INSTITUTIONAL INVESTORS - World Banksiteresources.worldbank.org/EXTBANKING/Resources/China-InstInv.pdf · Institutional Investors in China October 2001 page -3-INSTITUTIONAL INVESTORS:

INSTITUTIONAL INVESTORS:

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 Developmentin Hong Kong on 19/20. November 2001. This project evolved from an FSTA loan on the Chinesegovernment bond market where the lack of institutional investors was identified as a major constraint, andit involved two staff visits to Beijing and Shanghai in August 2001 and November 2001. The authors havegreatly benefited from discussions with Chinese policymakers, financial institutions, capital marketparticipants, and academics as well as from contributions by local consultants Messrs. Xu Shouchun, HuJie, 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 INVESTORS:CATALYSTS FOR CHINA’S CAPITAL MARKETS

Executive Summary

China’s financial system has been evolving rapidly and WTO agreements will requiremore reforms that promote openness and competitiveness. China’s capital markets willbe critical on this path in providing market-oriented financing, in enhancing theproductivity of domestic savings, and in underpinning China’s economic growth.Institutional investors could become the catalysts in transforming China’s financialsystem 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 theperforming bank loans could be turned into effective capital market bonds, China couldcatch up with the most innovative and productive financial systems in emerging markets.

Government bond markets have formed the foundation of capital market developmentin numerous emerging and OECD economies. Deregulation of banking, internationalintegration, social security reforms, privatizations, emergence of pension and mutualfunds, and technological advances have all propelled economies into a virtuous cycle ofcapital market innovation, institutional investor development, and productivity-driveneconomic 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 aspension reform is starting in pilot projects, as open-ended mutual funds are introducedand as the insurance industry is addressing its capital deficiency. However, assumingthat underground investment vehicles are regularized, that institutional assets areprofessionally managed, and that critical reforms are implemented, China could establisha solid base of institutional investors of 30% of GDP within five years.

Critical reforms need to include a consolidation of financial institutions with access ofcommercial banks to capital markets through financial holding companies. Moreover,fixed-income and equity capital markets need to develop on a level playing field whichallows equal access for state-owned and private companies, with strong emphasis onimproved corporate governance and transparency. Quasi-fiscal financing needs to beshifted into a market-determined supply of government T-bonds and T-bills at liberalizedinterest rates for all investors. The evolution of strong fixed-income mutual funds,strengthening of professional fund management in the insurance industry, and furthergrowth of new pension funds will be three key pillars. Institutions need to bestrengthened, with an integration of bond markets, a consolidation of regulatory agencies,a reduction of tax distortions and liberalization of investment limits, and an upgrading ofkey legislation which urgently need to regularize underground fund activities.Instruments need to be diversified into derivatives and diverse corporate bonds, whileconvertible bonds and asset-backed securities could be envisaged. These Markets andInstitutions and Instruments will decisively shape China’s future institutional investors.

Institutional Investors in China October 2001 page -3-

INSTITUTIONAL INVESTORS: CATALYSTS FOR CHINA’S CAPITAL 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 givesan illustration of today’s financial system in the People’s Republic of China. A countrywith one of the highest savings rates in the world has retained a very inefficient financialsystem that is bank/retail dominated with very low productivity of domestic savings. Onone hand, commercial banks intermediate huge deposits (150% of GDP) mostly to SOEswhich now only account for one third of GDP ; on the other hand, capital market accessfor private firms remains marginal as only 35 out of 1200 listed firms are private andcorporate debt markets are small (1% of GDP). Capital market development has beenshallow, as retail investors mostly speculate in the equity market (54% of GDP) whileinstitutional investors (assets 6% of GDP) just start to develop fixed-income products.

Policy makers are acknowledging that capital market development will be crucial toprovide market-oriented financing, to increase productivity of capital, and to underpinChina’s economic growth. This note argues that institutional investors could becomecatalysts on this path, that fixed-income products need to provide a solid basis, and thatgovernment debt markets are essential to attract institutional investor demand. Accessionto the WTO will focus policy makers’ attention to develop a more competitive financialsector structure, to promote financial innovation and joint ventures, and to provideinvestors with more diversified and market-based products. Eventually, deposits willneed to shift into mutual funds and private contractual savings, while bank loans willneed to shift into capital market financing (chart 1). This note is organized as follows:the next section reviews the international experience with institutional investors, beforecontrasting this with the current structure of Chinese institutional investors. The mainfollowing 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

HouseholdSavings

Deposits

SCB

Loan

SOE / CorpInvestment

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

Y 10,700 bn

HouseholdSavings

Deposits

SCB

Loan


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

Savings

Deposits

SCB

Loan


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

Y 10,700 bn

DebtCapital

Y 40 bn

access

Corporate

governance

DebtCapital

Y 40 bn

access

Corporate

governance

1 : 10Funds

EquityCapital

Capital

Y 650 bn

Y 85 bn

Y 700 bn (gray)

1 : 10Funds

EquityCapital

Capital

Y 650 bn

Y 85 bn

Y 700 bn (gray)

Funds

EquityCapital

Capital

Y 650 bn

Y 85 bn

Y 700 bn (gray)


2. International experience

Institutional assets in the OECD area have grown from $3 trillion in 1981 to $16 trillionin 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). Thefastest 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 theUnited States. Despite such rapid growth, institutional assets in emerging marketsaccount 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 issimilar to the size of these four economies combined, yet China manages only $60 billionof institutional assets, mainly because of its nascent mutual and pension funds. Table 1illustrates that China’s deposit share of GDP is twice as high as that of competitors, whileChina’s capital markets are half of the average size of its competitors with a strong biastowards equity markets. China’s institutional assets are below 6% of GDP as comparedto an average of 77% of GDP for its competitors which reveals the bank/retail dominanceand 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 Mutual Contractual Institutional

China 151.0 24.5 53.9 0.9 4.7 5.6Hong Kong SAR 275.6 37.4 384.9 137.6 18.5 156.2Singapore 101.1 57.9 229.5 163.2 73.7 236.9Korea 66.6 70.0 32.5 27.3 31.0 58.3Thailand 85.4 31.0 25.5 7.4 10.7 18.0Brazil 15.5 51.5 37.9 25.3 17.4 42.7Chile 45.7 18.2 97.0 6.7 77.5 84.2South Africa 50.9 44.8 163.0 13.2 129.6 142.8Average (7) 70.0 52.3 93.3 42.1 35.2 77.3

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% ofemerging markets’ GDP2, which is relatively small as compared to overall institutionalassets. The literature shows that five structural factors have been shaping the role andstructure 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 inaddition 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 emergingmarkets) but only 5% of portfolio investment. Kaminsky (2000) shows the volatility of foreign portfolioflows which significantly reduced the portfolio stock of $77 bn in Asia during 1996-2000.


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

Second, many mandatory social security systems have been transformed frompartially-funded or pay-as-you-go defined-benefit systems into fully-funded defined-contribution systems. Moreover, an aging population in OECD countries has led tocomplementary private pension plans which may be offered by banks, insurancecompanies, and investment funds. Voluntary corporate pension plans have also hadsubstantial increases in funded reserves. Chile is an example, where mandatorycontributions to privately managed pension funds were introduced in 1981, whichhave 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 ofindividual 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 privatizationinvestment funds. Banking crises and losses of depositors can also contribute toshifting savings towards investment funds. This was the case in Brazil, where mutualfunds performed well during crises, and where outsourcing from pension funds hasbeen common, building investment fund assets of 25% of GDP during the 1990s.

Fourth, liberalization of permissible activities of institutional investors in theproduction and distribution of their products and the investment of their assets hasgreatly increased their efficiency and profitability. Regulatory constraints oninvestment limits for asset classes and for cross-border activities have been graduallyrelaxed (details in appendix 2). Moreover, new product developments (asset-backedsecurities, private equity, derivatives, etc.) have enlarged the investment universe andadded liquidity. A good example is Korea where investment limits were graduallyliberalized and new product development has spurred financial innovation.

Fifth, enormous technological advances have enhanced the capacity of the financialsector and have dramatically reduced costs. Reliable and efficient clearing andsettlement systems, electronic trading systems, integrated risk management, and theintegration of capital markets all have stimulated growth of institutional investors.Hong Kong SAR is a case where regulatory systems have been upgraded to USstandards while electronic finance is rapidly growing and institutional links withinternational trading centers are being actively pursued.

