Emerging institutional investors in China

EMERGING INSTITUTIONAL INVESTORS rNCHINA OCTOBER 2 W EAST ASIA AND PACIFIC REGION THEWORLD BANK B  ABBREVIATIONS AIG American International Group, Inc. ABS Asset-Backed Securities AMCs Asset Management Companies BOC Bank of China BOCI Bank of China International CCB China Construction Bank CD Certificate of Deposit CIFs Collective Investment Funds CIRC China Insurance Regulatory Commission CITIC China International Trust and Investment Corporation CP Commercial Paper CSRC China Securities Regulatory Commission EU European Union FEFSI Federation Europeene des Fonds et Societes d'Investissement (European Federation of Investment Funds and Companies) GDP Gross Domestic Product IPOs Initial Public Offerings JV Joint Venture Ltd. Limited M&As Mergers and Acquisitions MMF Money Market Fund MOF Ministry of Finance MOLSS Ministry of Labor and Social Security NASD National Association of Securities Dealers NBFI Non-Bank Financial Institution . NPC National People's Congress NSSF National Social Security Fund OECD Organization for Economic Cooperation and Development PAYG Pay-as-You-Go PBOC People's Bank of China PRC People's Republic of China QFII Qualifying Foreign Institutional Investors Repo Repurchase Agreement RMB Renminbi (Chinese currency: Yuan) SAFE State Administration of Foreign Exchange SOE State -Owned Enterprises TICS Trust and Investment Companies us United States UK United Kingdom WTO World Trade Organization  Table of Contents EXECUTIVE SUMMARY ...............................................................................................I 1 INTRODUCTION ...............................................................................................1 2 THE ROLE OF INSTITUTIONAL INVESTORS IN CAPITAL M R K E T DEVELOPMENT ........................................................................................................2 3 TODAY'SINSTITUTIONAL LANDSCAPE.......................................................4 Overview .............................................................................................................4 Banks...................................................................................................................4 Pension Funds ..................................................................................................... 6 Insurance Companies ........................................................................................ 12 Collective Investment Funds............................................................................. 16 Securities Companies........................................................................................21 Trust and Investment Companies...................................................................... 23 Underground Funds .......................................................................................... 27 Summary of the Institutional Landscape and International Comparison.......... 28 4 CHANGES IN THE INSTITUTIONAL ASSET M N AGEMENT SCENE ........29 5 THE WAYFOR WARD......................................................................................36 Consolidation of Asset Management and Applicable Standards ......................37 Level Playing Field ........................................................................................... 40 Availability of Wider Range of Investment Opportunities and Products......... 42 Relaxation of Investment Restrictions ..............................................................44 Increased Role of Banks ................................................................................... 50 Pension Reform................................................................................................. 53 6 CONCLUSION..................................................................................................54 REFERENCES ..........................................................................................................60   EXECUTIVE SUMMARY This report describes the existing structure and activities of institutional investors in China. It identifies key principles for building a solid institutional investor base going forward. ' The nation's institutional investors are largely comprised of life insurance companiesand pension- and investment-fundmanagers. In addition, trust and investment companies (TICS) and securities companies offer their clients discretionary asset management services. Overall, China's ratio of institutionally-managed assets is small comparedto developed markets, representingaround 11percent of GDP. The life insurance industry is the largest repository of savings outside banking, and is enjoying strong growth in premium income. At present, life insurance companies are limited mainly to investing in government bonds and bank deposits, but may obtain CIRC permission to invest in other instruments, e.g., privately placed infrastructure bonds. The pension system entails a pay-as-you-go (PAYG) first tier, individual defined contribution accounts as a second tier, and a voluntary contribution. In some regions, individual accounts are used to cover shortfalls in the PAYG first tier. Overall, the prospects for significant accumulations in the individual accounts are limited; the odds are better that the voluntary schemes could eventually accumulate sizeable reserves. In addition, the National Social Security Fund (NSSF) could become a major capital market investor once a means is discovered for funding the establishmentof reserves. Closed-end and open-ended investment funds, both offered by fund management