institutional investors: catalysts for china's capital ... - World Bank Group

INSTITUTIONAL I NVESTORS: CATALYSTS FOR CHINA’S CAPITAL MARKETS

Oliver Fratzscher Yongbeom Kim Clemente del Valle The World Bank

This discussion paper has been prepared by the World Bank at the request of the Ministry of Finance, People’s Republic of China, for presentation at the seminar on Government Securities Market Development in Hong Kong on 19/20. November 2001. This project evolved from an FSTA loan on the Chinese government bond market where the lack of institutional investors was identified as a major constraint, and it involved two staff visits to Beijing and Shanghai in August 2001 and November 2001. The authors have greatly benefited from discussions with Chinese policymakers, financial institutions, capital market participants, and academics as well as from contributions by local consultants Messrs. Xu Shouchun, Hu Jie, and Li Qihan. Comments from Gerard Caprio, Patrick Conroy, Mark Dorfman, Thomas Glaessner, Patrick Honohan, Xiaofeng Hua, Terrance Hui, Rajiv Kalsi, Rodney Lester, JoAnn Paulson, Robert Liu, David Scott, Dimitri Vittas, Jun Wang, Xin Zhang, and Jianping Zhou are gratefully acknowledged.

INSTITUTIONAL I NVESTORS: CATALYSTS FOR CHINA’S CAPITAL MARKETS Executive Summary China’s financial system has been evolving rapidly and WTO agreements will require more reforms that promote openness and competitiveness. China’s capital markets will be critical on this path in providing market-oriented financing, in enhancing the productivity of domestic savings, and in underpinning China’s economic growth. Institutional investors could become the catalysts in transforming China’s financial system from a bank-driven retail culture into a capital-market-driven investment culture. IF half the deposits could be turned into mutual fund or pension fund assets while half the performing bank loans could be turned into effective capital market bonds, China could catch up with the most innovative and productive financial systems in emerging markets. Government bond markets have formed the foundation of capital market development in numerous emerging and OECD economies. Deregulation of banking, international integration, social security reforms, privatizations, emergence of pension and mutual funds, and technological advances have all propelled economies into a virtuous cycle of capital market innovation, institutional investor development, and productivity-driven economic growth. Capital markets often account for over 100% of GDP (Korea, Chile) and institutional investors can account for 75% of GDP in advanced emerging economies. In contrast, China’s institutional investors today account for less than 6% of GDP as pension reform is starting in pilot projects, as open-ended mutual funds are introduced and as the insurance industry is addressing its capital deficiency. However, assuming that underground investment vehicles are regularized, that institutional assets are professionally managed, and that critical reforms are implemented, China could establish a solid base of institutional investors of 30% of GDP within five years. Critical reforms need to include a consolidation of financial institutions with access of commercial banks to capital markets through financial holding companies. Moreover, fixed-income and equity capital markets need to develop on a level playing field which allows equal access for state-owned and private companies, with strong emphasis on improved corporate governance and transparency. Quasi-fiscal financing needs to be shifted into a market-determined supply of government T-bonds and T-bills at liberalized interest rates for all investors. The evolution of strong fixed-income mutual funds, strengthening of professional fund management in the insurance industry, and further growth of new pension funds will be three key pillars. Institutions need to be strengthened, with an integration of bond markets, a consolidation of regulatory agencies, a reduction of tax distortions and liberalization of investment limits, and an upgrading of key legislation which urgently need to regularize underground fund activities. Instruments need to be diversified into derivatives and diverse corporate bonds, while convertible bonds and asset-backed securities could be envisaged. These Markets and Institutions and Instruments will decisively shape China’s future institutional investors.

INSTITUTIONAL I NVESTORS: CATALYSTS FOR CHINA’S C APITAL MARKETS “Finance is, as it were, the stomach of the country, from which all the other organs take their tone.” William E. Gladstone (British Prime Minister), 1858

1.

Introduction to China’s financial system

300 million depositors – 30 million shareholders – 300 institutional investors – that gives an illustration of today’s financial system in the People’s Republic of China. A country with one of the highest savings rates in the world has retained a very inefficient financial system that is bank/retail dominated with very low productivity of domestic savings. On one hand, commercial banks intermediate huge deposits (150% of GDP) mostly to SOEs which now only account for one third of GDP ; on the other hand, capital market access for private firms remains marginal as only 35 out of 1200 listed firms are private and corporate debt markets are small (1% of GDP). Capital market development has been shallow, as retail investors mostly speculate in the equity market (54% of GDP) while institutional investors (assets 6% of GDP) just start to develop fixed-income products. Policy makers are acknowledging that capital market development will be crucial to provide market-oriented financing, to increase productivity of capital, and to underpin China’s economic growth. This note argues that institutional investors could become catalysts on this path, that fixed-income products need to provide a solid basis, and that government debt markets are essential to attract institutional investor demand. Accession to the WTO will focus policy makers’ attention to develop a more competitive financial sector structure, to promote financial innovation and joint ventures, and to provide investors with more diversified and market-based products. Eventually, deposits will need to shift into mutual funds and private contractual savings, while bank loans will need to shift into capital market financing (chart 1). This note is organized as follows: the next section reviews the international experience with institutional investors, before contrasting this with the current structure of Chinese institutional investors. The main following section elaborates on nine specific policy challenges (grouped into markets; institutions; instruments) before a final section addresses priorities and sequencing issues. Chart 1:

China’s Intermediation of Savings through Banks and Capital Markets SOE / Corp Investment

Y 650 bn

Y 40 bn

Equity Capital

Corporate governance

Capital

Debt Capital

Funds

Loan Y 10,700 bn access

SCB

Deposits 1 : 10

Y 85 bn Y 700 bn (gray)

Institutional Investors in China

Household Savings

Y 7,000 bn + Y 650 bn (FX)

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2.

International experience

Institutional assets in the OECD area have grown from $3 trillion in 1981 to $16 trillion in 1991 to an estimated $37 trillion in 2000, which represents106% of aggregate GDP. They include investment funds (33% of assets), life insurance companies (32% of assets), pension funds (27% of assets), and other institutional investors (8% of assets). The fastest annual growth rates of 16% have been observed in the investment fund business, which has grown to over $12 trillion globally and of which over 60% are based in the United States. Despite such rapid growth, institutional assets in emerging markets account for just 3% of global assets, and they are highly concentrated in four economies: Brazil, Korea, Singapore and Hong Kong SAR each manage institutional assets of about $250 billion or 80% of their GDP. In comparison, China’s GDP of $1,080 billion is similar to the size of these four economies combined, yet China manages only $60 billion of institutional assets, mainly because of its nascent mutual and pension funds. Table 1 illustrates that China’s deposit share of GDP is twice as high as that of competitors, while China’s capital markets are half of the average size of its competitors with a strong bias towards equity markets. China’s institutional assets are below 6% of GDP as compared to an average of 77% of GDP for its competitors which reveals the bank/retail dominance and illustrates structural problems in the area of institutional demand.1 Table 1: Assets of Institutional Investors (as percentage of GDP, 2000) % of GDP

Deposits

Bonds

Equity

China Hong Kong SAR Singapore Korea Thailand Brazil Chile South Africa

151.0 275.6 101.1 66.6 85.4 15.5 45.7 50.9

24.5 37.4 57.9 70.0 31.0 51.5 18.2 44.8

53.9 384.9 229.5 32.5 25.5 37.9 97.0 163.0

0.9 137.6 163.2 27.3 7.4 25.3 6.7 13.2

4.7 18.5 73.7 31.0 10.7 17.4 77.5 129.6

5.6 156.2 236.9 58.3 18.0 42.7 84.2 142.8

70.0

52.3

93.3

42.1

35.2

77.3

Average (7)

Mutual Contractual Institutional

Sources: IMF, OECD, ICI, Swiss Re, National Statistics. Data are end-2000 estimates. Note: Institutional = Mutual Funds+ Contractual Funds (Pension and Insurance).

These statistics only reflect the size of domestic institutional investors. In addition, foreign capital inflows from direct and portfolio investors are estimated at about 5% of emerging markets’ GDP2, which is relatively small as compared to overall institutional assets. The literature shows that five structural factors have been shaping the role and structure of institutional investors during their expansion over the past two decades: 1

The average GDP-weighted figures may be more meaningful as they include four larger economies in addition to Hong Kong SAR and Singapore, where non-resident institutional investments are significant. 2 IMF (2001e) illustrates that China has attracted 33% of foreign direct investment (aggregate for emerging markets) but only 5% of portfolio investment. Kaminsky (2000) shows the volatility of foreign portfolio flows which significantly reduced the portfolio stock of $77 bn in Asia during 1996-2000.


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

First, deregulation of banking and securities industries and international integration have increased competition and forced banks to seek new fee income from expanding to banc-assurance and investment fund business, which led to financial conglomerates (details in appendix 1). Singapore and Hong Kong SAR represent the best examples of rapidly growing international financial conglomerates and mutual funds, which have attracted 236% and 156% of GDP in institutional assets respectively.



Second, many mandatory social security systems have been transformed from partially-funded or pay-as-you-go defined-benefit systems into fully-funded definedcontribution systems. Moreover, an aging population in OECD countries has led to complementary private pension plans which may be offered by banks, insurance companies, and investment funds. Voluntary corporate pension plans have also had substantial increases in funded reserves. Chile is an example, where mandatory contributions to privately managed pension funds were introduced in 1981, which have grown to over 50% of GDP and have been a model for emerging economies.3



Third, investment funds have taken on a much larger role in the channeling of individual savings both in developed and emerging markets, due to following factors: cost effectiveness, better risk/return characteristics through professional management, versatility allowing different styles, convenience and enabling regulation. Moreover, voucher privatization plans in transitional economies have jump-started privatization investment funds. Banking crises and losses of depositors can also contribute to shifting savings towards investment funds. This was the case in Brazil, where mutual funds performed well during crises, and where outsourcing from pension funds has been common, building investment fund assets of 25% of GDP during the 1990s.

 Fourth, liberalization of permissible activities of institutional investors in the production and distribution of their products and the investment of their assets has greatly increased their efficiency and profitability. Regulatory constraints on investment limits for asset classes and for cross-border activities have been gradually relaxed (details in appendix 2). Moreover, new product developments (asset-backed securities, private equity, derivatives, etc.) have enlarged the investment universe and added liquidity. A good example is Korea where investment limits were gradually liberalized and new product development has spurred financial innovation.  Fifth, enormous technological advances have enhanced the capacity of the financial sector and have dramatically reduced costs. Reliable and efficient clearing and settlement systems, electronic trading systems, integrated risk management, and the integration of capital markets all have stimulated growth of institutional investors. Hong Kong SAR is a case where regulatory systems have been upgraded to US standards while electronic finance is rapidly growing and institutional links with international trading centers are being actively pursued. 3

Pension funds are often outsourcing parts of the fund management. For example, in the United States voluntary retirement plan assets [defined contribution plans (401k) and individual retirement accounts (IRA)] represented 36% of mutual fund assets in 1999. At the same time, Brazilian pension funds invested 31% of their assets into domestic mutual funds. Tax incentives are often an important growth factor.