3 Pension funds are often outsourcing parts of the fund management. For example, in the United Statesvoluntary 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 invested31% of their assets into domestic mutual funds. Tax incentives are often an important growth factor.


Box 1: Transforming the Government Securities Market in Italy

The structure of Italian domestic government debt in the mid-1980s has some similarities toChina’s structure today: large domestic debt volumes, mainly short-term maturities, and a larger number offloating rate securities. Over 80% of the debt outstanding was held by Italian households. This providedthe government with a very stable but also very risk-averse demand, which required either short-term orfloating rate securities. Italy subsequently succeeded in extending the average maturity of government debtand in developing a liquid government securities market based on three pillars: the adoption of a market-oriented approach in the primary market of government securities, the appointment of selected institutionalspecialists, 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 primarymarket by shifting from syndication to an open auction system where all market players could bidcompetitively. The government started to conduct regular auctions and to enhance the transparency ofinformation and procedures. Eventually, the government committed to a pre-announced yearly auctioncalendar, which made issuance more stable and predictable. The next step was to encourage the market tobuy longer-term securities. The strategy was to ensure a certain level of demand at each auction, and thiswas facilitated through a selected group of primary dealers who had some obligations including thesubscription of a specified share of securities at each auction. Italy had issued a relatively high proportionof floating rate notes in 1988 (44% of total debt) due to the reluctance of retail investors to buy long-termfixed-rate securities and assume interest rate risk. In its attempt to lengthen the average maturity of thedebt, the Italian Treasury succeeded to diversify the investor base, especially by building an institutionalinvestor base that can better manage risk than the domestic retail base, and which enabled the governmentto move progressively towards fixed–rate securities.

Second, the role of primary dealers and a set of tax advantages were key to attract foreigninvestors into the Italian market. Moving towards fixed-rate securities required to issue long-term floatingrate notes to alleviate refinancing risk and to gradually introduce T-bills, fixed-rate and zero coupon bondswhile reducing the issuance of floating rate notes. Floating rate notes typically had a 7-year maturity, andits coupon was linked to an average of the cut-off rates of four one-year T-Bill auctions plus a specifiedspread. The government decided to use primary market rates because they were perceived to be a betterindication of the market price, as the secondary market was never very active. The decision to use theaverage 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 supportiveenvironment and greater liquidity through a transparent, inexpensive, electronic network. The Italiangovernment decided that the best way to ensure liquidity in the market was to organize a wholesale marketthat was privately owned and supported by market makers. The MTS was organized in three layers: thedealers, the primary dealers and the specialists in government bonds. Primary Dealers were committed toquote two-way prices in selected securities, whereas Specialists (16 out of 40 primary dealers) had stricterrequirements, 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 forthese obligations, they enjoyed a number of privileges among which the right to buy securities at a secondround after the auction (at the price of the auction) and monthly meetings with the Treasury. The systemimproved secondary market trading by bringing anonymity, liquidity and depth, improving transparencyand efficiency in the trades. It benefited both the issuer by widening market distribution and by reducingthe cost of funding, as well as the securities dealers through lower transaction costs and even final investorswho did not have access to the wholesale market but indirectly enjoyed tighter spreads. The governmentintroduced its first 30-year bond in 1993 which was purchased primarily by large institutional investmentfunds. Italy managed to increase its share of long-term, fixed-rate debt to 55% by the beginning of 2000.


While these five stylized facts have been instrumental in the growth of institutionalinvestors, their impact has also been felt on capital markets and on the structure of thefinancial sector more generally. The impact of institutional investors on capital marketsand 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 institutionalinvestor 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 transactioncosts, encouraging long-term financial savings and contributing to economic growth.4

second, the Asian crisis has revealed that capital markets provide an additional pillarof financing and stability. As institutional investors help to increase long-termsavings, economies tend to become less vulnerable to interest rate and demand shocksand contribute to the reduction of financial market volatility.5 However, research ismore ambiguous on the impact of foreign institutional investors (esp. hedge-funds).

third, institutional investors act as catalysts to improve market infrastructure bycreating new products, enhancing liquidity, improving accurate pricing, encouragingentrance of new market participants, and through better clearing and settlement.

fourth, institutional investors establish high standards for compliance, disclosure andoversight of information (esp. financial statements) and help to improve corporategovernance of market participants.

fifth, institutional investors create new competition and potential synergies withbanking institutions, they often assist in developing new skills and are invaluableparticipants in privatizations as strategic investors.6

In terms of sequencing, developments have generally moved from fixed-income to equitymarkets, and from short-term maturities to an extended yield curve. Governmentsecurities have usually provided the necessary basis for broader market development,new products, and advanced infrastructure. Mutual funds are typically demanding moreshort-term fixed-income products, whereas pension funds typically need more long-duration products7 (details of asset allocation are provided in appendix 3). For example,Latin American mutual funds (Brazil, Chile, Argentina, Mexico) hold less than 10% oftheir assets in equities. In contrast, over 50% of UK pension fund assets are invested inequities. Holdings of life insurers vary according to the available instruments, forexample Singapore’s life insurers hold less than 30% of their assets in bonds due to theirrelatively short duration, whereas US life insurers hold 52% of their assets in mostlylong-term government and corporate bonds.

4 Holzmann (1997) shows econometrically that the development of financial markets in Chile correlateswith strong development of the real side of the economy, through rising total factor productivity and capitalaccumulation. It is estimated that long-term growth in Chile is between 1% to 3% higher mainly due to theeffects 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 investorson savings, growth, and financial market volatility. They also identify additional benefits, including lowercountry 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.


3. China’s institutional investors

The previous section has revealed some advantages of a strong institutional investor baseand 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 theresumption of government securities issues and continued with the establishment of stockexchanges in 1990, there is still a very narrow institutional investor base which accountsfor barely 6% of GDP. More effective financing through capital markets would requirethis narrow base to grow significantly from a very low base which compares to anaverage of 77% of GDP among comparators. This section illustrates three key areas ofnecessary reforms, which relate to pension reform, to professional management ofinsurance 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 towardsfinancial conglomerates and universal banking8 in order to enhance the competitivenessunder the WTO commitments for further market opening.

China’s financial sector has expanded in parallel with its rapid economic growth overthe past two decades. Then, the government budget was the dominant source ofinvestment. 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 comprisesfour state-owned commercial banks which were established in the late 1980s, which hold70% of the country’s deposits and mainly lend to SOEs, and which are in the process ofbeing recapitalized since 1998 (capital injection and limited transfer of NPLs). These arecomplemented by three policy banks (set up in 1994), ten national joint-stock commercialbanks, 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 non-bank financial institutions emerged, and over 700 international trust and investmentcompanies (ITICs) were created to channel foreign capital into Chinese industries, butafter the GITIC bankruptcy in 1998 their share of the financial sector quickly droppedbelow 10%. A number of intermediaries were allowed to conduct capital marketsbusiness, and today 88 brokerages and 13 comprehensive securities companies exist.

China is in the process of transferring social security responsibilities away from SOEstowards municipal Government agencies. China’s urban pension system is one of thelargest in the world and the government has declared that social security reform is one ofits top policy priorities. Today, the system is largely defined-benefit PAYG for olderindividuals, while younger workers’ benefits include a basic benefit of 20% of theregional average wage, an accrual rate for past service prior to 1996, and an annuity fromindividual account accumulations. Coverage has recently been extended from employeesof SOEs and collectively-owned firms to other formal sector urban workers. Contributionrates vary between 19% to 28% for employers and 5% to 6% for employees, which areexpected to rise gradually to 8%. In July 2001, the Government launched a pilot projectin Liaoning Province which seeks to establish the management systems for social securityprograms including pensions, health insurance, unemployment insurance and other

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


benefit programs at the municipal level. Suggestions for further improvements includethe gradual increase of retirement ages, the calculation of annuities based on lifeexpectancy at retirement, a uniform indexation to local consumer prices, and improvedreserve management.9 Current gross reserve estimates are in the range of $8 billion, butprojections show assets could possibly reach 20% of GDP by 2030.10 A recent study bythe Ministry of Labor and Boshi Fund Management suggests that total pension fundassets could grow by 30% to 40% in the first years based on 8% individual contributionrates. However, transition costs could be very substantial as current estimates ofunfunded liabilities of the pension system are in the range of 94% of GDP.

