The Seminar on Promoting Institutional Investors in China:
International Experiences and China's Strategy -- co-sponsored by
the World Bank, Institute of Finance of the Chinese Academy of
Social Sciences and Korea Development Institute -- was held in
Beijing on April 1, 2003 with well-balanced representation of over
170 participants from a variety of government organizations and
industry participants.
According to the majority of the seminar participants, China has
the potential of hosting one of the world's largest groups of
institutional investors. However at present, its fledgling
institutional investor sector is hamstrung by a set of obstacles:
i) asset management business is regulated unevenly by different
regulators; ii) institutional investors are subject to rigid
investment restrictions; iii) lack of diversified financial
instruments, coupled with poor capital market liquidity,
substantially restrict the scope of balanced portfolio management;
iv) institutional investors are still predominantly owned by the
public sector; and v) corporate governance on institutional
investors is generally weak.
Despite the country's rapid modernization, many legacies of the
planned economy remained and the "invisible hand" is not fully at
work. Indeed, the lack of harmonization over market, industry and
product regulatory responsibilities has slowed rational market
development. Ambiguities in the legal framework and the often
policy directed market developmental initiatives have also
subjected the country's institutional investors to high degrees of
uncertainties. As a result, sector development is compromised and
the role of institutional investors as efficient conduits between
the real sector and the financial sector is weakened.
In
order to promote a sound and efficient institutional investors
sector, China is recommended to take note of the following guiding
principles. These principles will assist China to establish
identifiable sector development initiatives that can be properly
sequenced and implemented. Policy-makers should be cognizant of the
fact that well-founded policy initiatives will underwrite further
growth in liquidity, discipline, diversity and sector
sustainability.
- Consolidation of standards for asset management services
- Level playing field for private and foreign sector
participants
- Availability of wider range of investment opportunities and
products
- Relaxation of investment restrictions
- Increased role of banks in supporting the institutional
investor sector
Specifically, China can adopt a general strategy to build
well-capitalized, creditworthy and efficient investment management
institutions in the country. This would involve steps to
substantially improve the corporate governance of all financial
institutions offering investment management services and to
strengthen their institutional capacity; the latter includes
ensuring that proper internal controls and internal audit
functions, risk management systems, management information systems
and external audit function are all in place and functioning
appropriately. It also would involve ensuring that the managers and
employees of investment institutions have adequate professional
skills and that they are subject to a system of controls and
incentives that promotes prudent behavior and acting in the
clients' best interest.
For the purpose of efficiency, simplicity and fairness (ensuring a
level playing field), common standards would be applied to all
investment management institutions that manage discretionary
investments of others, including insurance companies, pension
funds, investment fund managers, TICs and securities companies. A
thorough and coordinated review of existing regulations would be
sought with the aim to upgrade them where deficient and to
harmonize them for all classes of investment management
institutions. Similarly, action would be taken to harmonize the
professional qualification requirements of employees who advise
clients or make investment decisions on their behalf. The necessary
professional skills involve investment analysis and portfolio
management.
Efforts to strengthen the governance and institutional capacity of
investment management institutions will not be sufficiently
successful so long as those institutions remain under government
ownership, as almost all are today. Like commercial banks, only few
examples exist internationally of successful government-run
investment management institutions. Thus, ownership diversification
and privatization of existing institutional investors will be
integral to building a substantial professional institutional
investor base; promotion of new entry, including foreign
participation; and creation of level playing field for all
institutional investors, regardless of ownership.
To
this end, particular emphasis would be given the next few years on
increasing foreign participation in the institutional investor
market. The goal would be to transplant a critical mass of
technology and skills sufficient to rapidly and markedly upgrade
the capacity of institutional investors in China. A goal would be
to rapidly train a new flank of Chinese investment professionals to
lay the foundations for a strong domestic segment of the
institutional investor industry.
These general strategies and actions aside, additional steps would
be taken to induce increased securities demand by institutional
investors. Fixed-income mutual funds would be promoted as a means
to increase demand for longer-term government bonds. The proposed
strategy essentially is to promote the emergence of new classes of
mutual funds that would appeal to the growing demand of investors
having less risk appetite and longer investment time horizons.
Liberalization of interest rates in the primary government debt
market would be an essential prerequisite.
To
create demand for infrastructure bonds, action would be taken to
relax investment restrictions currently applied to different types
of institutional investors. China currently employs a restrictive
system of investment options under which investment managers are
permitted to invest only in those areas explicitly listed. The list
often contains limited options vis-`-vis international practices,
restricting institutional investors' ability to craft diverse and
balanced portfolios. A thorough and comprehensive review would be
sought, the aim being to rationalize, harmonize and liberalize the
investment restrictions currently in place. In particular,
investments in long-term infrastructure bonds meeting defined
information disclosure standards and risk characters would be
permitted for all classes of institutional investor. A complement
to expanding the range of permissible investments would be to
improve regulatory requirements on disclosure of risks and probable
returns.