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Box 1: Transforming the Government Securities Market in Italy The structure of Italian domestic government debt in the mid-1980s has some similarities to China’s structure today: large domestic debt volumes, mainly short-term maturities, and a larger number of floating rate securities. Over 80% of the debt outstanding was held by Italian households. This provided the government with a very stable but also very risk-averse demand, which required either short-term or floating rate securities. Italy subsequently succeeded in extending the average maturity of government debt and in developing a liquid government securities market based on three pillars: the adoption of a marketoriented approach in the primary market of government securities, the appointment of selected institutional specialists, and the development of a screen-based wholesale trading system. First, the Italian government adopted a market-oriented approach in the mid-1980s in the primary market by shifting from syndication to an open auction system where all market players could bid competitively. The government started to conduct regular auctions and to enhance the transparency of information and procedures. Eventually, the government committed to a pre-announced yearly auction calendar, which made issuance more stable and predictable. The next step was to encourage the market to buy longer-term securities. The strategy was to ensure a certain level of demand at each auction, and this was facilitated through a selected group of primary dealers who had some obligations including the subscription of a specified share of securities at each auction. Italy had issued a relatively high proportion of floating rate notes in 1988 (44% of total debt) due to the reluctance of retail investors to buy long-term fixed-rate securities and assume interest rate risk. In its attempt to lengthen the average maturity of the debt, the Italian Treasury succeeded to diversify the investor base, especially by building an institutional investor base that can better manage risk than the domestic retail base, and which enabled the government to move progressively towards fixed–rate securities. Second, the role of primary dealers and a set of tax advantages were key to attract foreign investors into the Italian market. Moving towards fixed-rate securities required to issue long-term floating rate notes to alleviate refinancing risk and to gradually introduce T-bills, fixed-rate and zero coupon bonds while reducing the issuance of floating rate notes. Floating rate notes typically had a 7-year maturity, and its coupon was linked to an average of the cut-off rates of four one-year T-Bill auctions plus a specified spread. The government decided to use primary market rates because they were perceived to be a better indication of the market price, as the secondary market was never very active. The decision to use the average of four auction stop-out rates aimed to prevent manipulation or excessive volatility. Finally, a screen-based trading system (MTS) was launched in order to create a supportive environment and greater liquidity through a transparent, inexpensive, electronic network. The Italian government decided that the best way to ensure liquidity in the market was to organize a wholesale market that was privately owned and supported by market makers. The MTS was organized in three layers: the dealers, the primary dealers and the specialists in government bonds. Primary Dealers were committed to quote two-way prices in selected securities, whereas Specialists (16 out of 40 primary dealers) had stricter requirements, like quoting two-way prices on a continuous basis on the MTS, a high turnover requirement, participation in Treasury auctions, constant monitoring by the Treasury and a few others. In exchange for these obligations, they enjoyed a number of privileges among which the right to buy securities at a second round after the auction (at the price of the auction) and monthly meetings with the Treasury. The system improved secondary market trading by bringing anonymity, liquidity and depth, improving transparency and efficiency in the trades. It benefited both the issuer by widening market distribution and by reducing the cost of funding, as well as the securities dealers through lower transaction costs and even final investors who did not have access to the wholesale market but indirectly enjoyed tighter spreads. The government introduced its first 30-year bond in 1993 which was purchased primarily by large institutional investment funds. Italy managed to increase its share of long-term, fixed-rate debt to 55% by the beginning of 2000.


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While these five stylized facts have been instrumental in the growth of institutional investors, their impact has also been felt on capital markets and on the structure of the financial sector more generally. The impact of institutional investors on capital markets and especially on government debt markets is illustrated in the interesting case of Italy, which shifted from over 80% retail demand during the 1980s to a strong institutional investor base in the 1990s. Again, five distinct effects can be illustrated:  first, the comparative advantage of institutional investors is in the capital market. Both form a virtuous cycle of growth, improved productivity, and lower transaction costs, encouraging long-term financial savings and contributing to economic growth.4  second, the Asian crisis has revealed that capital markets provide an additional pillar of financing and stability. As institutional investors help to increase long-term savings, economies tend to become less vulnerable to interest rate and demand shocks and contribute to the reduction of financial market volatility.5 However, research is more ambiguous on the impact of foreign institutional investors (esp. hedge-funds).  third, institutional investors act as catalysts to improve market infrastructure by creating new products, enhancing liquidity, improving accurate pricing, encouraging entrance of new market participants, and through better clearing and settlement.  fourth, institutional investors establish high standards for compliance, disclosure and oversight of information (esp. financial statements) and help to improve corporate governance of market participants.  fifth, institutional investors create new competition and potential synergies with banking institutions, they often assist in developing new skills and are invaluable participants in privatizations as strategic investors.6 In terms of sequencing, developments have generally moved from fixed-income to equity markets, and from short-term maturities to an extended yield curve. Government securities have usually provided the necessary basis for broader market development, new products, and advanced infrastructure. Mutual funds are typically demanding more short-term fixed-income products, whereas pension funds typically need more longduration products7 (details of asset allocation are provided in appendix 3). For example, Latin American mutual funds (Brazil, Chile, Argentina, Mexico) hold less than 10% of their assets in equities. In contrast, over 50% of UK pension fund assets are invested in equities. Holdings of life insurers vary according to the available instruments, for example Singapore’s life insurers hold less than 30% of their assets in bonds due to their relatively short duration, whereas US life insurers hold 52% of their assets in mostly long-term government and corporate bonds. 4

Holzmann (1997) shows econometrically that the development of financial markets in Chile correlates with strong development of the real side of the economy, through rising total factor productivity and capital accumulation. It is estimated that long-term growth in Chile is between 1% to 3% higher mainly due to the effects of the pension reform operating through the financial markets. 5 Impavido and Mussalem (2001) provide a review of the literature on the impact of institutional investors on savings, growth, and financial market volatility. They also identify additional benefits, including lower country risk premia, a flattening term structure, and efficiency gains. 6 These factors have been summarized from Kumar et. al. (1997), Blommestein (1998), and Fischer (1997). 7 Pension fund investments are also driven by risk-tolerance related to the age structure of their members.


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3.

China’s institutional investors

The previous section has revealed some advantages of a strong institutional investor base and the linkages with deeper capital markets and stronger economic growth. However, after two decades of capital market development in China, which started in 1981 with the resumption of government securities issues and continued with the establishment of stock exchanges in 1990, there is still a very narrow institutional investor base which accounts for barely 6% of GDP. More effective financing through capital markets would require this narrow base to grow significantly from a very low base which compares to an average of 77% of GDP among comparators. This section illustrates three key areas of necessary reforms, which relate to pension reform, to professional management of insurance company assets, and to particular emphasis on mutual fund joint ventures. Moreover, it is likely that, in the medium-term, the market structure may evolve towards financial conglomerates and universal banking8 in order to enhance the competitiveness under the WTO commitments for further market opening. China’s financial sector has expanded in parallel with its rapid economic growth over the past two decades. Then, the government budget was the dominant source of investment. Today, banking-sector assets are exceeding $1,900 billion (175% of GDP) after annual growth rates of 35% over the past decade. China’s banking system comprises four state-owned commercial banks which were established in the late 1980s, which hold 70% of the country’s deposits and mainly lend to SOEs, and which are in the process of being recapitalized since 1998 (capital injection and limited transfer of NPLs). These are complemented by three policy banks (set up in 1994), ten national joint-stock commercial banks, about 100 city commercial banks, and 1,700 urban and 39,000 rural cooperatives. Some 170 foreign banks have offices in China, but their market share is below 2%, although competition is expected to increase under WTO agreements. A range of nonbank financial institutions emerged, and over 700 international trust and investment companies (ITICs) were created to channel foreign capital into Chinese industries, but after the GITIC bankruptcy in 1998 their share of the financial sector quickly dropped below 10%. A number of intermediaries were allowed to conduct capital markets business, and today 88 brokerages and 13 comprehensive securities companies exist. China is in the process of transferring social security responsibilities away from SOEs towards municipal Government agencies. China’s urban pension system is one of the largest in the world and the government has declared that social security reform is one of its top policy priorities. Today, the system is largely defined-benefit PAYG for older individuals, while younger workers’ benefits include a basic benefit of 20% of the regional average wage, an accrual rate for past service prior to 1996, and an annuity from individual account accumulations. Coverage has recently been extended from employees of SOEs and collectively-owned firms to other formal sector urban workers. Contribution rates vary between 19% to 28% for employers and 5% to 6% for employees, which are expected to rise gradually to 8%. In July 2001, the Government launched a pilot project in Liaoning Province which seeks to establish the management systems for social security programs including pensions, health insurance, unemployment insurance and other 8

Universal Banking is defined as access of financial institutions to both banking and securities markets.


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benefit programs at the municipal level. Suggestions for further improvements include the gradual increase of retirement ages, the calculation of annuities based on life expectancy at retirement, a uniform indexation to local consumer prices, and improved reserve management.9 Current gross reserve estimates are in the range of $8 billion, but projections show assets could possibly reach 20% of GDP by 2030. 10 A recent study by the Ministry of Labor and Boshi Fund Management suggests that total pension fund assets could grow by 30% to 40% in the first years based on 8% individual contribution rates. However, transition costs could be very substantial as current estimates of unfunded liabilities of the pension system are in the range of 94% of GDP. China’s insurance industry represents the largest domestic institutional investor today with assets of about $42 billion (4% of GDP) and annual premium income of $22 billion (2% of GDP) of which 65% are derived from life insurance products. Today, the market consists of 31 insurers and over half a million agents, but four key players control 95% of the market. The largest state-owned insurance company resumed operations in 1979 and today still holds a market share of 54%, whereas two privately owned companies hold market shares of 31% and 11%. Industry experts project continued rapid growth of premium income (30% growth rates were achieved in the first half of 2001) given high household savings levels, an aging population, solid GDP growth, and rising penetration and depth. However, the industry appears to be haunted by an insolvency crisis due to weak profit margins, low investment returns (below 4%) and minimum guaranteed yields (which were recently reduced to 2.5%). Industry experts project a capital deficiency of RMB 75 billion by 2004, which is three times of its current equity.11 But two factors could alter these projections: 26 foreign insurers have reportedly received new licenses, life insurers are allowed to have 50% foreign ownership and non-life companies may form wholly-owned subsidiaries within two years of WTO entry. One successful example is AIG which re-entered the market in 1992 and gained a 10% market share of Shanghai’s life insurance market even under current restrictive conditions. Moreover, regulatory restrictions were partially relaxed on investment allocations, which now allow for up to 15% investments in equities, and minimum returns on unit-linked products have been lowered. This could put China’s insurance industry on a rapid growth path with direction towards Korea’s penetration rates with premium income of 10% of GDP. While China’s life insurance industry will likely remain the key institutional investor, the also fast growing mutual fund industry may become the key institutional asset manager. China currently has 14 fund management companies which run 45 securities investment funds with assets of $10 bn (1% of GDP) and annual growth rates of 35%. The first investment funds were established in 1991 and focused on real estate investment, but they were all closed at the end of 1997 as regulatory responsibility was transferred to CSRC. Currently, only securities and investment companies are allowed to establish mutual funds but ownership by banks is under consideration. Shares are traded on the stock exchanges but transparency remains low with reportedly wide-spread irregularities 9

Dorfman and Sin (2001) provide a more technical analysis of strategic options, which are based on the 2020 program as presented in World Bank (1997). 10 Goldman Sachs (2001) illustrates three scenarios for pension asset growth by 2030. 11 CICC (2000) provides a detailed overview of China’s insurance industry and analyses capital deficiency.