China’s insurance industry represents the largest domestic institutional investor todaywith 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 marketconsists of 31 insurers and over half a million agents, but four key players control 95% ofthe market. The largest state-owned insurance company resumed operations in 1979 andtoday still holds a market share of 54%, whereas two privately owned companies holdmarket shares of 31% and 11%. Industry experts project continued rapid growth ofpremium income (30% growth rates were achieved in the first half of 2001) given highhousehold savings levels, an aging population, solid GDP growth, and rising penetrationand depth. However, the industry appears to be haunted by an insolvency crisis due toweak profit margins, low investment returns (below 4%) and minimum guaranteed yields(which were recently reduced to 2.5%). Industry experts project a capital deficiency ofRMB 75 billion by 2004, which is three times of its current equity.11 But two factorscould alter these projections: 26 foreign insurers have reportedly received new licenses,life insurers are allowed to have 50% foreign ownership and non-life companies mayform wholly-owned subsidiaries within two years of WTO entry. One successfulexample is AIG which re-entered the market in 1992 and gained a 10% market share ofShanghai’s life insurance market even under current restrictive conditions. Moreover,regulatory restrictions were partially relaxed on investment allocations, which now allowfor up to 15% investments in equities, and minimum returns on unit-linked products havebeen lowered. This could put China’s insurance industry on a rapid growth path withdirection 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, thealso fast growing mutual fund industry may become the key institutional asset manager.China currently has 14 fund management companies which run 45 securities investmentfunds with assets of $10 bn (1% of GDP) and annual growth rates of 35%. The firstinvestment funds were established in 1991 and focused on real estate investment, but theywere all closed at the end of 1997 as regulatory responsibility was transferred to CSRC.Currently, only securities and investment companies are allowed to establish mutualfunds but ownership by banks is under consideration. Shares are traded on the stockexchanges 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 the2020 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.


including collusion and share-price manipulation.12 Mutual funds are required to hold20% 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 havebeen raised. As a result, the State Council is currently preparing an investment fund lawto strengthen corporate governance and to improve consumer protection. Liberalizationunder WTO agreements allows for joint ventures with 33% foreign ownership (49% afterthree years) and CSRC recently approved three open-ended mutual funds with foreignjoint ventures. Professional management should allow mutual funds to continue its rapidgrowth, especially when so-called underground funds which are reportedly managing $85billion 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 for27% 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 inresponse to competitive pressures under WTO agreements. After allowing for universalbanking structures in 1987, China divided its financial sector into four segments in 1993:banking, insurance, securities, and trusts. The new infant industries were nurtured andgrew rapidly with regulation lagging behind. Over the past two years, banks have builtpartnerships with non-financial institutions, insurance companies have used banks as adistribution network, fund management and insurance products were combined, and someintermediaries were allowed to borrow in the interbank market. Banks have beenparticularly keen to undertake “agency roles” in the stock market in order to grow theirintermediary business (8% of current profits vs. 50% in most international banks).

China still has a restrictive financial system when it is compared with activities ofinternational banking organizations. According to a 2001 global survey by the Instituteof International Bankers, it was the only country among 44 surveyed where banks werenot permitted altogether to engage in securities, insurance, real estate and investments inindustrial firms (appendix 1). However, a debate was started by a PBC statement in July2001 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 whichcould integrate the four segments into a structure of universal banking with subsidiariesor affiliates having access to capital markets. CSRC has also suggested to reviewbanking 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 bankswould merge with securities houses and insurance companies. In either case, the role ofinstitutional investors would be significantly enhanced as capital markets move to centerstage and generate the largest share of financial sector profits.14

12 Reported irregularities are based on research of a Shanghai Stock Exchange analyst, which werepublished 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 billionor nine times of regulated mutual fund assets, it identifies enterprises as main clients, and it concludes witheight 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 CSRCfor mergers and acquisition laws (May 15, 2001 in China Hand and Chinonline), the proposal by PBC tomove towards universal banking (July 25, 2001 in CBnet), and the proposal by CASS to create financialconglomerates (October 15, 2001 in Kyodo).


4. Policy actions

The previous section has illustrated the current status of institutional investors in Chinaand proposals to transform the current segmented structure of financial markets in orderto enhance their competitiveness. Clearly, macro-level reforms need to be complementedby specific policy actions at the micro-level which would help to create a more conduciveenvironment for institutional investors, which in turn would lead to more comprehensivecapital market development, higher productivity of capital and sustained economicgrowth. 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 andimproved corporate governance ; and third, enhancing instruments with focus oninterest 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 forone third of all flows into emerging markets. In contrast, China has maintained a closedcapital account for outflows and has attracted only 5% of portfolio inflows, as comparedto 14% in Korea which had put an earlier emphasis on capital market development. Aschart 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 andfor Brazil which both have a very strong basis for mutual funds. There are threeobservations 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 asome 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 ; andInstitutional Investment (shares as % of emerging markets stocks, 2000)

China

33.2%

Brazil10.8%

Mexico9.9%

Malaysia4.0%

Foreign Direct Investment

Others

29.9%

Singapore

6.0%

Argentina6.2%

China4.9%

Brazil

19.7%

Mexico

15.8%

Argentina

13.8%

Korea13.8%

SouthAfrica

7.3%

Others

24.7%

Portfolio Investment

Source: IMF and World Bank estimates for end-2000

China

4.2%Hong Kong

17.4%

Singapore16.9%

Korea15.3%

Brazil14.6%

SouthAfrica

11.7%

Others19.9%

Dom. Institutional InvestmentChina

33.2%

Brazil10.8%

Mexico9.9%

Malaysia4.0%


Others

29.9%

Singapore

6.0%

Argentina6.2%

China

33.2%

Brazil10.8%

Mexico9.9%

Malaysia4.0%


Others

29.9%

Singapore

6.0%

Argentina6.2%

China4.9%

Brazil

19.7%

Mexico

15.8%

Argentina

13.8%

Korea13.8%

SouthAfrica

7.3%

Others

24.7%



China4.9%

Brazil

19.7%

Mexico

15.8%

Argentina

13.8%

Korea13.8%

SouthAfrica

7.3%

Others

24.7%



China

4.2%Hong Kong

17.4%

Singapore16.9%

Korea15.3%

Brazil14.6%

SouthAfrica

11.7%

Others19.9%

Dom. Institutional InvestmentChina

4.2%Hong Kong

17.4%

Singapore16.9%

Korea15.3%

Brazil14.6%

SouthAfrica

11.7%

Others19.9%

Dom. Institutional Investment


China’s relative focus on real sector investment combined with a relatively closed capitalaccount also has implications for the structure of domestic capital markets, in particularthe relation between fixed-income and equity markets. Chile is a good example, wherestrong pension funds and deep capital markets combined with restrictions on the capitalaccount have tilted the balance towards equity markets as investors are constrained withfew higher-yield instruments. Brazil, however, has taken a different direction, wherevery profitable and liquid fixed-income markets have become dominant and haveattracted large portfolio inflows. The contrast is even larger between Hong Kong SARand Singapore, which both have impressive capital markets and large institutionalinvestor 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 fixed-income markets (more conglomerates, asset-management focus, FX and derivatives).

China appears to have favored equity market development as it was perceived as a morecost-effective tool in financing state-owned enterprises. Equity capital does not requirepayment of interest (dividend payments are optional) and does not require repayment ofprincipal. However, shareholders are expected to take an interest in improvingmanagement of the company, in enhancing corporate governance, and in enforcingmarket principles so that share valuations continue to rise. It is assumed that after mostSOEs have been listed, markets may force non-performing ones to close. This approachclearly shifts more risk on the equity holder and puts the issuer into a more favorableposition. On the other side of the coin, institutional investors don’t like to be fed withnon-performing assets, and the development of capital markets is stifled as medium- andsmall-sized private companies have no access to capital market financing. Competitionamong listed companies remains illusive, as long as no penalties arise from non-performance, such as de-listing or closure. The focus on retail investors does notpromote modern risk management or development of market infrastructure, and it mayencourage speculative bubbles unless more supply and diverse instruments are offered.

China also appears to have constrained fixed-income market development as a tool toboth keep deposits growing at state commercial banks and to keep cheap bank lending toSOEs flowing at low interest rates. Captive markets on illiquid savings bonds have alsobeen 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 arediminished 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 oftenbelow deposit rates.16 The distortion of incentives is revealed by a key statistic of assetallocation 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 isunique for any institutional investor in the world (appendix 3).

