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Saturday, October 18, 2008

Global Imbalances and the Future of China's SWFs

This current global financial crisis gives urgent need for policy makers in both the US and China to rethink. For the US, more savings/less consumption is needed; for China, more domestic demand needs to nurtured and sustained development should not mean putting all your bets on international trade. If this indeed is the macro trend for the coming ten years, China's current account surplus will be shrinking gradually.

China's foreign exchange reserves has been piling up fast and furious, now close to $2 trillion. To relieve the huge pressure for China's policy makers to seek higher return, and/or to diversify their portfolio holdings, Chinese government should eventually relax the foreign exchange controls, allowing free currency conversion and floating of its exchange rate.

The roots of huge foreign exchange reserves buildup goes back to China's rigid exchange rate regime. By ditching the fixed/managed exchange rate system and realizing free currency conversion, trade surplus will be held by Chinese enterprises and individuals. Instead of putting all money into government's hands and let government agencies, like CIC, do the investment for us (potentially losing our money), individuals and firms should make their own decisions by investing through more sophisticated private institutions. Chinese central bank should only maintain a small amount of foreign exchange reserves, say below $500 billion, to fend off potential currency attacks in future time of crisis. The need for CIC to invest globally will gradually die out and private institutional managers, such as mutual funds or asset management firms, domestic or foreign, will become the dominant force in China. CIC most likely will evolve into one of the many big players in the field, the equivalent of PIMCO, for example.

I hope we are heading toward this direction, and it's healthier than relying government to manage our money.