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including collusion and share-price manipulation. 12 Mutual funds are required to hold 20% of their assets in government bonds, and invest about 70% of their assets in equities. While returns have been impressive, concerns about their integrity and reputation have been raised. As a result, the State Council is currently preparing an investment fund law to strengthen corporate governance and to improve consumer protection. Liberalization under WTO agreements allows for joint ventures with 33% foreign ownership (49% after three years) and CSRC recently approved three open-ended mutual funds with foreign joint ventures. Professional management should allow mutual funds to continue its rapid growth, especially when so-called underground funds which are reportedly managing $85 billion will be transformed into regulated mutual funds.13 Assuming a current basis of $95 billion and annual real growth rates of 25%, the mutual fund assets could account for 27% of GDP within five years, which is comparable to Korea’s penetration rates today. The structure of China’s financial system could undergo significant changes in response to competitive pressures under WTO agreements. After allowing for universal banking structures in 1987, China divided its financial sector into four segments in 1993: banking, insurance, securities, and trusts. The new infant industries were nurtured and grew rapidly with regulation lagging behind. Over the past two years, banks have built partnerships with non-financial institutions, insurance companies have used banks as a distribution network, fund management and insurance products were combined, and some intermediaries were allowed to borrow in the interbank market. Banks have been particularly keen to undertake “agency roles” in the stock market in order to grow their intermediary business (8% of current profits vs. 50% in most international banks). China still has a restrictive financial system when it is compared with activities of international banking organizations. According to a 2001 global survey by the Institute of International Bankers, it was the only country among 44 surveyed where banks were not permitted altogether to engage in securities, insurance, real estate and investments in industrial firms (appendix 1). However, a debate was started by a PBC statement in July 2001 which suggested that “an urgent task is to pay more attention to universal banking.” Among the new proposals is the consideration of financial holding companies which could integrate the four segments into a structure of universal banking with subsidiaries or affiliates having access to capital markets. CSRC has also suggested to review banking and corporate laws in this context and to forge laws on mergers and acquisitions. Academics have also proposed to create financial conglomerates where the largest banks would merge with securities houses and insurance companies. In either case, the role of institutional investors would be significantly enhanced as capital markets move to center stage and generate the largest share of financial sector profits.14 12

Reported irregularities are based on research of a Shanghai Stock Exchange analyst, which were published by a financial magazine (Caijing, 2000) and are currently investigated by CSRC. 13 A recent report by Xia Bin (2001) estimates the present scale of underground funds at RMB 700 billion or nine times of regulated mutual fund assets, it identifies enterprises as main clients, and it concludes with eight policy suggestions on how to better integrate the regulatory framework. 14 Various articles on “universal banking” were published in mid-2001, for example the proposal by CSRC for mergers and acquisition laws (May 15, 2001 in China Hand and Chinonline), the proposal by PBC to move towards universal banking (July 25, 2001 in CBnet), and the proposal by CASS to create financial conglomerates (October 15, 2001 in Kyodo).


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4.

Policy actions

The previous section has illustrated the current status of institutional investors in China and proposals to transform the current segmented structure of financial markets in order to enhance their competitiveness. Clearly, macro-level reforms need to be complemented by specific policy actions at the micro-level which would help to create a more conducive environment for institutional investors, which in turn would lead to more comprehensive capital market development, higher productivity of capital and sustained economic growth. The discussion of these policy actions is divided into three categories: first, building markets with a focus to enhance entry and competition in capital markets ; second, strengthening institutions with a focus on market-oriented incentives and improved corporate governance ; and third, enhancing instruments with focus on interest rate liberalization and broader corporate bond market instruments. A.

Building Markets

A.1.

Fixed-income market development

China has been very successful in attracting foreign direct investment, which accounts for one third of all flows into emerging markets. In contrast, China has maintained a closed capital account for outflows and has attracted only 5% of portfolio inflows, as compared to 14% in Korea which had put an earlier emphasis on capital market development. As chart 2 illustrates, China also has a very small base of institutional investors with just 4% of the emerging market assets which again compares with shares of 15% for Korea and for Brazil which both have a very strong basis for mutual funds. There are three observations from this chart: There is a low correlation between real sector flows (FDI, mainly into Asia) and financial sector flows (PFI, mainly into Latin America). There is a some correlation between capital market development, openness and competitiveness (proxies for PFI) with institutional investor growth (esp. Hong Kong SAR, Singapore). There is also a high concentration in all three categories (70% for top-6 countries). Chart 2:

Concentration of Foreign Direct Investment ; Portfolio Investment ; and Institutional Investment (shares as % of emerging markets stocks, 2000)

Dom. Institutional Investment Others 19.9%

Portfolio Investment China

China 4. 2%

Others Hong Kong

4. 9%

24.7%

South Africa

China Brazil 19.7%

17.4%

South Africa

11.7%

Singapore 16.9%

Mexico 15.8%

Korea Korea 15.3%


Others

33.2%

29.9%

Malaysia 4.0%

7.3%

Brazil 14.6%

Foreign Direct Investment

13.8%

Argentina 13.8%

Singapore 6.0% Argentina 6.2%

Mexico 9.9%

Brazil 10.8%

Source: IMF and World Bank estimates for end-2000

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China’s relative focus on real sector investment combined with a relatively closed capital account also has implications for the structure of domestic capital markets, in particular the relation between fixed-income and equity markets. Chile is a good example, where strong pension funds and deep capital markets combined with restrictions on the capital account have tilted the balance towards equity markets as investors are constrained with few higher-yield instruments. Brazil, however, has taken a different direction, where very profitable and liquid fixed-income markets have become dominant and have attracted large portfolio inflows. The contrast is even larger between Hong Kong SAR and Singapore, which both have impressive capital markets and large institutional investor bases, yet Hong Kong SAR has focused more on equity markets (more SME, blue-chip listings, real-estate assets) in comparison to Singapore with focus on fixedincome markets (more conglomerates, asset-management focus, FX and derivatives). China appears to have favored equity market development as it was perceived as a more cost-effective tool in financing state-owned enterprises. Equity capital does not require payment of interest (dividend payments are optional) and does not require repayment of principal. However, shareholders are expected to take an interest in improving management of the company, in enhancing corporate governance, and in enforcing market principles so that share valuations continue to rise. It is assumed that after most SOEs have been listed, markets may force non-performing ones to close. This approach clearly shifts more risk on the equity holder and puts the issuer into a more favorable position. On the other side of the coin, institutional investors don’t like to be fed with non-performing assets, and the development of capital markets is stifled as medium- and small-sized private companies have no access to capital market financing. Competition among listed companies remains illusive, as long as no penalties arise from nonperformance, such as de-listing or closure. The focus on retail investors does not promote modern risk management or development of market infrastructure, and it may encourage speculative bubbles unless more supply and diverse instruments are offered. China also appears to have constrained fixed-income market development as a tool to both keep deposits growing at state commercial banks and to keep cheap bank lending to SOEs flowing at low interest rates. Captive markets on illiquid savings bonds have also been used to ensure cheap financing for the budget. However, by taxing interest income (20%) and trading profits (40%) the incentives for market development and liquidity are diminished and investments are increasingly shifted into higher yielding dollar deposits (the second largest in the world at $135 billion) or offshore into Hong Kong SAR. Moreover, as institutional investors can negotiate deposit rates with commercial banks,15 they may have little incentive to trade in capital markets where after-tax returns are often below deposit rates.16 The distortion of incentives is revealed by a key statistic of asset allocation of Chinese insurance companies, which in September 2001 were holding 54% of their assets in deposits or cash as compared to 24% in government securities, which is unique for any institutional investor in the world (appendix 3). 15

Deposit rates for institutional investors above US$ 3 million have been liberalized in September 2000. One of the largest insurance companies has negotiated deposit rates of 5.5% for 70-months deposits in September 2001 [as high as 7.5% in 2000] whereas bond market returns have been below 4% and retail deposit rates have been around 2%. 16


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International experience provides strong evidence that mature government securities markets are an essential component in order to build a solid basis of institutional investors. In fact, Chile has started by developing government bond markets after the pension reform in 1981 and only opened up equity markets in 1985. South Africa, Brazil, and Korea have developed fairly deep and sophisticated government securities markets which have attracted strong demand from institutional investors. Singapore and Hong Kong SAR have been issuing government bonds in significant size – although they are running a fiscal surplus – in order to develop markets, create institutional demand, and to provide benchmarks for corporate issuance. Singapore to date has issued government bonds of 25% of GDP with no budgetary need. And most Asian governments have stepped up the issuance of government bonds after the Asian crisis in 1997 as a tool for deepening capital markets in order to establish an additional financing anchor and to reduce vulnerabilities from short-term bank borrowings abroad. There is a consensus that fixed-income markets develop in parallel with equity markets, that government securities markets act as catalysts to attract institutional investor demand and that a level playing field is required. In the context of China, mutual funds could help in the development of short-term money markets and subsequently in government securities markets, but today there is not a single fixed-income mutual fund in existence. If mutual funds continue to focus exclusively on high-risk equity products there is a danger that their reputation could be tarnished, similar to the event in 1997 when all existing mutual funds were closed, but with longer-term implications. There has been a similar experience of Thailand’s mutual funds and Korea’s ITC, which performed very poorly during the Asian crisis and lost confidence of investors. Hence, it appears that the government needs to establish a level playing field and also needs to provide adequate incentives for institutional investors to engage in developing of fixed-income markets. A.2.

Supply of government securities

China‘s first government debt was incurred in 1953 to finance the economic recovery program, but issuance was suspended from 1958 to 1981. Since then, the government has gradually increased its issuance from RMB 20 bn (1% of GDP in 1990) to RMB 466 bn (5.2% of GDP in 2000). Financing has been used in three ways: for the general budget deficit ; for special fiscal stimulus programs ; and for bank recapitalization (onetime issue of RMB 270 bn in 1998). Three types of instruments have been offered: savings certificates (zero coupon, non-tradable, maturities up to five years, allowing early redemption) account for 48% of outstanding issues ; book-entry bonds (mostly interbank market, up to 20 years) account for 50% ; and special bonds (placements for specific investors) account for 2%. There are presently no issues of T-bills. The average time to maturity is 4.3 years and the average interest rate has dropped below 3.5%. China has pursued a policy of strictly centralizing and limiting debt issuance. Besides the central government, only the three policy banks can issue so-called financial policy bonds (about RMB 600 bn, mostly for infrastructure, sold to banks and insurance companies) which are also used by PBC for open market operations, some government agencies can


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issue so-called enterprise bonds (railway bonds, three gorges bonds, state power bonds), and select companies can issue corporate bonds (less than RMB 30 bn outstanding). Local governments and municipalities are not allowed to issue debt on their own. At the end of 2000, China’s total government debt accounted for RMB 2,000 bn (23% of GDP) of which 80% has been issued domestically. According to IMF estimates, quasi-fiscal liabilities of the Chinese government are at least 51% of GDP, which includes AMC debt of RMB 1,200 bn plus non-recoverable loans of the financial system of RMB 3,300 bn, plus estimated contingent liabilities17 from pension mandates of about 94% of GDP. 18 As it is illustrated in table 2, the stock of domestic debt could increase significantly once quasi-fiscal liabilities are included, although it could evolve in a gradual process. Table 2: China’s Government Debt and Contingent Liabilities (2000)

Government Debt Domestic Debt Treasury Bond Issuance Budget Deficit

bn RMB 2079 1677 466 325

%GDP 23.3 18.8 5.2 3.6

Quasi-Fiscal Debt SCB/SDB Debt AMC Debt Social Sec Cont Liab

bn RMB 4568 3361 1207 8404

%GDP 51.1 37.6 13.5 94.0

Sources: IMF, China Finance Yearbook, World Bank estimates. Data are estimates as of Dec 2000.