15 Deposit rates for institutional investors above US$ 3 million have been liberalized in September 2000.16 One of the largest insurance companies has negotiated deposit rates of 5.5% for 70-months deposits inSeptember 2001 [as high as 7.5% in 2000] whereas bond market returns have been below 4% and retaildeposit rates have been around 2%.


International experience provides strong evidence that mature government securitiesmarkets are an essential component in order to build a solid basis of institutionalinvestors. In fact, Chile has started by developing government bond markets after thepension reform in 1981 and only opened up equity markets in 1985. South Africa, Brazil,and Korea have developed fairly deep and sophisticated government securities marketswhich have attracted strong demand from institutional investors. Singapore and HongKong SAR have been issuing government bonds in significant size – although they arerunning a fiscal surplus – in order to develop markets, create institutional demand, and toprovide benchmarks for corporate issuance. Singapore to date has issued governmentbonds of 25% of GDP with no budgetary need. And most Asian governments havestepped up the issuance of government bonds after the Asian crisis in 1997 as a tool fordeepening capital markets in order to establish an additional financing anchor and toreduce 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 demandand that a level playing field is required. In the context of China, mutual funds couldhelp in the development of short-term money markets and subsequently in governmentsecurities 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 adanger that their reputation could be tarnished, similar to the event in 1997 when allexisting mutual funds were closed, but with longer-term implications. There has been asimilar experience of Thailand’s mutual funds and Korea’s ITC, which performed verypoorly during the Asian crisis and lost confidence of investors. Hence, it appears that thegovernment needs to establish a level playing field and also needs to provide adequateincentives 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 recoveryprogram, but issuance was suspended from 1958 to 1981. Since then, the governmenthas gradually increased its issuance from RMB 20 bn (1% of GDP in 1990) to RMB 466bn (5.2% of GDP in 2000). Financing has been used in three ways: for the generalbudget deficit ; for special fiscal stimulus programs ; and for bank recapitalization (one-time 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 earlyredemption) account for 48% of outstanding issues ; book-entry bonds (mostly interbankmarket, up to 20 years) account for 50% ; and special bonds (placements for specificinvestors) account for 2%. There are presently no issues of T-bills. The average time tomaturity 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 thecentral 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


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 theend 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-fiscalliabilities of the Chinese government are at least 51% of GDP, which includes AMC debtof 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 oncequasi-fiscal liabilities are included, although it could evolve in a gradual process.

Table 2: China’s Government Debt and Contingent Liabilities (2000)

bn RMB %GDP bn RMB %GDPGovernment Debt 2079 23.3 Quasi-Fiscal Debt 4568 51.1

Domestic Debt 1677 18.8 SCB/SDB Debt 3361 37.6Treasury Bond Issuance 466 5.2 AMC Debt 1207 13.5

Budget Deficit 325 3.6 Social Sec Cont Liab 8404 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 andenterprise bonds (rarely traded), and from tying remaining treasury bonds to reserverequirements and minimum holding requirements. The small and irregular size ofissues and the main distribution to the interbank market further limits liquidity.

Second, the absence of a Treasury bill market hampers efficient pricing of the leveland structure of baseline rates and the market-based formation of a yield curve, whichappears to be still anchored at the 12-month deposit rate. Moreover, market makersoften 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 off-budget is creating significant risks and uncertainties. Block-issuance will be moredifficult to price, and such expectations could lead to pressure on interest rates.Moreover, the accumulation of large contingent liabilities of social security mandatescould 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.18 The government had decided to sell shares of SOEs in the equity markets (two thirds of the stock marketcapitalization represent state-held shares) and to use 10% of new IPO proceeds for the new National SocialSecurity Fund. After equity indexes dropped by 30% in the third quarter of 2001, this policy has beentemporarily discontinued, which keeps very large unfunded social security liabilities.


As a result, it appears that the government might want to consider to gradually shift off-budget items to direct responsibility of MOF, which for example could be started byissuing long-term treasury bonds for the non-recoverable portions of AMC debt.19 Thesupply could be further enhanced by replacing maturing savings bonds with liquidbenchmark 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 (suchas AMC debt) on budget. However, international comparisons reveal (chart 3) thatChina’s domestic debt levels are relatively low, and real interest rates are among thelowest in emerging markets. Moreover, there is no clear relationship between higherdomestic debt levels and higher real interest rates, as it is illustrated in the case ofSingapore, where interest rates actually remain below LIBOR as its budget remains insurplus. China’s high savings rates and stable exchange rate have also contributed to lowreal interest rates. More transparency by managing quasi-fiscal liabilities on budget donot 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

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Real Int = 3.43 – 0.50 * Dflow – 0.04 * DstockR2 = 0.36 (2.97) (2.56) (1.40)

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 regulationsthat 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 thatnew NPLs would emerge, but ultimately the existing stock will need to be financed by the government.


A.3. Market infrastructure and liquidity

Institutional investors usually offer a premium for liquidity, whereas captive retailinvestors rarely engage in trading. Therefore, enhancements in liquidity and relatedmarket infrastructure often create additional demand from institutional investors.Liquidity is defined in four dimensions:21 width (bid-offer spread) ; depth (volumes atgiven price) ; immediacy (time to clear settle) ; and resiliency (time to return to previousprices after absorbing a large block trade). There are currently three major impedimentsto liquidity in China’s government securities market: the segmentation into the interbankand stock exchange markets ; the widespread misuse of repurchase instruments andrestrictive 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 infutures and repurchase markets. A repurchase contract (repo) is an arrangement in whichsecurities are used as collateral to obtain a short-term loan of funds, which are commonlyused 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 banksfor speculation in equity markets. PBC then banned banks from stock exchanges andtransferred their bond trading to the interbank market. The subsequent capital shortage atsecurities companies led to a PBC notice in late 1999 which allowed qualified securitiesand 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 OTCsystem and largely depends on bilateral transactions over the phone.22 The largestparticipants are the four state commercial banks, and the IBM is also functioning asmoney market where PBC conducts open market operations. In contrast, the stockexchange market (SEM) is based on a centralized cross-matching system in which dealersand end-users trade directly with each other without intermediation. The Securities Lawstipulates that listed bonds must be traded through centralized competitive pricing and notthrough an OTC. In terms of volumes, 88% of new issuance in 2000 was placed as non-listed bonds on the IBM, whereas it accounted for only 31% of government securitiestrading during that period, and for only 9% of spot trading.

The segmentation of government securities markets into IBM and SEM has restrictedprice discovery and liquidity.23 On one hand, the large commercial banks and insurancecompanies in the IBM have a homogeneous set of investment preferences which makestrading more difficult and implies a premium for low liquidity. On the other hand, thesecurities 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).22 However, counterparts are confined to members of IBM. In this regard, it would be characterized as alimited OTC market.23 As an example, a recent 15-year issue in the IBM was priced at 4.69% as compared to a subsequent20-year issue in the SEM at 4.26%, which indicates mis-pricing by at least 50 bp.


the SEM also reduces transparency and adds transaction costs. Repo operations arereportedly continuing with pre-1997 patterns of illegally borrowing funds in the IBM forspeculation in equity markets,24 which drain liquidity from the cash market and increasevolatility. The market segmentation appears to have failed to achieve its stated objective.Moreover, IBM statistics indicate that repo transactions in the first half of 2001accounted for 98% of all transactions (95% during 2000). It is highly unusual to have 50times 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 justtwo times stock during 2000, which compares with seven times in the case of Korea andeight times in the case of Singapore.25 Three regulatory practices are mostly responsiblefor the inefficiencies in cash money markets: market segmentation suppresses liquidity,restrictive PBC limits constrain cash operations26, and tax exemptions for repotransactions heavily bias transactions towards short-term repo operations.27

Inefficiencies in the clearing and settlement process explain why settlement can extendto T+5, why there is a long time lag before newly issued securities can be traded, andwhy DVP settlement is still not possible. The legal status of the China DepositoryCompany (CDC) remains in flux as at least five organizations are involved in itssupervision 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 theirrelationship with CDC are not clearly defined.28 As this infrastructure is improving withthe expected introduction of DVP in mid 2002, institutional activity may increase.