To
create greater investment demand for equities, actions would be
taken strengthen the professional capacity of institutional
investors to manage equity portfolios with a longer-term investment
horizon. Of particular relevance are life insurance companies and
pension funds having long-term investment horizons. Once
appropriate institutional capacity is put in place, investment
restrictions applicable to institutional investors would be further
relaxed to permit investment in equity securities.
Complementary actions would be taken to promote greater foreign
portfolio investment, whether under the new QFII regime or
otherwise. Tapping into demand for Chinese securities by
international investors would be leveraged both to increase the
absorptive capacity of the capital markets for a wide range on
instruments and to create an independent source of pressure for
improved instrument design and pricing, better corporate
governance, improved infrastructure project design, and the
like.
The workshop is intended to bring together all stakeholders
involved to discuss current issues and future directions in
promoting institutional investors in China.
The workshop also featured a country case study, Korea's insurance
sector, which is one of the largest in emerging economies and has
recently accomplished significant post-crisis restructuring.
In
the lead presentation, Yongbeom Kim, Senior Financial Economist of
the World Bank, noted China has one of the biggest savings in the
world, but China's institutional savings make up less than 10
percent of GDP, one of the lowest worldwide. Thus there is a huge
potential unrealized for institutionalizing household savings. He
argued that China faces indeed strong reasons to develop its
capital markets to effectively address key economic agendas: i) SOE
reform will require increased initial public offerings and strong
corporate governance; ii) banking sector restructuring will need
efficient debt capital markets to be developed; and iii) China
intends to mobilize its pension shortfalls through the sale of
state shares which in turn depends on the absorption capacity of
its capital markets. Citing two recent research papers by World
Bank, Mr. Kim stated that institutional investors play an
instrumental role in capital markets development: i) they provide
stable demand for equities and bonds, especially those with long
term maturities - by so doing, institutional investors act as a
countervailing force to the dominant position of commercial banks
and thus promote competition and efficiency in the overall
financial system; and ii) institutional investors also stimulate
financial innovation.
On
the other hand, he stressed, capital market itself needs to be
deepened and diversified for institutional investors to thrive: the
relationship stands to be two-way and interactive. In this context,
two unique and salient characteristics of the PRC equity market are
ill-suited for institutional investors. First, unlike the norm in
equity markets elsewhere, state shares and legal person shares,
accounting for 65% of the total number of shares, in principle
remain non-tradable even after a company is listed. This limits
availability of free floating shares. The other salient feature is
the predominance of small-cap stocks. The Chinese equity market is
one of the world's least concentrated markets. In most of the
world's equity markets, easily over 50% of market value is occupied
by the top 5% of listed stocks (by capitalization) in the
respective markets. The corresponding figure in the Chinese equity
markets is as low as 5.2%, less than one-tenth of the 68% average
observed in six other selected exchanges.
Mr. Kim also argued that a lack of variety in financial instruments
makes it difficult for institutional investors to actively manage
their portfolios. Insurance companies and pension funds want to
increase holding of corporate bonds, but issuance of corporate
bonds is subject to special government approval, something not
easily obtained. In addition, interest rate control on corporate
bonds does not allow spreads to be determined by creditworthiness
of an issuer. The homogenous credit ratings of the small universe
of outstanding corporate bonds (predominately triple-A rated at the
back of strong government affiliation and guarantee arrangements)
further highlights poor credit diversification and restrictive
investment channels. Foreign portfolio investments are also
prohibited under the current regulatory regime. Likewise, the
Company Law does not allow firms to issue such innovative products
as exchange bond or bond with warrants.
In
a following presentation, Mark St Giles, a World Bank Consultant,
provided guiding principles to develop a sound and efficient
institutional investors sector. Three points were particularly
noteworthy:
- Common standards would be applied to all investment management
institutions that manage discretionary investments of others,
including insurance companies, pension funds, investment fund
managers, trust and investment companies and securities companies.
A thorough and coordinated review of existing regulations would be
sought with the aim to upgrade them where deficient and to
harmonize them across all classes of investment management
institutions. Similarly, action would be taken to harmonize the
professional qualification requirements of employees who advise
clients or make investment decisions on their behalf. The necessary
professional skills in investment analysis and portfolio management
need to be substantially upgraded.
- Efforts to strengthen the governance and institutional capacity
of investment management institutions is not likely to be
sufficiently successful so long as those institutions remain under
government ownership, as almost all are today. Like commercial
banks, only few examples exist internationally of successful
government-run investment management institutions. Thus, integral
to building a substantial professional institutional investor base
are ownership diversification and privatization of existing
institutional investors; promotion of new entry, including foreign
participation; and creation of level playing field for all
institutional investors, regardless of ownership.