Institutional investors are having three major concerns with the current issuance policy:  First, over half of the market is captive which results from issuing savings bonds (recently reduced issuance to one third of total), from issuing policy bonds and enterprise bonds (rarely traded), and from tying remaining treasury bonds to reserve requirements and minimum holding requirements. The small and irregular size of issues and the main distribution to the interbank market further limits liquidity.  Second, the absence of a Treasury bill market hampers efficient pricing of the level and structure of baseline rates and the market-based formation of a yield curve, which appears to be still anchored at the 12-month deposit rate. Moreover, market makers often act as “price takers” and thereby further distort the price discovery process.  Third, the fact that at least two-thirds of China’s fiscal liabilities are managed offbudget is creating significant risks and uncertainties. Block-issuance will be more difficult to price, and such expectations could lead to pressure on interest rates. Moreover, the accumulation of large contingent liabilities of social security mandates could lead to a marked steepening of the yield curve when they become explicit. 17

This excludes public credit guarantees and unfunded liabilities for health and unemployment insurance. The government had decided to sell shares of SOEs in the equity markets (two thirds of the stock market capitalization represent state-held shares) and to use 10% of new IPO proceeds for the new National Social Security Fund. After equity indexes dropped by 30% in the third quarter of 2001, this policy has been temporarily discontinued, which keeps very large unfunded social security liabilities. 18


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As a result, it appears that the government might want to consider to gradually shift offbudget items to direct responsibility of MOF, which for example could be started by issuing long-term treasury bonds for the non-recoverable portions of AMC debt. 19 The supply could be further enhanced by replacing maturing savings bonds with liquid benchmark T-bonds and by implementing a T-bill program to improve price discovery. Policy makers may be concerned about the impact of shifting quasi-fiscal liabilities (such as AMC debt) on budget. However, international comparisons reveal (chart 3) that China’s domestic debt levels are relatively low, and real interest rates are among the lowest in emerging markets. Moreover, there is no clear relationship between higher domestic debt levels and higher real interest rates, as it is illustrated in the case of Singapore, where interest rates actually remain below LIBOR as its budget remains in surplus. China’s high savings rates and stable exchange rate have also contributed to low real interest rates. More transparency by managing quasi-fiscal liabilities on budget do not imply higher funding costs, unless new quasi-fiscal liabilities are created.20 Chart 3:

Real Interest Rates (CPI based) across Emerging Markets: Debt Stocks have little correlation but Flows (budget deficits) do matter

80

Real Int = 3.43 – 0.50 * Dflow – 0.04 * Dstock 2

R = 0.36

(2.97)

(2.56)

(1.40)

10 9

Domestic Debt / GDP (%)

60

7 6 5

40

4 3 20

Real Interest Rates (%)

8

2 1 0 K on g

ex ic o

on g

H

C

A

hi le

M

C

HI N

Po la nd

K or ea hi lip pi ne s P

ra zi l ha ila nd M al a ys ia T

B

ae l Is r

In di a In d on es ia Hu ng S ar ou y th A fr ic a

S

in ga p or e

0

Sources: IMF, World Bank, National Financial Statistics, data for end-2000.

19

Reportedly half of the AMC debt is currently held by PBC which may conflict with current regulations that PBC should not extend credit to the government. 20 This argument has often been used to delay the recapitalization of commercial banks as it is feared that new NPLs would emerge, but ultimately the existing stock will need to be financed by the government.


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A.3.

Market infrastructure and liquidity

Institutional investors usually offer a premium for liquidity, whereas captive retail investors rarely engage in trading. Therefore, enhancements in liquidity and related market infrastructure often create additional demand from institutional investors. Liquidity is defined in four dimensions: 21 width (bid-offer spread) ; depth (volumes at given price) ; immediacy (time to clear settle) ; and resiliency (time to return to previous prices after absorbing a large block trade). There are currently three major impediments to liquidity in China’s government securities market: the segmentation into the interbank and stock exchange markets ; the widespread misuse of repurchase instruments and restrictive money markets; and the inefficiencies in the clearing and settlement process, in addition to tax distortions and weaknesses in intermediaries. The segmentation of government bond markets is related to previous speculation in futures and repurchase markets. A repurchase contract (repo) is an arrangement in which securities are used as collateral to obtain a short-term loan of funds, which are commonly used to meet short-term liquidity needs of financial institutions. Until August 1997, commercial banks in China traded repos on Shanghai and Shenzhen stock exchanges, which were misused by securities firms to obtain long-term loans from commercial banks for speculation in equity markets. PBC then banned banks from stock exchanges and transferred their bond trading to the interbank market. The subsequent capital shortage at securities companies led to a PBC notice in late 1999 which allowed qualified securities and investment companies into the interbank market with permission to trade in repos. In terms of architecture, the interbank market (IBM) is similar to a quote-driven OTC system and largely depends on bilateral transactions over the phone. 22 The largest participants are the four state commercial banks, and the IBM is also functioning as money market where PBC conducts open market operations. In contrast, the stock exchange market (SEM) is based on a centralized cross-matching system in which dealers and end-users trade directly with each other without intermediation. The Securities Law stipulates that listed bonds must be traded through centralized competitive pricing and not through an OTC. In terms of volumes, 88% of new issuance in 2000 was placed as nonlisted bonds on the IBM, whereas it accounted for only 31% of government securities trading during that period, and for only 9% of spot trading. The segmentation of government securities markets into IBM and SEM has restricted price discovery and liquidity.23 On one hand, the large commercial banks and insurance companies in the IBM have a homogeneous set of investment preferences which makes trading more difficult and implies a premium for low liquidity. On the other hand, the securities companies with access to the IBM are mostly interested in repo operations. The regulatory uncertainty between PBC regulation of the IBM and CSRC regulation of 21

These four dimensions have been summarized by Davis and Steil (2001). However, counterparts are confined to members of IBM. In this regard, it would be characterized as a limited OTC market. 23 As an example, a recent 15-year issue in the IBM was priced at 4.69% as compared to a subsequent 20-year issue in the SEM at 4.26%, which indicates mis-pricing by at least 50 bp. 22


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the SEM also reduces transparency and adds transaction costs. Repo operations are reportedly continuing with pre-1997 patterns of illegally borrowing funds in the IBM for speculation in equity markets,24 which drain liquidity from the cash market and increase volatility. The market segmentation appears to have failed to achieve its stated objective. Moreover, IBM statistics indicate that repo transactions in the first half of 2001 accounted for 98% of all transactions (95% during 2000). It is highly unusual to have 50 times larger repo than cash trading, for example in Singapore the ratio is smaller than 1, and in Italy and Mexico the ratio is around 2. Turnover also remains repressed at just two times stock during 2000, which compares with seven times in the case of Korea and eight times in the case of Singapore. 25 Three regulatory practices are mostly responsible for the inefficiencies in cash money markets: market segmentation suppresses liquidity, restrictive PBC limits constrain cash operations26, and tax exemptions for repo transactions heavily bias transactions towards short-term repo operations.27 Inefficiencies in the clearing and settlement process explain why settlement can extend to T+5, why there is a long time lag before newly issued securities can be traded, and why DVP settlement is still not possible. The legal status of the China Depository Company (CDC) remains in flux as at least five organizations are involved in its supervision and after it was ruled that MOF and PBC should dispose of their ownership. The roles of sub-depositories (financial institutions and stock exchanges) and their relationship with CDC are not clearly defined.28 As this infrastructure is improving with the expected introduction of DVP in mid 2002, institutional activity may increase. To address these three concerns on market structure and liquidity, it has been suggested to consider integrating IBM and SEM,29 whereby mutual access for all participants would be granted and new issuance would be made through a single auction to all participants across markets. The interbank market would be strengthened through improved trading systems, harmonized tax structures, enhanced cash trading, and a level playing field for all participants. The stock exchange would upgrade its trading system to meet needs of all members30, which would be supported by strong regulations on repo transactions (limited collateral, fewer liquid instruments, master repo agreements, margin rules). At the same time, CDC would be designated as central clearinghouse and depository, and would obtain oversight functions of a self-regulatory organization.

24

PBC is reportedly continuing to investigate “unregulated money flowing to stock markets” (press reports, October 2001). 25 Even after excluding the large amount of savings bonds, turnover remains below four times stock with an excessive share of repo trading. 26 PBC regulations restrict local banks to 4% and 8% of customer deposits respectively for money market cash taking and placing limits, while foreign banks are limited to 150% of their RMB operating funds. Market participants identify these restrictions as main barriers to developing an effective CIBOR market. 27 Business tax and capital gains tax are applied to cash transactions, whereas repo transactions are exempt. 28 The lack of rules governing sub-depositories has been identified as main reason behind the current ban of non-financial investors holding marketable government securities. Similarly, banks are not allowed to engage in government securities dealing with end-investors. 29 This part draws on conclusions of a World Bank technical assistance report (MOF, January 2001). 30 It has been suggested to study Brazil’s electronic bond trading platform (SISBEX) which has different pits for market makers and other members and which handles over 50% of all government security trading.


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B.

Strengthening legal, regulatory, and institutional environment

B.1.

Performance incentives

China’s institutional investors have been subject to various regulatory constraints which have acted as disincentives for improved performance. Investment restrictions are the main concern which have created problems especially for insurance companies. Tax penalties on fixed-income investments and long-term savings are certainly detrimental in the establishment of any private pension programs. Collusion and lack of competition have also hampered mutual funds and partly explain the growth of underground funds. Regulators can address these three concerns and also draw on a rich experience in OECD countries and across emerging markets. Investment restrictions have often been justified by the need to protect retail investors and to limit volatility of investment portfolios. However, their track record has been negative, as returns have been reduced without an adequate reduction of risk. The literature reveals that risk-adjusted performance of pension funds across Latin America has suffered as a result of investment regulation.31 Pension funds have regularly underperformed their respective market benchmarks, but Chile’s pension funds have significantly improved their performance after investment limits were relaxed and private mangers were introduced at the beginning of the 1990s. The same observations appears to hold for closed-end equity mutual funds in China over the past three years, which had an average return of 35% as compared to equity index returns of 55%. The investment restrictions have been particularly painful for Chinese insurance companies, which on average had returns on their assets of below 4% in 2000, even after being allowed to invest up to 15% in equities. China has a “positive system” of investment options for financial institutions, which are permitted to invest only in those assets explicitly listed, restricting the ability to diversify portfolios. However, this system creates uncertainty about permissible actions. For example, in the case of the National Social Security Fund, there are presently no disclosed investment guidelines, and in the case of investment funds, the definition of “stocks” and “bonds” is not clear; leaving regulators exposed to ad hoc decisions. In turn, such regulation by exception creates rent-seeking behavior, where investors solicit regulatory approval for additional investment options.32 As it is illustrated in Box 2, investment limits and so-called draconian regulation are commonly observed in the initial stages of capital market development, but a gradual relaxation of these restrictions in a clear and transparent way is necessary to define general and specific investment rules. Appendix 2 shows investment limits for OECD countries as well as the evolution of investment limits in Chile, where annual real returns for pension funds have increased to 16% after liberalization.33 It is particularly important to note that Chile has opened up pension fund investments to foreign securities in 1992 31

An excellent summary for Latin America is provided by Srinivas and Yermo (1999). Insurance regulations illustrate the cumbersome approach: The Insurance Law (Article 104) allows investments into bank deposits, government and financial bonds, and other assets as approved by the State Council. CIRC then decided in July 1999 to include enterprise bonds and in August 1999 to allow interbank bond purchases and then in December 1999 to permit indirect investments in stocks through investment funds for up to 15% of total assets. 33 Statistics draw on OECD (2000), Grushka (2000), and Srinivas and Yermo (1999). 32


