To be presented at the Conference onFinancial Sector Reform in ChinaSeptember 11-13, 2001SummaryIntroductionTable 2: Comparison of three pension plansCHINA’S PENSION SYSTEM REFORM AND CAPITAL MARKET DEVELOPMENT Xin Wang Research Department, China International Capital Corp. To be presented at the Conference on Financial Sector Reform in China September 11-13, 2001 1China’s Pension System Reform and Capital Market Development Xin Wang State Council Office for Restructuring the Economic System Presented to the Kennedy School, Harvard University, International Conference on China and the WTO: the Financial Challenge September 12, 2001 2Summary The paper analyzes the interaction between the pension system and capital market development in general, and the case of China in particular. A funded pension system is most likely to boost the capital market, but in the absence of supportive financial infrastructure and effective financial regulation, A funded system will not be successful. China’s determination to establish a partial funded system is a first step in the right direction, but without the separation of individual accounts from the social pooling and their replenishment, the workout of the implicit pension debt, and improvements in pension fund management and regulation, the pension system will not be sustainable. As to capital market development, the key is to contract out pension fund management to professional asset managers, to support China’s major financial players, and to speed up the financial opening. At this point, investment of pension assets in mutual funds and a pilot program of private-placed, open-end funds can be initiated. 3Introduction There is close relationship between the pension system and the capital market, which is evident in developed countries where pension funds, with large amounts of assets,1 are the key institutional investors in the capital markets. Although this topic has not yet received much attention, the interaction between pension reform and capital market development may be striking. In recent years we have witnessed the reform of pension systems from pay-as-you-go to funded systems in some Latin American and East European countries, where the retirees’ pension benefits come mainly from their individual accounts, not from the contributions of the next generations. As a result, pension assets have increased dramatically, accounting for an increasing percentage of GDP (table 1). Because of the immediate impact of the investment performance of the pension funds on the retirees' pension benefits, many countries are paying close attention to the diversification of pension investments, resulting in the development of domestic capital markets. Part one of this paper presents an outline of the promotional impact of a funded pension system on the capital market by focusing on developing countries that are undergoing pension system reform. Part two analyzes the key factors influencing such an impact. Part three discusses the relationship between China's pension system reform and its capital market development. Policy implications are given in Part four and concluding remarks are presented in Part five. 1 The promotional impact of a funded pension system on capital markets 1.1 Increase in national savings and investment After the establishment of a funded pension system, social precautionary savings, as well as national savings, will increase substantially. More money will be available for capital market investment. In Chile, the ratio of social precautionary savings to GDP jumped from 1.9 percent in 1984 to 3.8 percent in 1994, and the ratio of national 1 In 1987the total assets of pension funds accounted for 29 percent of GDP in the OECD countries; in 1996, the ratio reached 38 percent. The annual growth rate of pension fund assets was 10.9 percent during the 1990-1996 period. 4savings to GDP increased from 13.6 percent to 26.8 percent (Sanchez 1998). Managed by professional institutions, the precautionary savings are beneficial to the optimization of resource allocation and economic growth. Take venture capital as an example. In 1998, US$13.3 billion of venture capital came from the investment of pension funds, accounting for 60 percent of the venture capital commitment; in 1997, the ratio was only 33.1 percent. Without a doubt, the pension funds have played a crucial role in the development of hi-tech industries and the so-called “New Economy.” Another convincing example is provided by an econometric study: the blossoming of pension funds in Chile led to a rise of one percentage point in the total factor productivity (TFP) on a yearly basis and the contribution factor of pension funds to TFP was 50 percent (AIYER 1997). Table 1: Private pension funds in Latin American countries Total assets (million US$) Percentage of GDP(%) 1998 2005* 2015* 1998 2005* 2015* Argentina 11526 57638 181942 3.5 12.8 26.1 Bolivia 367 4215 8538 4.1 32.0 41.8 Brazil 78308 104583 279541 9.5 15.3 26.4 Chile 31366 60127 126345 39.7 49.0 54.8 Colombia 1950 13961 58080 2.1 11.2 30.0 Mexico 9256 53106 165001 2.7 12.4 28.6 Peru 1723 8005 25302 2.5 8.9 18.9 Uruguay 361 1646 4200 1.3 4.5 7.8 Total amount/Average 135471 303172 848949 7.6 15.5 28.6 * Estimate SourceSalomon Smith Barney 1.2 Enhancement of financial competition and financial deepening The growth of pension funds represents a challenge to the dominant position of commercial banking and is beneficial to the expansion of financial markets, and hence, their liquidity and efficiency. A case in point is the case of Chile in 1984 when the stock 5and bond markets were virtually negligible and in 1997, when the capitalization of these two markets were US$7 billion and US$80 billion, respectively. At the end of 1998, 63 percent of government bonds, 54 percent of mortgage bills and banking notes, 16 percent of bank deposits, and 10 percent of stocks were all held by pension funds. 1.3 Acceleration of financial innovation The development of mortgage bonds, corporation bonds, and public agency bond markets in both Chile and Argentina has been largely attributed to pension system reforms. Recently, the emergence and growth of venture capital and infrastructure funds in these countries have attracted more and more pension investment. Furthermore, pension investment has been the driving force behind the evolution of financial derivatives. In