To address these three concerns on market structure and liquidity, it has been suggestedto consider integrating IBM and SEM,29 whereby mutual access for all participantswould be granted and new issuance would be made through a single auction to allparticipants across markets. The interbank market would be strengthened throughimproved trading systems, harmonized tax structures, enhanced cash trading, and a levelplaying field for all participants. The stock exchange would upgrade its trading system tomeet needs of all members30, which would be supported by strong regulations on repotransactions (limited collateral, fewer liquid instruments, master repo agreements, marginrules). At the same time, CDC would be designated as central clearinghouse anddepository, and would obtain oversight functions of a self-regulatory organization.

24 PBC is reportedly continuing to investigate “unregulated money flowing to stock markets” (pressreports, October 2001).25 Even after excluding the large amount of savings bonds, turnover remains below four times stock withan excessive share of repo trading.26 PBC regulations restrict local banks to 4% and 8% of customer deposits respectively for money marketcash 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 ofnon-financial investors holding marketable government securities. Similarly, banks are not allowed toengage 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 differentpits for market makers and other members and which handles over 50% of all government security trading.


B. Strengthening legal, regulatory, and institutional environment

B.1. Performance incentives

China’s institutional investors have been subject to various regulatory constraints whichhave acted as disincentives for improved performance. Investment restrictions are themain concern which have created problems especially for insurance companies. Taxpenalties on fixed-income investments and long-term savings are certainly detrimental inthe establishment of any private pension programs. Collusion and lack of competitionhave 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 OECDcountries and across emerging markets.

Investment restrictions have often been justified by the need to protect retail investorsand to limit volatility of investment portfolios. However, their track record has beennegative, as returns have been reduced without an adequate reduction of risk. Theliterature reveals that risk-adjusted performance of pension funds across Latin Americahas suffered as a result of investment regulation.31 Pension funds have regularly under-performed their respective market benchmarks, but Chile’s pension funds havesignificantly improved their performance after investment limits were relaxed and privatemangers were introduced at the beginning of the 1990s. The same observations appearsto hold for closed-end equity mutual funds in China over the past three years, which hadan average return of 35% as compared to equity index returns of 55%. The investmentrestrictions have been particularly painful for Chinese insurance companies, which onaverage had returns on their assets of below 4% in 2000, even after being allowed toinvest up to 15% in equities. China has a “positive system” of investment options forfinancial institutions, which are permitted to invest only in those assets explicitly listed,restricting the ability to diversify portfolios. However, this system creates uncertaintyabout 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 investmentfunds, the definition of “stocks” and “bonds” is not clear; leaving regulators exposed toad 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 arecommonly observed in the initial stages of capital market development, but a gradualrelaxation of these restrictions in a clear and transparent way is necessary to definegeneral and specific investment rules. Appendix 2 shows investment limits for OECDcountries as well as the evolution of investment limits in Chile, where annual real returnsfor pension funds have increased to 16% after liberalization.33 It is particularly importantto 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).32 Insurance regulations illustrate the cumbersome approach: The Insurance Law (Article 104) allowsinvestments into bank deposits, government and financial bonds, and other assets as approved by the StateCouncil. CIRC then decided in July 1999 to include enterprise bonds and in August 1999 to allow inter-bank bond purchases and then in December 1999 to permit indirect investments in stocks throughinvestment funds for up to 15% of total assets.33 Statistics draw on OECD (2000), Grushka (2000), and Srinivas and Yermo (1999).


(current limit of 12%). While pension funds in Latin America have typically held themajority of their assets in government securities or CDs (68% in the case of Chile), Asianpension funds have been holding a majority of assets in equities (50% in the case ofSingapore’s CPF and 51% in the case of Hong Kong’s MPF). Although Hong Kong’smandatory provident fund has only been established in 2000, it has immediatelyoutsourced 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 limitedinternational 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 fundsand insurance companies. Main characteristics of the relaxed regulations include: a voluntary system withhigh individual choice and multiple providers, no minimum return rule nor state guarantees, and reactivesupervision. In contrast, draconian regulations involve: compulsory system with limited individual choiceand 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” conceptwith adequate disclosure. In a draconian approach, on the other hand, detailed investment limits areestablished on the proportion of a fund that can be invested in particular assets or asset classes. In OECDcountries, 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 ofinstruments, it is easier to enforce explicit limits. The prudent person rule is more flexible, being morecompatible with sophisticated financial markets. The draconian approach might be justified in the initialstages of development. It is, however, beneficial to relax draconian regulations without too much delay aslocal 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 andinfrastructure, to support long-term savings and investment, and to promote financialinnovation and instruments. For example, individual retirement accounts in the USbenefit from tax exemptions (only benefits are taxed when paid out) and municipal bondsand various money market mutual funds also benefit from tax exemptions to promotediversification into higher-risk fixed-income instruments. Singapore and Hong KongSAR are good examples where tax exemptions have been used to build domestic fixed-income markets and to promote institutional investments:34 Singapore has waived alltaxes on domestic debt securities (including for nonresidents), has exempted primarydealers from any profit taxes on bond market trading and financial institutions from taxeson their fee income from underwriting and distributing bonds, and has reduced taxesderived from swaps trading to 10% to further stimulate that market. Hong Kong SAR hasexempted all exchange fund and multilateral agency debt from all taxes, has waived allprofit taxes from interest and dividends for institutional investors, and has reduced by50% 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).


China’s distortionary tax regime appears to hinder the development of institutionalinvestors and penalizes cash versus repo trading in government securities. Cash tradingprofits are taxed at 40% (33% capital gains tax plus 7% business tax) whereas repotransaction are exempt from business tax. Moreover, transaction taxes are among thehighest 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 taxeshave been significantly reduced or eliminated in most OECD countries during the pastdecade. In the case of the UK in the mid-1990s, it has been found that liquidity wouldhave increased by 70% if the transaction costs were reduced from then 2% to 1% (withlong-run elasticity of 1.65).35 Clearly, the current system of securities taxation in Chinais hindering the development of debt markets and of institutional investors.

Competition in China’s mutual fund industry has been very limited, whereby onlysecurities firms and ITICs are allowed to form fund management vehicles. There is not asingle fixed-income mutual fund in existence which has limited the outsourcing byinstitutional investors. Moreover, it appears that Chinese banks are preventing mutualfund development by offering “special” negotiated rates for institutional deposits. Incontrast, 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 isnoteworthy, however, that competition includes banks and NBFI, which have graduallyshifted retail deposits into capital markets, which improved their yield and provided fee-income to the intermediary. In the United States, money-market mutual funds have beenintroduced in 1974 and have been among the fastest growing sectors of the financialsystem. At the end of 1996, 28% of all US mutual funds held only assets that were fullytax-exempt, and at the end of 2000, money market mutual funds accounted for $1,728billion of assets or 14% of all US investment funds. In general, mutual fund returns havesignificantly exceeded deposit rates, and transaction costs have recently declineddramatically. As a result, institutional investors could greatly benefit from the removal ofinvestment barriers. This may require regulatory incentives to improve competition inthe mutual fund industry and to support the entry of money market mutual funds. It mayalso require tax neutrality for qualified debt securities and intermediaries, as well as agradual 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 aninstitutional structure that shares information on borrowers, that promotes good corporategovernance, that effectively enforces prudential standards, and builds institutionalcapacity. All four elements are critical to improve the operating environment in China.

The economic literature demonstrates that asymmetric information between the borrowerand the lender poses problems of adverse selection and moral hazard and makes itimpossible 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.


the credit analysis available to lenders. Although China has a large number of creditrating agencies and has established a joint venture company with strong internationalexperience, credit ratings are mostly not required nor valued, and non-transparentlicensing has enabled rent-seeking by many weak regional credit rating agencies. Forexample, PBC requires ratings for commercial bank loans to employ the many relatedregional credit agencies. In contrast, PBC has ruled that bond issues by commercialbanks do not require ratings, and CSRC has decided that convertible bond issues mayhave “optional” ratings. Unless regulators follow international best practice and requirequalified credit ratings for all issuance and allow for differential credit pricing, there isvery little incentive for institutional investors to develop corporate bond markets.