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(current limit of 12%). While pension funds in Latin America have typically held the majority of their assets in government securities or CDs (68% in the case of Chile), Asian pension funds have been holding a majority of assets in equities (50% in the case of Singapore’s CPF and 51% in the case of Hong Kong’s MPF). Although Hong Kong’s mandatory provident fund has only been established in 2000, it has immediately outsourced investments and held on average 41% of its assets overseas (as of June 2001). This suggests that additional limits for fixed-income mutual fund products and for limited international products (i.e. Hong Kong SAR) could strengthen institutional investors. Box 2: Regulation of private pension funds Regulations of private pension funds may fall into two models: ‘Relaxed’ regulations and ‘Draconian’ regulations. This classification may be applied for regulations of similar institutions including mutual funds and insurance companies. Main characteristics of the relaxed regulations include: a voluntary system with high individual choice and multiple providers, no minimum return rule nor state guarantees, and reactive supervision. In contrast, draconian regulations involve: compulsory system with limited individual choice and specialized providers, minimum return rule along with state guarantees, and proactive supervision. Draconian regulations has been applied in countries with weak capital markets and limited trading. Draconian regulations aim to offer safeguards, control moral hazard, and prevent early failures. In terms of investment regime, relaxed regulations are associated with a “prudent person” concept with adequate disclosure. In a draconian approach, on the other hand, detailed investment limits are established on the proportion of a fund that can be invested in particular assets or asset classes. In OECD countries, the prudent person rule is prevalent with implicit asset class limits and some individual limits. In some emerging economies, explicit asset class limits are more widely adopted. Given limited supply of instruments, it is easier to enforce explicit limits. The prudent person rule is more flexible, being more compatible with sophisticated financial markets. The draconian approach might be justified in the initial stages of development. It is, however, beneficial to relax draconian regulations without too much delay as local markets develop and systems mature. Source: Dimitri Vittas (1998) “Regulatory Controversies of Private Pension Funds”.

Tax incentives have commonly been used to develop domestic financial markets and infrastructure, to support long-term savings and investment, and to promote financial innovation and instruments. For example, individual retirement accounts in the US benefit from tax exemptions (only benefits are taxed when paid out) and municipal bonds and various money market mutual funds also benefit from tax exemptions to promote diversification into higher-risk fixed-income instruments. Singapore and Hong Kong SAR are good examples where tax exemptions have been used to build domestic fixedincome markets and to promote institutional investments:34 Singapore has waived all taxes on domestic debt securities (including for nonresidents), has exempted primary dealers from any profit taxes on bond market trading and financial institutions from taxes on their fee income from underwriting and distributing bonds, and has reduced taxes derived from swaps trading to 10% to further stimulate that market. Hong Kong SAR has exempted all exchange fund and multilateral agency debt from all taxes, has waived all profit taxes from interest and dividends for institutional investors, and has reduced by 50% all taxes on long-term investment grade debt issued in Hong Kong SAR.

34

Details are provided in the IMF documents “Singapore: selected issues” (No. 01/177, October 2001) and “Hong Kong SAR SAR: selected issues” (No. 01/146, August 2001).


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China’s distortionary tax regime appears to hinder the development of institutional investors and penalizes cash versus repo trading in government securities. Cash trading profits are taxed at 40% (33% capital gains tax plus 7% business tax) whereas repo transaction are exempt from business tax. Moreover, transaction taxes are among the highest in the world, stamp duty for equities is 6 bp plus two-way commission of 1.5%, in addition to an income tax on capital gains. The literature shows that transaction taxes have been significantly reduced or eliminated in most OECD countries during the past decade. In the case of the UK in the mid-1990s, it has been found that liquidity would have increased by 70% if the transaction costs were reduced from then 2% to 1% (with long-run elasticity of 1.65).35 Clearly, the current system of securities taxation in China is hindering the development of debt markets and of institutional investors. Competition in China’s mutual fund industry has been very limited, whereby only securities firms and ITICs are allowed to form fund management vehicles. There is not a single fixed-income mutual fund in existence which has limited the outsourcing by institutional investors. Moreover, it appears that Chinese banks are preventing mutual fund development by offering “special” negotiated rates for institutional deposits. In contrast, Korea has a highly competitive mutual fund industry accounting for assets of $125 bn or 27% of GDP, of which at least 20% is invested in money market funds. It is noteworthy, however, that competition includes banks and NBFI, which have gradually shifted retail deposits into capital markets, which improved their yield and provided feeincome to the intermediary. In the United States, money-market mutual funds have been introduced in 1974 and have been among the fastest growing sectors of the financial system. At the end of 1996, 28% of all US mutual funds held only assets that were fully tax-exempt, and at the end of 2000, money market mutual funds accounted for $1,728 billion of assets or 14% of all US investment funds. In general, mutual fund returns have significantly exceeded deposit rates, and transaction costs have recently declined dramatically. As a result, institutional investors could greatly benefit from the removal of investment barriers. This may require regulatory incentives to improve competition in the mutual fund industry and to support the entry of money market mutual funds. It may also require tax neutrality for qualified debt securities and intermediaries, as well as a gradual relaxation of investment limits, especially in the case of insurance companies. B.2.

Institutional capacity and corporate governance

Assuming that all incentives are set correctly, institutional investors also require an institutional structure that shares information on borrowers, that promotes good corporate governance, that effectively enforces prudential standards, and builds institutional capacity. All four elements are critical to improve the operating environment in China. The economic literature demonstrates that asymmetric information between the borrower and the lender poses problems of adverse selection and moral hazard and makes it impossible for the price of the loan or interest rate to play a market clearing function. Credit markets with problems of asymmetric information typically tend to ration credit. Credit information registries can reduce the extent of asymmetric information by making 35

Claessens and Klingebiel (2001) provide a good summary on transaction taxes.


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the credit analysis available to lenders. Although China has a large number of credit rating agencies and has established a joint venture company with strong international experience, credit ratings are mostly not required nor valued, and non-transparent licensing has enabled rent-seeking by many weak regional credit rating agencies. For example, PBC requires ratings for commercial bank loans to employ the many related regional credit agencies. In contrast, PBC has ruled that bond issues by commercial banks do not require ratings, and CSRC has decided that convertible bond issues may have “optional” ratings. Unless regulators follow international best practice and require qualified credit ratings for all issuance and allow for differential credit pricing, there is very little incentive for institutional investors to develop corporate bond markets. Good corporate governance has been a buzzword since the Asian crisis, and a recent survey has found that institutional investors in fact pay a premium for assets or companies that have good corporate governance.36 For example, the survey among international institutional investors found that corporate governance in Korea is perceived to be relatively good but still lagging behind US standards. As a result, institutional investors would on average pay a premium of 24% for Korean companies that have the best corporate governance, in other words, corporate governance is as important as financial performance in pricing securities. Another concrete example is Brazil, where a “novo mercado” has been established for companies that are meeting best practice for information disclosure and corporate governance. Moreover, in Thailand an “Institute of Directors” has been established to enforce international accounting standards and to review the independence of company boards.37 In China, progress on transparency and corporate governance has been slow, ownership and boards of intermediaries and insurance companies are still widely controlled by the state, but the establishment of selfregulatory bodies and the enforcement of international accounting standards have been helpful. China’s Security Association has been joined by the Investment Fund Association in August 2001 to help in market development and self-regulatory oversight. Enforcement of prudential standards is also essential to build confidence among market participants about the rules of the game, in particular regarding capital adequacy. On one hand, institutional investors need to rely on adequately capitalized intermediaries, on the other hand, they themselves need to be transparent to protect retail investors. Action is often taken after a crisis, as in the case of Canada in 1993 when one of the largest insurers failed and the supervisory regime was re-engineered, and in the case of Korea, where the Insurance Law was significantly strengthened and 13 out of 50 insurance companies were closed after the Asian crisis. In China, serious concerns have been raised about the capital base of securities and investment companies, which may need to be consolidated. Moreover, investment banking research has revealed that most of the Chinese insurance companies are seriously under-capitalized and that the existing equity needs to be quadrupled within three years. 38 In both cases, ownership structures may need to be changed and institutional capacity in risk management may need to be 36

International investor opinion survey conducted by McKinsey & Company and the Asia Pacific Institute of Institutional Investor Magazine, October 1999. 37 Mako (2001) summarizes a range of corporate governance issues in the Asian context. 38 st CICC (November 2000) “Looking to the 21 Century: an analysis of China’s Insurance Industry”.


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enhanced in order to strengthen the financial viability. Box 3 illustrates the importance of transparency and risk management in case of Korean investment funds. Box 3: Weak regulation of Korea’s investment funds In Korea, investment funds operated by investment trust companies (ITCs) have been established since the 1970s and are covered by an elaborate legal and regulatory framework. Penetration of investment funds in Korea has been among the highest in emerging economies. At its height in 1999, the ITC sector was as big as the volume of deposits at commercial banks. However, the ITC sector suffered from a lot of problems, eventually being bailed out by the government in 2000: First, most of funds were not marketed to market and inter fund transfers were common to smooth returns. Korean investment funds were widely regarded as quasi-bank accounts by investors. Second, many investments were concentrated into corporate bonds issued by top five conglomerates, including the illfated Daewoo group. Third, poor risk management led to a mismatch between assets and liabilities. With a large portion of liquid liabilities, especially from financial institutions, the ITCs invested in relatively longer-term assets. This mismatch led to a systemic risk when a collapse of Daewoo group triggered a run on redemption in 1999. A massive amount of corporate bonds, major investments of the ITCs, could not be sold at fair prices. Fourth, although the legal and regulatory framework contained strong principles, they have been weakly enforced. Custodians were not genuinely independent and did not exercise oversight. The regulators were slow to identify and punish malpractices such as commingling of customer assets, offering of a guarantee, and concentration of investments. The Korean experience suggests that when key principles -- such as transparency, accounting rules, valuation methods, independent oversight, risk management guidelines -- are not consistently enforced, an explosive growth of the sector may not be sustainable.

B.3.

