By Lou Jiwei，Chairman 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.