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Sovereign Wealth and the Financial Crisis

04-09 17:46 Caijing

China's sovereign wealth fund CIC is holding cash assets and plans to ride out the economic downturn with minimal risk.

By Lou JiweiChairman of China Investment Corp


(Caijing Magazine)Financial problems triggered by the U.S. subprime mortgage crisis more than a year ago led to a global financial and economic crunch that’s now rigorously testing the world’s economic development.


This experience is unlike previous crises in several ways. First, the crisis started in developed economies with sound financial infrastructures, while past crises occurred in developing countries.


Second, although this crisis on the surface appeared to be triggered by the burst of an assets bubble, the more profound reason was unbalanced world economic development. Thus, structural barriers are at the core of the crisis.


These two characteristics – namely, economic and financial globalization and unbalanced economic growth -- resulted in a global economic recession that ultimately may be deeper and more extensive than crises of the past. Hits to financial stability and economic development have gone far beyond expectations. This economic recession is perhaps an L-type rather than a V-type or a U-type.


In the face of this once-in-100-years crisis, a worldwide discussion is about how to make adaptable adjustments of sovereign assets and foreign exchange reserves management.


Forex and the Crisis


Throughout the crisis, countries worldwide have been paying more attention to foreign exchange reserves. What is a proper level? The International Monetary Fund and other institutions have proposed several measurement methods, including dividing forex reserves by national short-term foreign debt, dividing forex reserves by M2, dividing Forex reserves by import value, dividing forex reserves by total foreign debt, and dividing forex reserves by GDP.


This kind of measurement is meaningful under normal conditions, but the situation is different in a crisis. For example, a bank should secure an 8 percent capital adequacy rate in normal times. In times of crisis, this percentage seems far from enough. Thus, the proper level of reserves should vary according to a country’s individual needs.


Some East Asian countries have maintained relatively high foreign exchange reserves or sovereign assets because, in step with their traditions and culture, their citizens are willing to maintain high reserves. This is also related to a “demographic bonus” at their current stages of development.


On the other hand, since the collapse of the Bretton Woods system, it has been necessary to maintain a certain level of foreign exchange reserves. And especially since the 1998 Asian financial crisis, East Asian countries have substantially increased their foreign exchange reserve capacities to prevent flows of global speculative capital linked to ineffective supervision.


Amid the current crisis, a relatively high forex capacity has had a positive impact by preventing a contagion of crises and stabilizing foreign exchange rates for these countries.


Investment Shift


What was the overall performance for international institutional investors during 2008?


In the face of this systematic crisis, which has affected even large institutional investors, many traditional investment methods have been invalidated. Strategies that were effective and complementary under normal conditions did not work this time. These included the assets allocation strategy, investment strategy and investment portfolios, the use of Beta and Alpha investment strategies, as well as strategies for hedging against inflation and deflation. All we see is one result: a slumping stock market and most companies suffering enormous losses or even bankruptcy, affecting Wall Street as well as Main Street.


Among major institutional investors, mutual funds and pension funds have suffered the largest losses, as their strategies are based on diversification, also known as passive investment. Comparatively, as sovereign wealth funds and donations funds took rather active management and larger adjustment, losses were overall less severe.


For example, the Norwegian pension fund enjoyed sound investment returns for years but hit a negative return at -23.3 percent in 2008, a loss about US$ 90 billion. All investment earnings since the fund was established 12 years ago suddenly evaporated. Indeed, only 1 percent hedge funds made money by adopting some unusual strategies.


Among investment types, only government bonds issued by developed countries were profitable last year, as they served as a temporary “safe harbor” that raised values.


What, then, can be said about the performance of sovereign wealth funds? As a model system for managing sovereign assets, and during a half-century of development, sovereign wealth funds have contributed to their home countries as well as the countries targeted by their investments. They are long-term investors and pursue long-term returns with a capacity for controllable risk.


Last October, representatives from 26 sovereign wealth funds and the International Monetary Fund jointly drafted the Santiago Principles which well introduced the basic features, governance structures and investment policies of sovereign funds. This effort should be helpful in promoting a stable global system, while maintaining an open investment environment and a system of free capital flow.