Legal and regulatory environment

Particular attention has been devoted to changing the Company Law, to establishing a Public Debt Law, to finalizing an Investment Fund Law, and to amending the Commercial Banking Law. All four laws are critical to establish a legal and regulatory environment that is conducive to financial innovation: China’s regulatory framework appears to be highly fragmented. In the context of bond markets, at least five regulators are involved: MOF for the primary market of government securities, PBC for financial policy bonds, CSRC for listing of enterprise and corporate bonds, CIRC for insurance companies, and SDPC for issuance of corporate bonds. Each regulator issues its own set of rules and regulations39 , which are not always consistent with each other, and which create ambiguities and uncertainties. Consolidation of regulatory authority on all debt securities could designate CSRC as lead regulator, which would include all secondary markets for non-governmental bonds. 40 One option to realize that consolidation would be to re-define “securities” in the Securities Law to include all types of bonds, while exempting government bonds from prospectus needs. 39

More than twenty ad hoc rules have been issued by different regulatory bodies in the bond markets. The Securities Law (Article 2) explicitly confines the role of CSRC in the government securities market, stipulating that “the issuing and trading of government bonds shall be separately provided for laws and administrative regulations.” 40


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Moreover, China does not have a Public Debt Law41 that exclusively regulates government public debt, and it instead relies on a set of regulations which leave many loopholes. For example, procedures on the borrowing limit and parliamentary approval, on the legal underpinning of marketable book-entry government securities, on secondary market regulation, on the status of CDC, and on the relationship between regulators have not been clarified by law. Therefore, it would be helpful to formalize these procedures either by amending the State Budget Law or by establishing a new Public Debt Law. China’s Company Law has been identified as a major hurdle to financial innovation, financial sector restructuring, and corporate bond market development. It has adopted the European Civil law tradition, thereby dictating a very rigid capital structure. For example, to issue corporate bonds, a company must meet the following conditions (Article 160): (a) for a joint stock company, its minimum net asset value is RMB30 million, and for a limited liability company, RMB60 million; (b) cumulative value of the bond issues may not exceed forty percent of the company’s net asset value; (c) average distributable profit for past three years must be sufficient to cover interest on the company bonds for one year; and (d) interest rate for the bonds shall not exceed the State Council set ceiling.42 Reviewing outdated provisions on mergers and acquisition, on capital structures, and on allowing more innovative financial products could strengthen the Company Law. CSRC’s decision to allow open-ended mutual funds with foreign joint ventures into the market has improved transparency and has opened a potentially huge market segment. However, a key stumbling block is the issue to regularize the large reported underground funds, which needs to be addressed in the Investment Fund Law that has been in preparation by the State Council for the past two years. It appears to be essential to create a competitive, well regulated environment that can underpin an expected rapid growth of this market, and which allows banks and insurance companies full access,43 which includes specialized private, umbrella and guarantee funds, which prevents conflict of interest, protects investors, provides for segregation of assets and proper oversight, and adopts strict accounting and disclosure requirements. Market participants have suggested that one way to include underground funds is to shift from currently “rigid entry barrier and lax enforcement” to a new regime of “relaxed entry but very strict enforcement”. This may involve an amendment to the Commercial Banking Law to ease the current strict segregation principle, which prohibits commercial banks from direct access to capital markets and fund management, although they can indirectly engage through repo transactions with securities firms. Unless commercial banks are officially allowed access to professional fund management, it will be impossible to regulate widespread underground fund management which is reportedly driven by large institutional clients. 41

A Government Securities Law has been drafted in 1997 but was never adopted by the State Council. The Company Law does not allow bonds with warrants or option-linked bonds. Further, unclearly defined is the coordination between the Securities Law and the Company Law. More details are provided by Kim (2001) “Legal and regulatory issues in China’s securities market” (mimeo). 43 According to the CSRC circular of May 25, 2001, the promoters of fund management companies will not be limited to securities companies and trust and investment companies but also include other entities which are qualified and approved by the CSRC. All applicants need to submit their self-discipline promise to the stock exchange twelve months prior to the date of application to establish a fund management company. 42


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C.

Enhancing instruments

C.1.

Interest rate liberalization

China has used domestic interest rates as pivotal policy tool to direct credit and influence market structures. Economic reforms promoting the growth of the private sector have been integrally linked to financial reforms on liberalizing interest rates. While nominal interest rates have declined rapidly, real rates have turned positive since 1996. Today, administered short-term interest rates remain well below rates in the US and Hong Kong SAR. Lending rates have also been partially liberalized as commercial banks are allowed up to 30% discretion from basic rates. However, administrative limits on bank lending and deposit rates are remaining, but need to be phased out gradually in the near future. There are thee main reasons why further liberalization of interest rates is inevitable:  Capital controls are becoming ineffective in the process of globalization and increased trade and financial integration. Institutional investors have a choice of avoiding domestic bond markets by shifting offshore into dollar deposits (already 15% of GDP) or by shifting into Hong Kong SAR through unregulated vehicles or capital flight (estimated above 2% of GDP each year). Negative spreads to US rates will only be sustainable with expectations of an appreciating exchange rate.  Foreign financial institutions are already competing for domestic savings. The growth of insurance premia is partly driven by a shift of precautionary savings into better performing instruments (fast growth of unit trusts). WTO agreements promise foreign financial institutions to have access to domestic deposits within a few years, which will require improved competitiveness of domestic commercial banks which can no longer rely on preferential treatment through controlled interest rates.  Economic growth has been limited by credit rationing and lack of access for private firms, which only account for a small fraction of lending and zero debt capital market financing.44 Unless lending rates are liberalized and de-coupled from capital market rates, this large market segment may be exclusively serviced by foreign competitors. Moreover, the expected massive need for infrastructure financing may not be realized unless institutional investors are rewarded with more return for higher risks.

From a perspective of institutional investors, investment decisions in bond markets are made across the yield curve for a variety of credits, on- or off-shore, with or without hedging, depending on the asset-liability mix of their balance sheet. Anticipating the ongoing liberalization of the real economy and the implementation of WTO promises, it appears necessary to consider three specific steps in further liberalizing interest rates:45

44

Gregory and Stenev (2001) conducted a survey among private firms in China and found that 80% considered their lack of access to financing a serious constraint for future growth. 45 Conventions on expressing interest rates are not following international practice. For example, five-year fixed loan rates are adjusted annually with the prevailing five-year rate.


October 2001

page -24-

Chart 4:

Chinese Interest Rates (1996 and 2001) versus UST

10

8

Banks (96) Banks (01)

6

GovSec(01)

%

Corp(00/01)

4

UST(01) USCorp(A)

2

0 7-day 1-m

3-m

6-m

1-yr

2-yr

5-yr

10-yr 20-yr

Sources: Chinabond.com.cn and Bondsonline.com ; data as of August 30, 2001.

First, liberalization of interest rates does not imply rising rates but differentiation of rates. Chart 4 illustrates the dramatic shift of nominal interest rates over the past five years (diamond and square symbols, administrative rates for August 1996 and August 2001) which declined by 1% in the short-end and 6% at the long-end. Interest rates could remain below US rates, as it is shown in the example of Singapore with persistently negative spreads. However, differentials for corporate credits need to be much larger than an average 70 bp during the past two years. In the US, credit spreads for single A corporates in seven year paper exceed UST by 150 bp (zero and plus symbols). Also, higher-risk infrastructure financing will be constrained by existing bands. Hence, wider bands and larger differentiation of lending rates for corporate credits are needed. Second, liberalization of interest rates does not imply loosing control over short-term targets but market orientation of longer-term rates. Chart 4 reveals that one-year deposit rates continue to act as anchor for one-year treasury bond yields (pink versus red lines), which would normally be market-determined in treasury bill markets. Moreover, the shape of the current yield curve is very similar to the US yield curve, which may not be realistic for long-term rates. Typically, large quasi-fiscal liabilities create expectations of higher long-term interest rates especially when markets are integrated and excess demand has been met. Moreover, bank interest margins also remain 50% below the average of emerging economies,46 which corroborates the suggestion that more flexibility on longer-term lending rates is required, whereas prohibitively high deposit rates for institutional investors appear to be unsustainable and may create moral hazard.

46

A more complete analysis of interest rate developments and interest margins is Honohan (2001).


October 2001

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Third, liberalization of interest rates does not imply higher volatility but greater market depth. The fact that 98% of all interbank market trading is currently taking place in repos suggests that there is both a need for more short-term funding through treasury bills and a need to trade along the yield curve. This pressure would be alleviated by simply allowing short positions on government benchmark securities along the yield curve,47 which would also allow traders to take a view on future interest rate changes. Allowing short positions would also be a helpful step towards re-establishing futures and swap markets, it would greatly support the performance of fixed-income mutual funds, and would enable better asset-liability management of institutional investors. Experience in other Asian economies has shown that additional instruments create more demand, deeper markets, and less volatility, especially in the presence of a closed capital account.48 Hong Kong’s experience in introducing short-trading reveals that liquidity can be greatly improved while risks are manageable by requiring a net long position for investors.

C.2.

New product development

Mature capital markets are characterized by the existence of derivative instruments that allow risk-sharing and hedging of positions. The literature identifies a number of positive effects from derivative instruments:49 higher liquidity, lower volatility, easier market access, lower transaction costs, and improved depth of the market. On the other hand, suspicion has been raised on whether speculators could destabilize underlying cash markets, especially in the presence of institutional weaknesses. This has been the case in China, where the incident known as “accident GS 327” on February 23, 1995 led to the closure of futures markets when speculation on futures of three-year government bonds exceeded nine times of its outstanding stock. At the root of the problem was institutional weakness, especially the absence of margin requirements50 and standardized contracts, widespread overdraft trading, and confusion among four regulatory agencies. However, the vast majority of the empirical evidence (incl. in emerging economies such as Brazil, Mexico, and Hungary) shows that derivative markets have a stabilizing function and that temporary problems can be resolved through regulatory action and strong institutions (as it has repeatedly been demonstrated in Hong Kong SAR since 1997). By allowing markets to share risks, the efficiency of capital in general can be improved. Chinese institutional investors have eagerly requested the re-opening of futures markets under stronger institutions and streamlined regulation. They are pointing to numerous benefits that could enhance demand by domestic institutional investors, reduce risks of

47

A pilot model could initially limit number of securities and volumes, and it would provide a good indication in risk preferences of market participants and needs for additional instruments. Large short positions are an indicator that interest rates are not yet at market-clearing levels. 48 Both Singapore and Hong Kong SAR have developed very deep derivative markets that have proven supportive for their government securities markets. 49 An excellent summary of the literature is provided by Jochum and Kodres (1998) who also apply their analysis in Mexico, Brazil, and Hungary and find that futures markets usually reduce cash market volatility. 50 Rather than requiring at least 5% initial margin deposit, Chinese exchanges agreed on 2.5% in Shanghai, 1.5% in Shenzhen, and 1% in Wuhan, without enforcement of overdraft trading prohibitions.


October 2001

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asset-liability mismatches, and even attract qualified foreign institutional investors.51 In fact, Singapore and Hong Kong SAR are experiencing the benefits of foreign portfolio inflows as they both are part of the main local market index ELMI+, each holding a share of 10%, and Singapore was recently also included in the main global government bond index GBI which reportedly has contributed to new inflows which could be as high as $10 billion each in the cases of Hong Kong SAR, Singapore, and Brazil.52 However, it would appear to be prudent for China to first strengthen institutional capacity especially in the area of risk management of banks, intermediaries and investment funds which require more sophisticated finance skills to properly diversify risk and reduce ALM mismatches. Moreover, it would be desirable to strengthen market infrastructure with standardized contracts, margin requirements, a strong clearing house, and integration of regulators to CSRC in order to allow effective enforcement of regulations. The introduction of new instruments could then prove highly beneficial to enhance the role of institutional investors, to deepen fixed-income markets, and to reduce vulnerability. Sequencing might proceed by starting with index instruments, then futures, and swaps, options, and other derivatives. C.3.

Corporate bond markets

Mortgage-backed securities, asset-backed securities, convertible bonds, and diverse corporate bonds are four other products that have evolved in more mature capital markets, where government bonds are utilized for setting benchmarks. These products truly enable risk-sharing of the private sector through the capital markets and as a result they have been greatly contributing to raising the productivity of capital. Mortgage and other asset-backed securities have the appealing feature of collateralizing and therefore reducing risk for the investor and, at the same time, substantially increasing the creditworthiness of the borrower as a real or financial asset is leveraged to mobilize liquidity. While China currently does not have any of these products except for a few corporate bonds (less than 1% of GDP), other comparator countries have issued corporate bonds accounting on average for 15% of their GDP (21% in Korea, 30% in Singapore). This appears to be an area of great potential for China, albeit in a medium-term perspective. Institutional investors are often interested to take both equity and debt positions in corporations so that they can diversify their risk and have a maximum impact of good governance and management of the company. Moreover, corporate debt offers a new asset class for portfolio diversification, and is attractive for institutional investors that look for “high-yield” products. In this respect, a corporate debt market would be a very valuable complement to China’s dominant equity market and evolving government debt market, and it would allow access for medium- and smaller-sized firms to capital market financing. Moreover, it would help to reduce volatility by providing a more stable source of financing than equity markets, which are highly cyclical and often do not allow companies to raise new financing.

