets in the US ultimately led to a global financial and economic crisis, which brings severe challenges to the world economic growth. Compared with the previous ones, this crisis bears some distinctive features.

First, this financial crisis originated from the developed countries with relatively sophisticated financial systems; while the previous crises mainly started from the emerging markets. During this crisis, financial markets and real economy of the developed countries were the first to be hit, and then the crisis spread to emerging markets and developing countries. The crisis has had different impact on countries with different economic fundamentals. With lessons drawn from the Asia Financial Crisis of 1997-98, East Asian countries have gradually adjusted and improved their macro policies and economic structures, so the impact of the current crisis on them has been relatively mild.

Second, apparently the financial crisis was caused by the burst of the asset bubbles, but the root cause is the imbalances of the existing global economic development model. The crisis reflects the unsustainability of this model and the genesis of the crisis lies in structural problems. Take the US for example: the US features over-consumption, high-leverage and a high-risk virtual economy. Of course, China has its own structural challenges.

Related readings:  CIC cautious about financial derivatives investment  CIC sees 'good opportunity' for int'l investment  China's sovereign fund in 'no hurry to invest overseas'  Sovereign fund beneficial to investment, economy

Third, due to the above mentioned two characteristics, as well as the economic and financial globalization and macroeconomic imbalances, the depth and time span of the current global economic recession may well exceed a normal crisis, and the impact of the crisis on the financial stability and economic development may well go beyond previous estimations. The recovery from this economic recession would most likely be an L type, instead of a V or U type.

In the face of crisis, the major economies have taken unprecedented measures to address it, such as pumping liquidity into the market, lowering interest rates, rescuing domestic financial institutions and adopting various economic stimulus policies, which help to forestall the further spread of the crisis. Because the measures taken are mainly short-term oriented, which can only temporarily relieve the pain of economic recession instead of adjusting the economic structure from the perspective of long-term and healthy economic development, the policy measures may not be as effective as expected. According to the recent economic data, global financial markets have yet to resume normal functioning and the downward trend of the real economy has yet to be reversed. Therefore, it is difficult to strike a balance between crisis response measures and structural adjustment. But, as the crisis worsens, consensus has begun to develop and the crisis response should also bring about opportunities for reform.

During the Asia Financial Crisis in 1998, the Chinese Government adopted proactive fiscal policies and other crisis response measures, on one hand; and deepened economic structure reform, such as SOE reform, financial sector reform, housing reform, and entering the WTO on the other. Through those measures, the economic viability has been enhanced and domestic demand has been increased. After this round of crisis started, as mentioned by Premier Wen Jiabao at the World Economic Forum, the Chinese government has acted in an active and responsible way, promptly introducing ten measures to shore up domestic demand and avoid rapid decline of the economy. Meanwhile, China continues to strive to solve some existing structural problems. Seizing the opportunity of international economic structural adjustment, we have tried to accelerate the formation of an economic pattern which is mainly driven by domestic demand, particularly consumer demand. For instance, the Chinese government will aggressively push forward the social security reform, increase basic retirement pension, unemployment insurance and work-related injury compensation of enterprises and strive to establish a basic medical care system covering both urban and rural residents in three years. The objective is to promote consumption by addressing the root causes. Only by combining measures addressing short-term difficulties with strategies promoting long-term economic growth, can we turn the crisis into opportunities. I am confident in China's future economic growth. Despite the severity of the current crisis, China will be one of the earliest countries to emerge from the distress.

As an emerging market economy, China's market system is not highly sophisticated, so there is still ample room for structural reform and demand expansion, which underlines opportunities amidst the crisis. The US is fully geared up to combat the crisis from two fronts, namely stimulate the economy aggressively on the one hand, and strengthen balance sheets of financial institutions on the other hand. We hope the crisis would lead to forceful reforms, which would fundamentally improve the economic structure.

IMF and some other institutions have proposed several calculation methods to assess whether the size of foreign reserves is appropriate, such as the ratio of the reserve to short-term foreign debt, to M2, to corresponding monthly import, to total foreign debt, or to GDP, etc. Those calculation methods may make sense in normal times, but not during the crisis. Take capital adequacy ratio of banks for example. In ordinary times, the required ratio is 8 percent. But when a crisis strikes, such ratio is far less than adequate. Therefore, whether the size of reserve is appropriate depends on the specific national conditions of a country. Let's take a look at the East Asian countries. They maintained relatively large stocks of foreign exchange reserves or sovereign assets. On the one hand, due to their tradition and culture, people of those countries tend to be thrift and save a lot. It is also related to the population structure of their current development stage. On the other hand, under the so-called Jamaica accord, foreign exchange reserves of considerable size are established to fend off and prevent transaction risks. Especially after the 1998 Asia Financial Crisis, all East Asian countries increased their reserves by a large margin. It is a measure to guard against excessive global speculative capital flows which lack effective regulation. During the current crisis, large reserves have played a positive role for those countries to prevent the spreading of the crisis and to maintain stable exchange rates.

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