companies, are still in their infancy. Closed-end funds used to dominate, since they have been around longer, but open-ended funds, despite their short history, hold high growth potential. Domestic fund management companies have reportedly been prone to irregularities,includingcollusion and share-price manipulation. IThis report-written by Yongbeom Kim (Senior Financial Economist, East Asia and Pacific Region, the World Bank) and Mark St Giles (international consultant, Cadogan Financiabis an abbreviated and updated version of an earlier report titled, "Developing Institutional Investors in the People's Republic of China." The main thrust of the earlier report was presented at an international seminar on "Promoting Institutional Investors in China," held on April 1,2003, in Beijing. Irene S. M. Ho contributed substantively to the earlier report, while research assistance for this version was provided by Yiping Zhang. The earlier version benefited from valuable comments from David Scott, Dimitri Vittas, Jun Wang, and Xiaoqing Yu. Meanwhile, the findings, interpretations, and conclusions expressed in this paper are entirely those of the authors, They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent.  Securities companies and TICS offer discretionary management services for 1 portfolios of large investors, i.e., mainly for large state-owned enterprises (SOEs). Guaranteed returns are often offered, largely for investments in the equity market. But the market downturn since mid-2001has impaired the ability of securities companies and TICs to honor the promised guaranteed returns for investors. The collapse of many large TICs in recent years revealed many abusive and imprudent practices. Commercial banks play a limited role in distribution, mainly conducting as-agent sales of mutual funds and life insurance. They are prohibited from engaging in securities and insurance activities as principals, although some banks have been able to circumvent these restrictions through affiliated firms. China has the potential to build one of the largest institutional investor bases worldwide. Promoting the emergence of competent institutional investors is an important complement to an overall capital markets development strategy. Since institutional investors tend to have longer-term investment time horizons, they provide an ideal source of funds for investment in longer-term government and infrastructure bonds. Moreover, institutional investors would add depth and liquidity to the equity markets. Tapping into this demand will improve prospects for the market to better absorb increased equity supply resulting from the sale of state shares. Institutional investors would increase pressure on firms, listed and otherwise, to adopt better corporate governance structures and practices. The benefits cited above can be achieved through a general strategy to build well- capitalized, creditworthy and efficient investment management institutions in China. 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 would include ensuring that proper internal controls and internal audit functions, risk management systems, management information systems and an 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 of upgrading 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 are not likely to be sufficiently successful as long as those  institutions remain under government ownership, as almost all are today. Only a few examples exist internationally of successfill government-run investment management institutions, and these have occurred under social and economic conditions very different from those in China. Thus, the factors 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 a level playing field for all institutional investors, regardless of ownership. To this end, particular emphasis would be given over the next few years to 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, and to rapidly train a new cadre of Chinese investment professionals to lay the foundations for a strong domestic segment of the institutional investor industry. In addition to these general strategies and actions, steps would be taken to encourage increased securities demand by institutional investors. Fixed-income mutual funds would be promoted as a means of increasing 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/or 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 permits investment managers to invest only in those types of products explicitly listed, thus restricting institutional investors' ability to craft diverse and balanced portfolios. Further, the permitted investments are often limited, in comparison to international practices. A thorough and comprehensive review would be sought, with the goal of rationalizing, harmonizing and liberalizing the investment restrictions currently in place. In particular, investments in long-term infrastructure bonds meeting defined information disclosure standards and risk characteristics 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 to 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. Once appropriate institutional capacity is 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, and improved infrastructure project design.  1 INTRODUCTION 1. China needs to develop solid long- national, strategic objectives, resulting in a term investment institutions, which can be highly polarized deployment of savings by broadly categorized as pension funds, life- the population. insurance companies and collective investment funds. 