Good corporate governance has been a buzzword since the Asian crisis, and a recentsurvey has found that institutional investors in fact pay a premium for assets orcompanies that have good corporate governance.36 For example, the survey amonginternational institutional investors found that corporate governance in Korea is perceivedto be relatively good but still lagging behind US standards. As a result, institutionalinvestors would on average pay a premium of 24% for Korean companies that have thebest corporate governance, in other words, corporate governance is as important asfinancial performance in pricing securities. Another concrete example is Brazil, where a“novo mercado” has been established for companies that are meeting best practice forinformation disclosure and corporate governance. Moreover, in Thailand an “Institute ofDirectors” has been established to enforce international accounting standards and toreview the independence of company boards.37 In China, progress on transparency andcorporate governance has been slow, ownership and boards of intermediaries andinsurance companies are still widely controlled by the state, but the establishment of self-regulatory bodies and the enforcement of international accounting standards have beenhelpful. China’s Security Association has been joined by the Investment FundAssociation in August 2001 to help in market development and self-regulatory oversight.

Enforcement of prudential standards is also essential to build confidence amongmarket 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 thelargest insurers failed and the supervisory regime was re-engineered, and in the case ofKorea, where the Insurance Law was significantly strengthened and 13 out of 50insurance companies were closed after the Asian crisis. In China, serious concerns havebeen raised about the capital base of securities and investment companies, which mayneed to be consolidated. Moreover, investment banking research has revealed that mostof the Chinese insurance companies are seriously under-capitalized and that the existingequity needs to be quadrupled within three years.38 In both cases, ownership structuresmay 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 Instituteof Institutional Investor Magazine, October 1999.37 Mako (2001) summarizes a range of corporate governance issues in the Asian context.38 CICC (November 2000) “Looking to the 21st Century: an analysis of China’s Insurance Industry”.


enhanced in order to strengthen the financial viability. Box 3 illustrates the importanceof 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 establishedsince the 1970s and are covered by an elaborate legal and regulatory framework. Penetration of investmentfunds in Korea has been among the highest in emerging economies. At its height in 1999, the ITC sectorwas as big as the volume of deposits at commercial banks. However, the ITC sector suffered from a lot ofproblems, 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 smoothreturns. Korean investment funds were widely regarded as quasi-bank accounts by investors. Second, manyinvestments were concentrated into corporate bonds issued by top five conglomerates, including the ill-fated Daewoo group. Third, poor risk management led to a mismatch between assets and liabilities. With alarge portion of liquid liabilities, especially from financial institutions, the ITCs invested in relativelylonger-term assets. This mismatch led to a systemic risk when a collapse of Daewoo group triggered a runon redemption in 1999. A massive amount of corporate bonds, major investments of the ITCs, could not besold at fair prices. Fourth, although the legal and regulatory framework contained strong principles, theyhave 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, anexplosive 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 aPublic Debt Law, to finalizing an Investment Fund Law, and to amending theCommercial Banking Law. All four laws are critical to establish a legal and regulatoryenvironment that is conducive to financial innovation:

China’s regulatory framework appears to be highly fragmented. In the context of bondmarkets, at least five regulators are involved: MOF for the primary market ofgovernment securities, PBC for financial policy bonds, CSRC for listing of enterprise andcorporate bonds, CIRC for insurance companies, and SDPC for issuance of corporatebonds. Each regulator issues its own set of rules and regulations39 , which are not alwaysconsistent with each other, and which create ambiguities and uncertainties. Consolidationof 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 torealize that consolidation would be to re-define “securities” in the Securities Law toinclude 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.40 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 andadministrative regulations.”


Moreover, China does not have a Public Debt Law41 that exclusively regulatesgovernment public debt, and it instead relies on a set of regulations which leave manyloopholes. For example, procedures on the borrowing limit and parliamentary approval,on the legal underpinning of marketable book-entry government securities, on secondarymarket regulation, on the status of CDC, and on the relationship between regulators havenot been clarified by law. Therefore, it would be helpful to formalize these procedureseither 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 theEuropean 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 alimited liability company, RMB60 million; (b) cumulative value of the bond issues maynot exceed forty percent of the company’s net asset value; (c) average distributable profitfor past three years must be sufficient to cover interest on the company bonds for oneyear; 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 onallowing more innovative financial products could strengthen the Company Law.

CSRC’s decision to allow open-ended mutual funds with foreign joint ventures into themarket has improved transparency and has opened a potentially huge market segment.However, a key stumbling block is the issue to regularize the large reported undergroundfunds, which needs to be addressed in the Investment Fund Law that has been inpreparation by the State Council for the past two years. It appears to be essential tocreate a competitive, well regulated environment that can underpin an expected rapidgrowth of this market, and which allows banks and insurance companies full access,43

which includes specialized private, umbrella and guarantee funds, which prevents conflictof interest, protects investors, provides for segregation of assets and proper oversight, andadopts strict accounting and disclosure requirements. Market participants have suggestedthat one way to include underground funds is to shift from currently “rigid entry barrierand 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 currentstrict segregation principle, which prohibits commercial banks from direct access tocapital markets and fund management, although they can indirectly engage through repotransactions with securities firms. Unless commercial banks are officially allowed accessto professional fund management, it will be impossible to regulate widespreadunderground 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.42 The Company Law does not allow bonds with warrants or option-linked bonds. Further, unclearlydefined is the coordination between the Securities Law and the Company Law. More details are providedby 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 notbe limited to securities companies and trust and investment companies but also include other entities whichare qualified and approved by the CSRC. All applicants need to submit their self-discipline promise to thestock exchange twelve months prior to the date of application to establish a fund management company.


C. Enhancing instruments

C.1. Interest rate liberalization

China has used domestic interest rates as pivotal policy tool to direct credit and influencemarket structures. Economic reforms promoting the growth of the private sector havebeen integrally linked to financial reforms on liberalizing interest rates. While nominalinterest 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 KongSAR. Lending rates have also been partially liberalized as commercial banks are allowedup to 30% discretion from basic rates. However, administrative limits on bank lendingand 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 andincreased trade and financial integration. Institutional investors have a choice ofavoiding domestic bond markets by shifting offshore into dollar deposits (already15% of GDP) or by shifting into Hong Kong SAR through unregulated vehicles orcapital flight (estimated above 2% of GDP each year). Negative spreads to US rateswill only be sustainable with expectations of an appreciating exchange rate.

Foreign financial institutions are already competing for domestic savings. Thegrowth of insurance premia is partly driven by a shift of precautionary savings intobetter performing instruments (fast growth of unit trusts). WTO agreements promiseforeign financial institutions to have access to domestic deposits within a few years,which will require improved competitiveness of domestic commercial banks whichcan no longer rely on preferential treatment through controlled interest rates.

Economic growth has been limited by credit rationing and lack of access for privatefirms, which only account for a small fraction of lending and zero debt capital marketfinancing.44 Unless lending rates are liberalized and de-coupled from capital marketrates, this large market segment may be exclusively serviced by foreign competitors.Moreover, the expected massive need for infrastructure financing may not be realizedunless institutional investors are rewarded with more return for higher risks.

From a perspective of institutional investors, investment decisions in bond markets aremade across the yield curve for a variety of credits, on- or off-shore, with or withouthedging, depending on the asset-liability mix of their balance sheet. Anticipating theongoing liberalization of the real economy and the implementation of WTO promises, itappears 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-yearfixed loan rates are adjusted annually with the prevailing five-year rate.


Chart 4: Chinese Interest Rates (1996 and 2001) versus UST

0

2

4

6

8

10

7-day 1-m 3-m 6-m 1-yr 2-yr 5-yr 10-yr 20-yr

Banks (96)

Banks (01)

GovSec(01)

Corp(00/01)

UST(01)

USCorp(A)

%

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 couldremain below US rates, as it is shown in the example of Singapore with persistentlynegative spreads. However, differentials for corporate credits need to be much largerthan an average 70 bp during the past two years. In the US, credit spreads for single Acorporates 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, widerbands and larger differentiation of lending rates for corporate credits are needed.

Second, liberalization of interest rates does not imply loosing control over short-termtargets but market orientation of longer-term rates. Chart 4 reveals that one-year depositrates 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, theshape of the current yield curve is very similar to the US yield curve, which may not berealistic for long-term rates. Typically, large quasi-fiscal liabilities create expectations ofhigher long-term interest rates especially when markets are integrated and excess demandhas been met. Moreover, bank interest margins also remain 50% below the average ofemerging economies,46 which corroborates the suggestion that more flexibility onlonger-term lending rates is required, whereas prohibitively high deposit rates forinstitutional 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).