- Action would be taken to relax investment restrictions
currently applied to different types of institutional investors. A
thorough and comprehensive review would be sought, the aim being to
rationalize, harmonize and liberalize the investment restrictions
currently in place. In particular, investments in long-term
infrastructure bonds meeting defined information disclosure
standards and risk characters would be permitted for all classes of
institutional investors. A complement to expanding the range of
permissible investments would be to improve regulatory requirements
on disclosure of risks and probable returns.
Second session concerned promotion of the collective investment
scheme which may possibly be a double-edged sword -- the fastest
growing institutional investor sector worldwide but prone to
irregularities such as fraud and conflicts of interest. It was
noted that this sector could outgrow institutional capacities,
sowing the seeds for future problems. Mr. Du Shuming, Deputy
Director from Galaxy Securities, and Mr. Tao Xiuming, Senior
Partner of Junjejun Law Firm, respectively discussed salient
features of the mutual funds and trust businesses of China's trust
and investment companies, including serious drawbacks in investor
protection.
Mr. Du reaffirmed the positive role of mutual funds in the
mobilization of household deposits, investor base diversification,
enhancing corporate governance and capital markets efficiency.
Further advancements will, however, be hinged upon continued
enhancements in the regulatory regime, information disclosure,
investor education, distribution framework, corporate governance
and product innovation. In the presentation on China's trust
business, Mr. Tao established that the country's new breed of
post-restructuring trust companies are keen to build up their core
competencies in the trust business, underpinned by collective
capital trust products. However, the lack of credit culture,
deficiencies in institutional arrangements, ambiguities in the
Trust Law, as well as firm-specific risk management and control
issues, stand to be major challenges for the sector's further
development.
The session concluded with another presentation by Mark St Giles on
lessons from international experience, especially classic failure
stories of mutual funds in Russia, India, and Korea. On key
building blocks for developing sound collective investment schemes,
the importance of information disclosure, fair pricing of net asset
value, and control of conflict of interest were extensively
discussed.
Third session was devoted to a country case study of Korea's
insurance sector. In a keynote speech for the session, Jong-Koo
Lee, Standing Commissioner of Korea's Financial Supervisory
Commission, stated that the financial crisis of 1997 had clearly
created an opportunity for the Korean government to overhaul the
basic economic structure. The sense of urgency and consensus on the
need for the drastic reform enabled the government to undertake
full-fledged financial and corporate restructuring programs, using
public funds amounting to US$ 130 billion. As a result of the
success that they achieved with restructuring efforts, both sectors
have regained financial soundness. With the Korean financial system
operating in line with international standards, the economy has
established strong fundamentals to further promote market
disciplines. As for Korea's institutional investors, he said that
Korea's institutional investors in general used to maintain
reserved stance in practicing their shareholder's rights. They
would either entirely drop their voting rights or keep neutral
positions by casting shadow votes upon sensitive issues. According
to his observations, this may all change and they are expected to
take upon new active roles to meet the social demand by closely
monitoring corporate management, and ultimately to meet their
objectives of increasing share values.
Concerning Korea's insurance sector, Seungtae Lim, Senior Economist
of the World Bank, explained contributing factors to the sector's
mercurial growth. In addition, he reviewed Korea's experience in
insurance market opening since the late 1980s. Unique distribution
practices enabled domestic insurers to effectively foil foreign
competition. However, the flipside was that the prevailing domestic
entrenchment prevented the sector from reaping the potential
benefits from foreign participation, which in part contributed to
the status quo that led to painful restructuring of the industry.
In retrospect, he derived the following lessons from Korea's
experience:
- Upon opening market, competition should be carefully guided so
as not to arise in non-productive areas
- Limitations on asset management should have been lifted more
vigorously. Overly strict restrictions prevented life insurers from
successfully adjusting to market changes
- Corporate governance should have been improved before allowing
new entrants
- Role of supervisory authority should be strengthened for market
discipline. The role of supervisory authority should be made clear
in advance to provide more predictability and freedom to
insurers
In
a following discussion session, Craig W. Thorburn, Senior Financial
Sector Specialist of the World Bank, derived implications of the
Korean experience on China's insurance market development.
According to him, the Korean insurance market provides considerable
comparisons of interest to those participating in or overseeing the
development of insurance in China. First, the issues which arise
from a lower interest rate environment and asset liabilities
mismatches are common features in both countries as they are also
in many other jurisdictions. This suggests that useful lessons can
be learnt from an examination of how companies are addressing these
challenges. Second, the competitive environment in insurance sector
is recognized to require improved performance and discipline. In
this respect, avoiding the risk of poor management and corporate
governance will be an important challenge to be faced
vigilantly.
(China.org.cn April 1, 2003)