51

The Chinese government is reportedly considering the introduction of a “Qualified Foreign Institutional Investor” scheme, similar to the one currently in effect in India and Taiwan ROC. 52 This section draws on statistics provided by Kaminsky et. al. (2000).


October 2001

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However, three obstacles need to be managed before a meaningful corporate debt market can emerge in China: first, regulatory uncertainty needs to be resolved by determining a lead regulator for all aspects of corporate debt. Currently, SDPC maintains a queuing system for corporate debt issuance, which has been marginal and mostly limited to SOEs, which could be replaced by a disclosure-based review system operated by CSRC. Second, the Company Law needs to be revised to allow for a more flexible structure of capital and to allow for hybrid types of bonds (such as warrant- or optionlinked bonds) and legislation for the asset disposition process needs to be strengthened. Third, interest rates need to be further liberalized to allow wider bands of at least 50% around base lending rates for higher-risk corporate debt. This would effectively lead to maximum rates of about 9% for corporate issuers, which are still far below rates in the informal economy, where small companies often pay rates above 20%. There may be one alternative approach to jump-start the corporate bond market under existing constraints, which would be to issue convertible bonds, which are already under CSRC jurisdiction, which have previously been issued under existing legislation, and which could be attractive for institutional investors even under existing interest rate caps due to the embedded equity option. One example might be for the government to sell its remaining shares in SOEs through convertible bonds rather than through cash markets, which might help to stabilize the currently jittery equity markets while at the same time strengthening corporate governance through bondholders which will most likely be institutional investors. This could provide an early pilot model to establish what could become one of Asia’s largest fixed-income markets. 5.

Priorities and conclusion

This paper has illustrated the critical importance of institutional investors in further developing China’s capital markets, both in enhancing demand for government securities and in improving productivity of capital through new capital market instruments. Three main themes have been identified: Consolidation – Origination – and Innovation. 

Consolidation of financial markets is closely related to access for commercial banks to capital market operations through financial holding companies, allowing them to shift deposits to more profitable areas and to rebuild competitiveness. This could also improve competition among mutual funds. Unless key commercial banks embrace capital markets as a future opportunity, their development is likely to be stifled.



Origination through market principles requires shifting quasi-fiscal liabilities on budget and enhancing supply at liberalized interest rates on a level playing field. Professional fund management of insurance companies, evolution of fixed-income mutual funds, and continuing reform of pension and social security funds will be essential pillars of future diversified demand for fixed-income securities in China.



Innovation with fixed-income products could substantially improve risk-sharing in capital markets and enhance productivity. Liquidity could be enhanced by hedging products; money markets could be strengthened by balanced taxation and regulation; and transparency could be greatly improved by regularizing underground funds.


October 2001

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There are two significant events for Chinese capital markets: the accession to the World Trade Organization with the gradual implementation of liberalization commitments ; and the opening of China’s capital account with increasing international financial integration. These events will require a number of policy measures related to markets, institutions, and instruments which are graphically illustrated with some details in chart 5.  Market development needs simultaneous attention to equity and fixed-income markets, a modern financial sector structure, strong mutual funds, increased supply of government bonds and bills, and integration of the two segmented securities markets.  Institution building requires liberalizing investment limits, reducing tax distortions, promoting contractual savings, improving corporate governance with better accounting and disclosure standards, and enhancing of the regulatory framework.  Diversification of instruments requires further interest rate differentiation so that capital market returns are competitive as compared to institutional deposit rates, building a strong foundation for derivative markets, and promoting corporate bonds. Institutional investors could then follow Korea’s successful path and grow rapidly from currently 6% of GDP to about 30% of GDP over the next five years. The evolution of China’s capital markets from little transparent retail segments towards an institutional risk-sharing mechanism would not only underpin future economic growth but also provide a new pillar of financial stability while the financial system reinvigorates itself.

Chart 5:

China’s Puzzle of Developing Institutional Investors and Capital Markets

la st

Financial conglomerate structures to enhance competitiveness New competition in fixed- income mutual fund products

Investment Fund Law to regularize underground funds Consolidated regulatory structures and collaboration Gradual interest-rate liberalization, de-link from deposit rates New hedging products (short selling) for institutional needs Corporate bond issuance to enhance corporate governance.


cruci al

SE Q UE

More market-oriented issuance of Government securities

Insurance AM

Corporate

N CE

Professional asset management of insurance company assets

Mutual Funds

Regulation

GS Supply

Bank access MARKETS

now

October 2001

Inv Fund Law INSTITUTIONS

WTO member

T IME

Hedging

Interest rates INSTRUMENTS

C/A open

page -29-

6.

References

Asian Development Bank, 1999, “Rising to Asia’s Challenge: enhanced role of capital markets”, policy paper RETA 5770, March 1999. Bank of International Settlement (BIS), 2001, “Consolidation in the Financial Sector”, Group of Ten, January 2001. http://www.bis.org/publ/gten05summ.pdf

Bank of International Settlement (BIS), 1999, “Strengthening the Banking System in China: issues and experience”, Conference Volume, March 1999. Bank of Korea, 2001, “Financial Sector Restructuring in 2000”, Quarterly Bulletin, March 2001. http://www.bok.or.kr/index_e.html

Bank Negara Malaysia, 2001, “Financial Sector Masterplan”, March 2001. http://www.bnm.gov.my/feature/fsmp/en_ch02.pdf

Bank of Thailand, 2001, “Trends and Prospects of Thailand’s Banking and Financial Sector and its Impacts on the Thai Economy”, May 2001. http://www.bot.or.th/BOTHomepage/General/PressReleasesAndSpeeches/Speeches/english_version/Speech4May/speech.pdf

Berg, Andrew, 1999, “The Asia Crisis: Causes, Policy Responses and Outcomes”, IMF Working Paper WP/99/138, International Monetary Fund. http://www.imf.org/external/pubs/ft/wp/1999/wp99138.pdf

Blommestein, Hendrikus, 2001, “Key policy issues in developing fixed income securities markets in emerging market economies” in: Bond Market Development in Asia, OECD. Blommestein, Hendrikus, 1998, “Impact of Institutional Investors on Financial Markets”, in: Institutional Investors in the New Financial Landscape, OECD. Chile Ministry of Finance, 2001, “Chile: capital market reform”, April 20, 2001. http://www.minhda.cl/castellano/inicio.html

China International Corporation Limited (CiCC), 2000, “Looking to the 21st Century: an analysis of China’s Insurance Industry”, November 2000. Claessens, Stijn and Daniela Klingebiel, 2001, “Corporate governance reform issues in the Brasilian Equity Markets”, mimeo, The World Bank. Davis, E. Philip and Benn Steil, 2001, Institutional Investors, MIT Press. Dorfman, Mark and Yvonne Sin, 2001, “China: Social Security Reform – Technical Analysis of Strategic Options”, World Bank HDN. Deutsche Bank, 2001, “Local Debt Markets” in Hong Kong, Korea, Singapore, Thailand ; GM Research. Deutsche Bank, 2001, “China’s Financial Liberalization Agenda”, May 2001. Fischer, Bernhard, 1998, “The role of contractual savings institutions in emerging markets”, in: Institutional Investors in the New Financial Landscape, OECD. Gao, Jian, 2001, “Debt Market in China” in: Bond Market Development in Asia, OECD. Goldman Sachs, 2001, “Capital Markets are Transforming China”, Global Economics No. 61.


October 2001

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Grushka, Carlos, 2001, “An overview of the reformed pension systems in Latin America”, in: “OECD Private Pensions Conference No. 3”, OECD. Gregory, Neil and Stoyan Tenev, 2001, “The Financing of Private Enterprise in China”, Finance & Development, March 2001. http://www.imf.org/external/pubs/ft/fandd/2001/03/gregory.htm

Harwood, Alison, 2000, “Building Local Bond Markets: an Asian perspective”, Int Finance Corporation. Heilmann, Sebastian, 2001, “Der Aktienmarkt der VR China: staatliche Regulierung und institutioneller Wandel”, Trier University, May 2001. http://www.asienpolitik.de/pdf/aktienmarkt1.pdf

Holzmann, Robert, 1997, “Pension Reform, Financial Market Development, and Economic Growth: preliminary evidence from Chile”, IMF Staff Paper 44(2), June 1997. http://www.imf.org/external/pubs/cat/longres.cfm?sk=1925.0

Holzmann, Robert, 2000, “The World Bank approach to pension reform”, International Social Security Review 53(1), January 2000. Hong Kong Mandatory Provident Fund, 2001, “MPF Statistical Digest”, September 2001. http://www.mpfahk.org/eng/download/14_7.htm

Honohan, Patrick, 2001, “Notes on prospects and policies for China’s liberalized interest rates”, mimeo. Impavido, Gregorio and Alberto R. Musalem, 2001, “Contractual Savings, Stock and Asset Markets”, WP 2490, The World Bank, January 2001. http://econ.worldbank.org/files/1300_wps2490.pdf

International Monetary Fund, 2001a, “Korea: selected issues”, IMF Staff Country Report 01/101, July 2001, International Monetary Fund. http://www.imf.org/external/pubs/ft/scr/2001/cr01101.pdf

International Monetary Fund, 2001b, “Hong Kong SAR: selected issues”, IMF Staff Country Report 01/146, August 2001, International Monetary Fund. http://www.imf.org/external/pubs/ft/scr/2001/cr01146.pdf

International Monetary Fund, 2001c, “Thailand: selected issues”, IMF Staff Country Report 01/147, August 2001, International Monetary Fund. http://www.imf.org/external/pubs/ft/scr/2001/cr01147.pdf

International Monetary Fund, 2001d, “Singapore: selected issues”, IMF Staff Country Report 01/177, October 2001, International Monetary Fund. http://www.imf.org/external/pubs/ft/weo/2001/02/index.htm

International Monetary Fund, 2001e, “World Economic Outlook”, Oct 2001, International Monetary Fund. http://www.imf.org/external/pubs/ft/weo/2001/02/index.htm

Investment Company Institute, 2001, “Worldwide Assets of Open-End Investment Companies”. Jochum, Christian and Laura Kodres, 1998, “Does the introduction of futures on emerging market currencies destabilize the underlying currencies ?”, IMF Staff Papers 45(3), September 1998. Kaminsky, Graciela et. al., 2000, “Mutual Fund Investment in Emerging Markets: an overview”, Working Paper 2529, The World Bank, September 2000. http://econ.worldbank.org/files/1359_wps2529.pdf

Kim, Yongbeom, 2001, “Law and Regulatory Issues in China’s Securities Market”, mimeo, World Bank. Kumar, Anjali et. al., 1997, “China’s Emerging Capital Markets”, FT Press, June 1997.