7. The more risk-averse individuals prefer to keep savings with institutions that 2. These types of institutions currently they recognize and trust (largely banks, the exist in China, but they are at a nascent stage government, and to some extent life- of development and would benefit from insurance companies) despite falling yields more clearly defined plans for their future resulting from a progressive reduction in development. interest rates; real returns on offer are now very low by international standards. At the 3. China's capital markets and other end of the spectrum, those prepared to investment sectors have been growing accept risk gamble in the equity markets. swiftly, but at the cost of being developed There is little on offer between these two ahead of the strategic, legislative and extremes. regulatory framework. 8. Currently, Chinese households 4. The resulting institutional landscape deposit 75 percent of their savings into is characterized by blurred boundaries banks, with only 4 percent invested in the among the different institutions and their insurance-and-pensionsector. In contrast, in activities; an insufficient legal base; varied the US, the insurance-and-pension sector (and sometimes competing) regulatory holds the biggest share with 30 percent, agencies; and jurisdictional uncertainties while currency and deposits account for only among institutions. 15 percent. Japan's case, in a sense, looks somewhat similar to China's, but Japan has 5. The rigid and restrictive structure a solid insurance-and-pension sector that placed on institutional investors along with attracts more than 25 percent of household unclear direction resulted in the emergence savings. of so-called underground funds-informal, semi-legal structures designed to let larger 9. To have a balanced financial system, investors seek semi-professional managers household savings ought to be well spread for their portfolios. across banking and non-bankingproducts, as in the US. Thus the medium-term objective 6. There are few well-recognized and for China would be to increase its non-bank trusted non-bank financial institutions sector, especially its institutional investors (NBFIs) among the institutional investors. sector, to a level on par with Japan's. This has discouraged the vast pool of domestic household savings from being 10. To reach these goals, this paper notes constructively mobilized to meet key the existing structure and the activities of institutional investors in China and provides - Household deposits stood at RMB 8.04 trillion, or some principles on how to build a solid US$ 971 billion (1 US$ = 8.28 Yuan), which is 83.8 institutional investor base going forward. percent of GDP at end-May 2002, while the total balance of all deposits amounted to RMB 15.33 trillion (160 percent of GDP).  11. Specifically, this paper reviews the the implications of financial sector opening relationship between capital market and the emergence of financial development and institutional investors conglomerates (section 4); discusses (section 2); provides a brief overview of principles for successful development of China's financial landscape vis-a-vis institutional investors in China (section 5); institutional investors (section 3); focuses on and summarizes the conclusions and recent changes in the institutional asset recommendations (section 6). management scene, with special attention to 2 THE ROLE OF INSTITUTIONAL INVESTORS IN CAPITAL MARKET DEVELOPMENT 12. China has strong reasons to develop and equity. One of the most distinctive its capital markets. SOE sector reform, recent changes in financial markets is the banking system restructuring, and pension 'institutionalization of ~ a v i n ~ ' ~shift - - a away reform constitute key economic agendas for from individuals' holding equity directly the government, and successful toward intermediaries holding it5 The drop implementation of these three agendas will in individual holdings to a large degree has require robust capital markets. SOE reform, been replaced by the increased share of for example, will involve increased initial pension funds, life insurance companies, and public offerings and strong corporate collective investment funds. Among them, governance; and banking sector collective investment funds have recently restructuring will need efficient debt capital exhibited the most rapid growth in many markets to be developed. Further, China countries. For example, the recent intends to address its pension shortfalls comparative figures from the Organization through its sale of state shares, which in turn for Economic Cooperation and Development depends on the absorption capacity of its (OECD) show that collective investment capital markets. funds in OECD countries had an average annual growth rate of 20 percent in the years 13. To develop her capital markets, 1991-1998, compared to 13 percent for China needs, among other things, to foster pension funds and 11 percent for insurance 3 the institutional investors sector. companies. Institutional investors play an instrumental role in capital market development in the 15. Second, institutional investors act as following ways: catalysts for financial innovation by creating new products, improving accurate pricing of 14. First, they provide a means of financial assets, encouraging new market- channeling savings into the capital markets with medium- to long-term investment 4David and Steil (2001) provide a comprehensive horizons and with low-to-medium-risk to economic assessment of this important shift. Individual ownership of equity has fallen in the investors. They also provide absorption United States from 79 percent in 1966 to around 50 capacity for issues of public and private debt percent in 1993, while corresponding numbers in Japan were 53 percent in 1953 and about 20 percent 3 Major agendas include increasing the supply of in 1993 (Allen and Gale, 2001,p. 58-67). 