Third, liberalization of interest rates does not imply higher volatility but greater marketdepth. The fact that 98% of all interbank market trading is currently taking place in repossuggests that there is both a need for more short-term funding through treasury bills and aneed to trade along the yield curve. This pressure would be alleviated by simply allowingshort positions on government benchmark securities along the yield curve,47 which wouldalso allow traders to take a view on future interest rate changes. Allowing short positionswould also be a helpful step towards re-establishing futures and swap markets, it wouldgreatly support the performance of fixed-income mutual funds, and would enable betterasset-liability management of institutional investors. Experience in other Asianeconomies has shown that additional instruments create more demand, deepermarkets, 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 greatlyimproved 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 thatallow risk-sharing and hedging of positions. The literature identifies a number of positiveeffects from derivative instruments:49 higher liquidity, lower volatility, easier marketaccess, lower transaction costs, and improved depth of the market. On the other hand,suspicion has been raised on whether speculators could destabilize underlying cashmarkets, especially in the presence of institutional weaknesses. This has been the case inChina, where the incident known as “accident GS 327” on February 23, 1995 led to theclosure of futures markets when speculation on futures of three-year government bondsexceeded nine times of its outstanding stock. At the root of the problem was institutionalweakness, 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 andthat temporary problems can be resolved through regulatory action and strong institutions(as it has repeatedly been demonstrated in Hong Kong SAR since 1997). By allowingmarkets to share risks, the efficiency of capital in general can be improved.

Chinese institutional investors have eagerly requested the re-opening of futures marketsunder stronger institutions and streamlined regulation. They are pointing to numerousbenefits 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 goodindication in risk preferences of market participants and needs for additional instruments. Large shortpositions 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 provensupportive for their government securities markets.49 An excellent summary of the literature is provided by Jochum and Kodres (1998) who also apply theiranalysis 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.


asset-liability mismatches, and even attract qualified foreign institutional investors.51 Infact, Singapore and Hong Kong SAR are experiencing the benefits of foreign portfolioinflows as they both are part of the main local market index ELMI+, each holding a shareof 10%, and Singapore was recently also included in the main global government bondindex 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, itwould appear to be prudent for China to first strengthen institutional capacity especiallyin the area of risk management of banks, intermediaries and investment funds whichrequire more sophisticated finance skills to properly diversify risk and reduce ALMmismatches. Moreover, it would be desirable to strengthen market infrastructure withstandardized contracts, margin requirements, a strong clearing house, and integration ofregulators to CSRC in order to allow effective enforcement of regulations. Theintroduction of new instruments could then prove highly beneficial to enhance the roleof 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 diversecorporate bonds are four other products that have evolved in more mature capitalmarkets, where government bonds are utilized for setting benchmarks. These productstruly enable risk-sharing of the private sector through the capital markets and as a resultthey have been greatly contributing to raising the productivity of capital. Mortgage andother asset-backed securities have the appealing feature of collateralizing and thereforereducing risk for the investor and, at the same time, substantially increasing the credit-worthiness 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 corporatebonds (less than 1% of GDP), other comparator countries have issued corporate bondsaccounting on average for 15% of their GDP (21% in Korea, 30% in Singapore). Thisappears 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 incorporations so that they can diversify their risk and have a maximum impact of goodgovernance and management of the company. Moreover, corporate debt offers a newasset class for portfolio diversification, and is attractive for institutional investors thatlook for “high-yield” products. In this respect, a corporate debt market would be a veryvaluable complement to China’s dominant equity market and evolving government debtmarket, and it would allow access for medium- and smaller-sized firms to capital marketfinancing. Moreover, it would help to reduce volatility by providing a more stable sourceof financing than equity markets, which are highly cyclical and often do not allowcompanies to raise new financing.

51 The Chinese government is reportedly considering the introduction of a “Qualified Foreign InstitutionalInvestor” 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).


However, three obstacles need to be managed before a meaningful corporate debtmarket can emerge in China: first, regulatory uncertainty needs to be resolved bydetermining a lead regulator for all aspects of corporate debt. Currently, SDPC maintainsa queuing system for corporate debt issuance, which has been marginal and mostlylimited to SOEs, which could be replaced by a disclosure-based review system operatedby CSRC. Second, the Company Law needs to be revised to allow for a more flexiblestructure of capital and to allow for hybrid types of bonds (such as warrant- or option-linked 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 tomaximum rates of about 9% for corporate issuers, which are still far below rates in theinformal economy, where small companies often pay rates above 20%.

There may be one alternative approach to jump-start the corporate bond market underexisting constraints, which would be to issue convertible bonds , which are already underCSRC jurisdiction, which have previously been issued under existing legislation, andwhich could be attractive for institutional investors even under existing interest rate capsdue to the embedded equity option. One example might be for the government to sell itsremaining 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 timestrengthening corporate governance through bondholders which will most likely beinstitutional investors. This could provide an early pilot model to establish what couldbecome one of Asia’s largest fixed-income markets.

5. Priorities and conclusion

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

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

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

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


There are two significant events for Chinese capital markets: the accession to the WorldTrade Organization with the gradual implementation of liberalization commitments ; andthe 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-incomemarkets, a modern financial sector structure, strong mutual funds, increased supply ofgovernment 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 betteraccounting and disclosure standards, and enhancing of the regulatory framework.

Diversification of instruments requires further interest rate differentiation so thatcapital 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 fromcurrently 6% of GDP to about 30% of GDP over the next five years. The evolution ofChina’s capital markets from little transparent retail segments towards an institutionalrisk-sharing mechanism would not only underpin future economic growth but alsoprovide a new pillar of financial stability while the financial system reinvigorates itself.

Chart 5: China’s Puzzle of Developing Institutional Investors and Capital Markets

MutualMutualFundsFunds

GS SupplyGS Supply

Bank accessBank access

T I M ET I M EC/A openC/A opennownow WTO memberWTO member

SE

QU

EN

CE

SE

QU

EN

CE

c ru c

i al

c ru c

i al

las t

las t

MARKETSMARKETS

RegulationRegulation

Insurance AMInsurance AM

Inv Fund LawInv Fund Law

INSTITUTIONSINSTITUTIONS

HedgingHedging

CorporateCorporate

Interest ratesInterest rates

INSTRUMENTSINSTRUMENTS

MutualMutualFundsFunds

GS SupplyGS Supply

Bank accessBank access

T I M ET I M EC/A openC/A opennownow WTO memberWTO member

SE

QU

EN

CE

SE

QU

EN

CE

c ru c

i al

c ru c

i al

las t

las t

MARKETSMARKETS

RegulationRegulation

Insurance AMInsurance AM

Inv Fund LawInv Fund Law

INSTITUTIONSINSTITUTIONS

HedgingHedging

CorporateCorporate

Interest ratesInterest rates

INSTRUMENTSINSTRUMENTSINSTRUMENTSINSTRUMENTS

Financial conglomerate structures to enhance competitiveness

New competition in fixed- income mutual fund products

Professional asset management of insurance company assets

More market-oriented issuance of Government securities

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.


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Bank of Korea, 2001, “Financial Sector Restructuring in 2000”, Quarterly Bulletin, March 2001.http://www.bok.or.kr/index_e.html

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Bank of Thailand, 2001, “Trends and Prospects of Thailand’s Banking and Financial Sector and its Impactson 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 PaperWP/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 inemerging market economies” in: Bond Market Development in Asia, OECD.

Blommestein, Hendrikus, 1998, “Impact of Institutional Investors on Financial Markets”, in: InstitutionalInvestors in the New Financial Landscape, OECD.

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China International Corporation Limited (CiCC), 2000, “Looking to the 21st Century: an analysis ofChina’s Insurance Industry”, November 2000.

Claessens, Stijn and Daniela Klingebiel, 2001, “Corporate governance reform issues in the Brasilian EquityMarkets”, 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 StrategicOptions”, 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.


Grushka, Carlos, 2001, “An overview of the reformed pension systems in Latin America”, in: “OECDPrivate Pensions Conference No. 3”, OECD.

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Harwood, Alison, 2000, “Building Local Bond Markets: an Asian perspective”, Int Finance Corporation.