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Leckie, Stuart, 1999, “Pension Funds in China”, ISI Publications. Mako, William P, 2001, “Corporate Restructuring Strategies: recent lessons”, mimeo, The World Bank. Monetary Authority of Singapore (MAS), 2000, “Financial Sector Liberalisation: going global”, presentation by DPM Lee Hsien Loong, April 2000, Singapore. http://www.mas.gov.sg/newsarchive/news_policyindex.html

Neoh, Anthony, 2000, “China’s domestic capital markets in the new millennium”, ChinaOnline, Aug 2000. OECD, 1998, Institutional Investors Statistical Yearbook. People’s Bank of China, 2000, “China Financial Outlook”. People’s Bank of China, 2001, “Almanac of China’s Finance and Banking, 2000”, Beijing. Shin, Inseok and Hongkyu Park, 2001, “Historical Perspective on Korea’s Bond Market: 1980-2000”, Working Paper, Korea Development Institute, March 2001. Shirai, Sayuri, 2001a, “Searching for new regulatory frameworks for the intermediate financial market structure in post-crisis Asia”, ADBI Research Paper No. 24, September 2001, Asian Development Bank. http://www.adbi.org/PDF/wp/wp24.pdf

Shirai, Sayuri, 2001b, “Overview of Financial Market Structures in Asia”, ADBI Research Paper No. 25, September 2001, Asian Development Bank. http://www.adbi.org/PDF/wp/wp25.pdf

Swiss Re Sigma, 2000, “Emerging markets: the insurance industry in the face of globalisation”, Research Report 4/2000. http://www.swissre.com/

Srinivas, P.S. and Juan Yermo, 1999, “Do investment regulations compromise pension fund performance?”, LAC Viewpoint, World Bank. US Department of State, 2001, “Fund Management in China”, mimeo, April 2001. Vittas, Dimitri, 1998, “The Regulation of Private Pension Funds”, The World Bank. Vittas, Dimitri, 1999, “Institutional Investors and Securities Markets: which comes first?”, Working Paper 2032, The World Bank. http://econ.worldbank.org/docs/364.pdf

World Bank, 1997, “China 2020: Old Age Security and Pension Reform in China”. World Bank, 2001a, “Developing Government Bond Markets: a handbook”, July 2001. World Bank, 2001b, “The China Government Bond Market”, FSTA report, mimeo. World Bank, 2001c, “Finance for Growth: policy choices in a volatile world”, May 2001, The World Bank. Xu, Xiaoping, 1998, “China’s Financial System under Transition”, Macmillan Press. Yermo, Juan, 2000, “Institutional Investors in Latin America: recent trends and regulatory challenges”, in: “Private Pension Systems and Policy Issues, No. 1”, OECD. Zhou, Jianping, 2000, “Causes of Financial Crises and Implications for China” in: Financial Market Reform in China, Westview Press.


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7.

Appendix 1: Permissible activities for banking organizations

Country

Securities

Insurance

Real Estate

Australia

Permitted

Limited

Brazil

Permitted through subsidiaries

Permitted through subsidiaries Permitted through subsidiaries

China

Not Permitted

Not Permitted

EU

Not Applicable Permitted

Not Applicable Permitted through subsidiaries

Japan

Some services (selling of government bonds, investment trusts)

Korea

Permitted through affiliates

Some services (selling insurance policies in connection with housing loans) Permitted through affiliates

Poland

Partially permitted

Russia

Bank Investment in Industrial Firms Permitted with limits

Limited to holding bank premises Not Permitted Not Applicable Limited; Unlimited through subsidiaries Generally limited to holding of bank premises

Limited to suppliers to the bank

Limited to 60% of bank capital

Prior approval for investments in excess of 15%

Permitted

Permitted

Permitted

Not permitted

Not permitted

Singapore

Permitted with MAS approval

Permitted with MAS approval

United States

Permitted, but underwriting and dealing in corporate securities must be done through: 1) a nonbank subsidiary of a bank holding company; 2) a nonbank subsidiary of a financial holding company; 3) a financial subsidiary of a national bank

Insurance underwriting and sales are permissible for nonbank subsidiaries of financial holding companies. National banks and their subsidiaries are generally restricted to agency sales activities

Limited to 20% of bank’s capital Generally limited to holding bank premises

Permitted up to 25% of bank capital Permitted, but not more than one group Permitted with regulatory approval

Germany

Industrial Firm Investment in Banks Permitted with regulatory approval (more than 15%) Permitted

Not Permitted

Not Permitted

Permitted with limits Permitted with limits

No general restrictions Permitted, subject to regulatory consent (suitability of the shareholder) Permitted

Limited to holding 5% interest

Permitted up hold up to 5% of voting shares through bank holding company

Permitted, subject to regulatory consent (suitability of the shareholder) Permitted Permitted with regulatory approval (more than 25%) Permitted with regulatory approval (5%, 12%, and 20% or more) Permitted to make non-controlling investments up to 25% of the voting shares

Source: Institute of International Bankers, Global Survey 2001, http://www.iib.org/global/2001/GS2001.pdf


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Appendix 2A: OECD Investment Limits for life insurance companies

Country Australia Belgium Czech Republic Denmark Finland France Germany Hungary Iceland Italy Japan Korea Luxembourg Mexico Netherlands Norway Poland Portugal Spain Sweden Switzerland Turkey United Kingdom United States EC

Corporate Bonds 100 100 NA 40 50 65 50 NA Y 100 10 100 40 60 N 30 5 60 100 50 N 2 N VAR

Bonds Government Bonds 100 100 NA 100 100 100 50 NA N 100 100 100 100 100 N 100 100 60 100 100 N N N VAR

Shares

Mortgage

Loans

Cash

Derivatives

Unit Trust

100 100 20 N 40 10 50 NA Y 10 N 100 N 5 N 30 5 25 45 25 N N N

Real Estate 100 100 25 N 40 40 25 NA Y 40 20 15 40 25 10 100 25 45 45 25 N 15 N

100 100 10 40 50 65 30 NA Y 35 30 40 25 30 N 35 30 50 100 25 30 25 N

100 5 N Y Y 10 50 NA Y Y 10 100 10 5 8 1 N 25 5 N N 5 N

100 100 NA Y 3 N N NA Y 15 N 100 20 NA 3 100 100 20 3 3  3 3

100 5 N N N N N N N N N 5 N 30 N NA N N NA N

100 100 10 40 N NA 30 N N Y N 100 25 NA N 30 30 20 Y N

N N

10 N

VAR

N

N

VAR

3

NA

VAR

Source: OECD (2000) “Investment regulation of insurance companies and pension funds: issues for discussion”.


October 2001

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APPENDIX 2B: LATIN AMERICAN INVESTMENT LIMITS (MAY 1998) PORTFOLIO LIMITS Argentina Chile Bolivia (2) Peru Govt. Securities 50 $180mn min 30 Federal Govt. Securities 50 Provincial & Municipal 15(1) Securities Central Bank Securities 30 Corporate Bonds 40 45 0 35 Corporate Bonds, long term 28 Corporate Bonds, short term 14 10 Corporate Bonds, convertible 28 10 Corporate Bonds, priv. firms 14 Bank Bonds 0 25 Mortage-backed securities 28 50 Letters of credit 50 Fixed Term Deposits 28 50 rest 30 Short Term margin loans 10 Repurchase Agreements Shares, plc's 35 37 0 20 Shares, workers' shares 20 Shares, real state co's Shares, preferred share 10 certificate Shares, privatized firms 14 Stock index instruments Securitized instruments 0 Primary Issues, new ventures 10 Mutual Funds 14 5 0 10 Real estate funds 10 Venture Capital Funds 5 Securitized credit funds 5 Direct Investment Funds 10 Foreign Securities 10 12 0 5 Foreign Govt. Securities 10 Foreign corp. bonds & shares 7 Foreign Assets, fixed income 12 Foreign Assets, var. income 6 Hedging instruments 2 9 10

Colombia 50

Mexico 100

Uruguay 75-85(4)

20

35

25

50 30

10

25 30 30

15 30

0

25

5 20(3) 5

10

0

0 0

10

Sources: Pension Fund Regulators ; Srinivas and Yermo (1999). (1) Nacion AFJP must invest between 20 and 50% (or $300m) in these instruments to finance regional projects. (2) Bolivia has not issued regulation for the actual limit. (3) limit of 15% for instruments backed by non-admitted assets, real state and infrastructure projects (4) up from 80-100 in 1996. The legislated limits were 70-90 in 1997, 60-80 in 1998, 50-70 in 1999, 40-60 in 2000, 30-60 in 2001-5. The difference can be invested in securities not issued by the central state.


October 2001

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APPENDIX 2C: EVOLUTION OF INVESTMENT LIMITS IN CHILE (1981-1998) PORTFOLIO LIMITS Government Securities Corporate Bonds Corporate Bonds, convertible Mortage-backed securities Letters of credit Fixed Term Deposits Shares, plc's Mutual Funds Real state funds Venture Capital Funds Securitized credit funds Foreign Securities Foreign Assets, fixed income Foreign Assets, variable income Futures and Options

1981 100 60 0 70 70 70 0 0 0 0 0 0 0 0 0

1982 100 60 0 40 40 40 0 0 0 0 0 0 0 0 0

1985 50 40 10 40 40 40 30 0 0 0 0 0 0 0 0

1990 45 40 10 50 50 50 30 10 10 0 0 0 0 0 0

1992 45 40 10 50 50 50 30 10 10 0 0 3 0 0 0

1995 50 40 10 50 50 50 37 10 10 0 0 9 9 4.5 9

1996 50 45 10 50 50 50 37 5 10 5 5 9 9 4.5 9

1997 50 45 10 50 50 50 37 5 10 5 5 12 12 6 9

Sources: Pension Fund Superintendency ; Srinivas and Yermo (1999).


October 2001

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1998 50 45 10 50 50 50 37 5 10 5 5 12 12 6 12

APPENDIX 3A: PENSION FUNDS Portfolio Composition (1998, in %) PORTFOLIO LIMITS United Kingdom United States Germany Japan Canada France Italy Argentina Brazil Chile Colombia Mexico

Domestic Bonds 14 21 43 34 38 65 35 53 11 45 46 98

Liquidity 4 4 0 5 5 0 0 21 10 32 50 2

Loans / (1) Funds 0 1 33 14 3 18 1 7 33 3 0 0

Domestic Equity 52 53 10 23 27 10 16 18 19 15 3 0

Property

Domestic Equity 48 26 17 10 26 15 12 10 7 4 ... ...

Property

3 0 7 0 3 2 48 0 0 0 0 0

Foreign Assets 18 11 7 18 15 5 0 0 0 6 0 0

APPENDIX 3B: LIFE INSURERS Portfolio Composition (1998, in %) PORTFOLIO LIMITS United Kingdom United States Germany Japan Canada France Italy Argentina Brazil Chile Colombia Mexico

Domestic Bonds 25 52 14 36 55 74 75 40 47 46 ... ...

Liquidity 5 6 1 5 7 1 0 34 3 34 ... ...

Loans / (1) Funds 1 8 57 30 28 2 1 11 37 11 ... ...

6 0 4 0 7 7 1 ... 6 8 ... ...

Foreign Assets 13 1 0 9 3 0 0 0 0 1 ... ...

APPENDIX 3C: OPEN-END MUTUAL FUNDS Portfolio Composition (1998, in %) PORTFOLIO LIMITS United Kingdom United States Germany Japan Canada France Italy Argentina Brazil Chile Colombia

Domestic Bonds 8 30 22 27 18 37 54 96 90 95 87

Liquidity 4 17 10 23 20 29 19 ... ... ... ...

Loans / (1) Funds 0 0 0 18 3 0 0 ... ... ... ...

Sources: Davis and Steil (2001) and OECD (2000).


October 2001

Domestic Property Foreign Equity Assets 56 2 33 51 0 ... 18 0 29 9 0 22 31 0 23 20 0 14 22 0 0 4 ... ... 10 ... ... 5 ... ... 13 ... ... (1) Loans for OECD ; Inv Funds for EM

page -37-


October 2001

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