China Investment Corp. (CIC) participated in this effort and supported the Santiago Principles. CIC also hopes to see a good response from countries that accept investments so that they can treat sovereign wealth funds in a just, fairly and indiscriminate manner, and provide a fine investment environment to bolster investor confidence.


During this crisis, sovereign wealth funds have suffered some losses and are going through a very difficult time. They are trying to rebalance and reshuffle their portfolios. Some funds adjusted investment strategies or amended investment solutions by shifting to domestic investments.


As the sole sovereign wealth fund in China, CIC continues to comply with our previously set goals of cautious overseas investments and commercial operations. One important factor is that, despite China’s high level of foreign exchange reserves, CIC has not shifted its investment goals or strategy.


CIC and the Crisis

As an entity specializing in forex investment management, CIC has positioned itself differently from central banks, with their traditional forex management.


CIC’s mission is to diligently seek long-term investments that maximize returns while maintaining a rigorous approach to managing risks for the benefit of shareholders. Thus, through its management style, CIC sticks with a commercial orientation that maximizes financial returns. In terms of risk tolerance, CIC can afford rather high, short-term risk fluctuations to maximize long-term returns. In strategic assets allocation, CIC is more aggressive than traditional central banks in managing forex reserves by investing both traditional equity and fixed-income investments that have rather low liquidity but are forecast for rather high investment returns.


Affected by limited talent and capital, CIC developed an investment strategy based on “an investment approach that is a mixture of international financial products, with most assets invested in public market products and the rest invested in alternative assets.” Meanwhile, direct investment should not be abandoned. Investments are mainly made through external fund managers with a gradual increasing weight of proprietary investments.


In the past year, the global financial crisis has had impact on the immature CIC in terms of all its businesses, especially overseas financial products investments. But CIC is young and has a relatively limited investment volume at this early stage.


Meanwhile, CIC has worked hard to analyze and understand the global financial market and macroeconomic trends. The fund made timely adjustments to annual assets allocation by slowing equity-product investments and ensuring a prudent, cash-management-led investment strategy. The fund holds a rather high percentage of cash assets to prevent major risk and losses.


Overall CIC posted minor, book-value losses for outsourced investment in 2008. But overall financial conditions were stable and basically met the goals set in early 2008 by the board of directors. Its financial conditions were far better than for some other sovereign wealth funds.


In addition, CIC has strengthened its corporate governance system to provide the skills and supervisory mechanism for managing market risks.


CIC established clear investment guidelines, a risk framework, governance structure and operational mechanism by using all kinds of resources to ensure systemized risk management. Since its establishment, CIC’s operations have been based on economic and financial interests.


CIC’s supervisory mechanism includes a board of directors and executive committee. It also has a board of supervisors to create a two-tiered system of corporate governance for independent operations and effective supervision. The board of directors is mandated to oversee the fund’s operation and overall performance. The board of supervisors has the responsibility to oversee accounting and financial activities, as well as monitor whether the board of directors and senior executives follow a code of ethical conduct.


It is a most difficult year for the global economy in 2009. Macroeconomic trends and financial markets still bear huge uncertainties, especially for financial institutions in the United States and Europe with extremely weak balance sheets. It remains to be seen what sort of improvement policies will be implemented.


In the face of such a complex external environment, CIC will continue to strengthen strategic research, risk management and internal system building. Meanwhile, the fund will stick with its stable investment strategy – namely, a long-term and diversified investment strategy -- by balancing the allocation of all kinds of assets. Specifically, the company will lower its market risks by taking good control of investment timing and asset types while diversifying invested regions. CIC will make timely investments in open market equities as well as fixed-income and alternative assets in compliance with the fund’s assets allocation principle and assessment of international economic and financial conditions.


One thing that deserves emphasis is that CIC seeks financial returns for outsource investments; it does not take over companies or resources. CIC hopes to achieve win-win solutions so that the fund receives necessary investment returns,  while the companies that receive its investments can develop and benefit, making CIC a fund that’s welcomed by governments.


The author is chairman and CEO of China Investment Corp. This article is an adaptation of a speech delivered at the Second IMF Roundtable Seminar for Managers of Sovereign Wealth Assets and Reserves.


Full Article in Chinese: http://magazine.caijing.com.cn/2009-03-29/110129659.html

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