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7. Appendix 1: Permissible activities for banking organizations

Country Securities Insurance Real Estate Bank Investmentin IndustrialFirms

Industrial FirmInvestment inBanks

Australia Permitted Permittedthroughsubsidiaries

Limited Permitted withlimits

Permitted withregulatory approval(more than 15%)

Brazil Permittedthroughsubsidiaries

Permittedthroughsubsidiaries

Limited toholdingbankpremises

Limited tosuppliers to thebank

Permitted

China Not Permitted Not Permitted NotPermitted

Not Permitted Not Permitted

EU NotApplicable

NotApplicable

NotApplicable

Permitted withlimits

No generalrestrictions

Germany Permitted Permittedthroughsubsidiaries

Limited;Unlimitedthroughsubsidiaries

Permitted withlimits

Permitted, subject toregulatory consent(suitability of theshareholder)

Japan Some services(selling ofgovernmentbonds,investmenttrusts)

Some services(sellinginsurancepolicies inconnectionwith housingloans)

Generallylimited toholding ofbankpremises

Limited to holding5% interest

Permitted

Korea Permittedthroughaffiliates

Permittedthroughaffiliates

Limited to60% of bankcapital

Prior approval forinvestments inexcess of 15%

Permitted, subject toregulatory consent(suitability of theshareholder)

Poland Partiallypermitted

Permitted Permitted Permitted up to25% of bankcapital

Permitted

Russia Permitted Not permitted Notpermitted

Permitted, but notmore than onegroup

Permitted withregulatory approval(more than 25%)

Singapore Permitted withMAS approval

Permitted withMAS approval

Limited to20% ofbank’scapital

Permitted withregulatory approval

Permitted withregulatory approval(5%, 12%, and 20%or more)

UnitedStates

Permitted, butunderwritingand dealing incorporatesecurities mustbe donethrough: 1) anonbanksubsidiary of abank holdingcompany; 2) anonbanksubsidiary of afinancialholdingcompany; 3) afinancialsubsidiary of anational bank

Insuranceunderwritingand sales arepermissible fornonbanksubsidiaries offinancialholdingcompanies.National banksand theirsubsidiariesare generallyrestricted toagency salesactivities

Generallylimited toholdingbankpremises

Permitted up holdup to 5% of votingshares throughbank holdingcompany

Permitted to makenon-controllinginvestments up to25% of the votingshares

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


Appendix 2A: OECD Investment Limits for life insurance companies

BondsCountry Corporate

BondsGovernmentBonds

Shares Mortgage RealEstate

Loans Cash Derivatives Unit Trust

Australia 100 100 100 100 100 100 100 100 100Belgium 100 100 100 100 100 5 100 5 100Czech Republic NA NA 10 20 25 N NA N 10Denmark 40 100 40 N N Y Y N 40Finland 50 100 50 40 40 Y 3 N NFrance 65 100 65 10 40 10 N N NAGermany 50 50 30 50 25 50 N N 30Hungary NA NA NA NA NA NA NA N NIceland Y N Y Y Y Y Y N NItaly 100 100 35 10 40 Y 15 N YJapan 10 100 30 N 20 10 N N NKorea 100 100 40 100 15 100 100 5 100Luxembourg 40 100 25 N 40 10 20 N 25Mexico 60 100 30 5 25 5 NA 30 NANetherlands N N N N 10 8 3 N NNorway 30 100 35 30 100 1 100 NA 30Poland 5 100 30 5 25 N 100 N 30Portugal 60 60 50 25 45 25 20 N 20Spain 100 100 100 45 45 5 3 NA YSweden 50 100 25 25 25 N 3 N NSwitzerland N N 30 N N N Turkey 2 N 25 N 15 5 3 N 10United Kingdom N N N N N N 3 N NUnited StatesEC VAR VAR VAR N N VAR 3 NA VAR

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


APPENDIX 2B: LATIN AMERICAN INVESTMENT LIMITS (MAY 1998)PORTFOLIO LIMITS Argentina Chile Bolivia (2) Peru Colombia Mexico UruguayGovt. Securities 50 $180mn min 30 50 100 75-85(4)Federal Govt. Securities 50Provincial & MunicipalSecurities

15(1)

Central Bank Securities 30Corporate Bonds 40 45 0 35 20 35 25Corporate Bonds, long term 28Corporate Bonds, short term 14 10Corporate Bonds, convertible 28 10Corporate Bonds, priv. firms 14Bank Bonds 0 25 50 10 25Mortage-backed securities 28 50 30 30Letters of credit 50Fixed Term Deposits 28 50 rest 30 30Short Term margin loans 10Repurchase Agreements 15Shares, plc's 35 37 0 20 30 0 25Shares, workers' shares 20Shares, real state co'sShares, preferred sharecertificate

10

Shares, privatized firms 14Stock index instruments 5Securitized instruments 0 20(3)Primary Issues, new ventures 10Mutual Funds 14 5 0 10 5 0Real estate funds 10Venture Capital Funds 5Securitized credit funds 5Direct Investment Funds 10Foreign Securities 10 12 0 5 10 0Foreign Govt. Securities 10Foreign corp. bonds & shares 7 0Foreign Assets, fixed income 12 10Foreign Assets, var. income 6Hedging instruments 2 9 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 regionalprojects.(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, 40-60in 2000, 30-60 in 2001-5. The difference can be invested in securities not issued by the central state.


APPENDIX 2C: EVOLUTION OF INVESTMENT LIMITS IN CHILE (1981-1998)

PORTFOLIO LIMITS 1981 1982 1985 1990 1992 1995 1996 1997 1998Government Securities 100 100 50 45 45 50 50 50 50Corporate Bonds 60 60 40 40 40 40 45 45 45Corporate Bonds, convertible 0 0 10 10 10 10 10 10 10Mortage-backed securities 70 40 40 50 50 50 50 50 50Letters of credit 70 40 40 50 50 50 50 50 50Fixed Term Deposits 70 40 40 50 50 50 50 50 50Shares, plc's 0 0 30 30 30 37 37 37 37Mutual Funds 0 0 0 10 10 10 5 5 5Real state funds 0 0 0 10 10 10 10 10 10Venture Capital Funds 0 0 0 0 0 0 5 5 5Securitized credit funds 0 0 0 0 0 0 5 5 5Foreign Securities 0 0 0 0 3 9 9 12 12Foreign Assets, fixed income 0 0 0 0 0 9 9 12 12Foreign Assets, variable income 0 0 0 0 0 4.5 4.5 6 6Futures and Options 0 0 0 0 0 9 9 9 12

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


APPENDIX 3A: PENSION FUNDS Portfolio Composition (1998, in %)

PORTFOLIO LIMITS DomesticBonds

Liquidity Loans / (1)Funds

DomesticEquity

Property ForeignAssets

United Kingdom 14 4 0 52 3 18United States 21 4 1 53 0 11Germany 43 0 33 10 7 7Japan 34 5 14 23 0 18Canada 38 5 3 27 3 15France 65 0 18 10 2 5Italy 35 0 1 16 48 0Argentina 53 21 7 18 0 0Brazil 11 10 33 19 0 0Chile 45 32 3 15 0 6Colombia 46 50 0 3 0 0Mexico 98 2 0 0 0 0

APPENDIX 3B: LIFE INSURERS Portfolio Composition (1998, in %)



DomesticEquity


United Kingdom 25 5 1 48 6 13United States 52 6 8 26 0 1Germany 14 1 57 17 4 0Japan 36 5 30 10 0 9Canada 55 7 28 26 7 3France 74 1 2 15 7 0Italy 75 0 1 12 1 0Argentina 40 34 11 10 ... 0Brazil 47 3 37 7 6 0Chile 46 34 11 4 8 1Colombia ... ... ... ... ... ...Mexico ... ... ... ... ... ...

APPENDIX 3C: OPEN-END MUTUAL FUNDS Portfolio Composition (1998, in %)



DomesticEquity


United Kingdom 8 4 0 56 2 33United States 30 17 0 51 0 ...Germany 22 10 0 18 0 29Japan 27 23 18 9 0 22Canada 18 20 3 31 0 23France 37 29 0 20 0 14Italy 54 19 0 22 0 0Argentina 96 ... ... 4 ... ...Brazil 90 ... ... 10 ... ...Chile 95 ... ... 5 ... ...Colombia 87 ... ... 13 ... ...Sources: Davis and Steil (2001) and OECD (2000). (1) Loans for OECD ; Inv Funds for EM


Documents

INSTITUTIONAL INVESTORS - World Banksiteresources.worldbank.org/EXTBANKING/Resources/China-InstInv.pdf · Institutional Investors in China October 2001 page -3-INSTITUTIONAL INVESTORS: