wealth funds

A currency crash would weigh down banks and the government by magnifying the value of foreign hard currency debts in local-currency terms, raising the risk of government default and banking crises. Or a bank collapse would injure the economy, triggering fiscal strains and capital flight and raising the risk of government default or currency crises. Additionally, a sovereign default would devastate banks’ balance sheets and elevate the country’s risk premium, raising the pressure for banking and currency crises. Any one of these types of crises was apt to trigger another. Many emerging countries found themselves caught in this vicious cycle. The largest and most alarming wave came during the 1997–98 Asian financial crisis. Caused by a still-disputed combination of weakening macroeconomic conditions and self-fulfilling investor pessimism, the crisis shut down access to capital markets and led to widespread devaluations of currencies and credit crunches across South and East Asia, causing, in turn, stock-market declines and sharp recessions. An agreement that Indonesia and the IMF struck in early 1998 was a defining moment of the crisis. Indonesian President Suharto was forced to accept a bailout from the IMF to avoid a default. In exchange, he had to comply with the IMF’s demands for drastic economic reforms meant to prevent another crisis and achieve a sustainable outcome: reducing Indonesia’s deficit, permitting the failure of insolvent firms and banks, and raising interest rates. The photograph of the signing of the agreement, showing Suharto hunched over papers with the IMF’s managing director, Michel Camdessus, standing over his shoulder like a watchful schoolmaster, captured the humiliation of Indonesia and other states that had been struck by the crisis and were now forced to rely on Western aid and bow to stiff conditions. In the years that followed, emerging economies would take steps to avoid such dependence on foreign assistance. Outside help was to give way to self-help.

The $12 Trillion-Step Program

Around 1990, global central-bank reserves totaled approximately $200 billion. By 2009, that number had climbed to about $8 trillion, and sovereign wealth funds accounted for as much as another $4 trillion. In other words, a remarkable $12 trillion was being hoarded for a hypothetical disaster. The emergence of these massive war chests is arguably the most important story of the global economy over the last two decades. And it is almost entirely the making of emerging-market economies, among them, Brazil, Chile, China, Russia, and Singapore, which increased their reserves from four percent of their GDPs in 1997 to 27 percent in 2007. Emerging markets had learned to save up wealth for rainy-day funds, creating for themselves a means of financial adjustment that they could control in times of stress — unlike the strategy of relying on the IMF or other foreign powers. Yet this self-insurance did not come cheap. Critics in emerging economies and abroad worried that such plans to save for later rather than spend now would result in unjustified opportunity costs, such as lost investment opportunities, lower consumption and social spending, and low interest rates on U.S. Treasury securities. These concerns magnified as the reserves grew from hundreds of billions of dollars to trillions from the 1990s to the early years of this century.