6 quality shares; improving securities regulation; better Fernando et al. (2003) provides an excellent survey protecting investors' rights; enhancing market of the global growth of collective investment funds. integrity; and reforming corporate governance. OECD (2002).  participant entry, and pursuing better institutional investors to the development of clearing and settlement. In the US, for capital markets. Specifically, this research example, institutional investors, especially usually shows that those countries with more pension funds, played a key role in developed institutional investors sectors are introducing such innovative products as also the counties with more advanced capital zero-coupon bonds, mortgage-backed markets, both in terms of market size and securities and financial derivatives since the value traded (e.g., Calatan, Impavido, and 1970s. Similarly, the development of Musalem, 2000). Impavido, Musalem, and money market funds (MMF) has contributed Tressel (2003) suggested that the to financial innovations in money markets, development of contractual savings notably CDs, CP, swaps, and repurchase institutions (pension funds and life insurance agreement (RP). Pressure from large companies) had a positive impact on the institutional investors to lower commission development of equity markets in countries charges for large trading volumes often led with a capital market-based financial system, to freeing up stock brokerage commissions while the development of the contractual and sparked even broader capital market savings sector contributed to the bond reform-eventual1 y resulting in the so-called market more in countries with a bank-based the "Big Bang" in the United States in the financial system. As a country case, the 1970s and in the United Kingdom in the Chilean pension scheme8, initially set up in 1980s. 1981, and the capital market development that followed is widely viewed as 16. Finally, institutional investors help exemplifying the positive interaction establish high standards for compliance, between them. disclosure and oversight of information (especially financial statements) and help 18. The close linkage between strong improve corporate governance of market institutional investors and capital market participants. Only large shareholders such development should not be seen as a "one- as institutional investors have sufficient way street," however. Instead, the incentives and abilities, including the relationship is interactive: capital market financial ability, to monitor and communicate with corporate management This innovative scheme was designed to replace the on a consistent basis. In the United States, state pay-as-you-go (PAYG) system that was among large public pension funds such as the the earliest in the world offering almost universal California Public Employees Retirement coverage (established in 1925, ten years before the Scheme (CalPERs) and the Teachers US scheme). Under Chile's privatized system, which is monitored and regulated by the government, Insurance and Annuity Association-College neither the worker nor the employer pays a social Retirement Equities Fund (TIAA-CREF) security tax to the state. Nor does the worker collect have played a prominent role in shareholder a government-funded pension. Instead, during his activism. The mode of intervention varies, working life, he has 10 percent of his wages and may include submission of shareholder automatically deposited by his employer each month in his own, individual account. The contribution is proposals to companies and directors; direct not taxed. His pension level is determined by the negotiation with corporate management; and amount of money he accumulates during the number publicly targeting corporations through the of years he is working. The steady growth of funds media (see Gillan and Starks, 2002). under management has not only achieved the primary purpose, to provide social security benefits for old age, sickness and unemployment, but has also had the 17. Cross-country empirical research effect of energizing the capital market. See also supports the importance of strong Holzmann (1997).  structure can either stimulate or impede if things go wrong; meaning that the development of institutional investors, enabling legislation plays a major role in especially collective investment funds creating and sustaining investor confidence. (CIFs). As argued by Vittas (1998), pension The availability (or lack thereof) of suitable funds and life insurance companies could financial instruments is of major importance develop on their own even when capital as well, especially for money market funds markets are underdeveloped. They initially whose success depends largely on their easy could develop on the basis of non- access to the higher wholesale money marketable instruments such as loans, bank market instruments<Ds, CP, swaps, and deposits, non-marketable government bonds, RP-that are not usually available to book reserves, and property investment. ordinary investors. The case is different for CIFs, however. Unlike insurance contracts and defined 19. Further, if institutional investors are benefit employer-sponsored pension constrained by restrictive investment limits, schemes, in which the insurance company they cannot fully exert their beneficial and the sponsor respectively stand between impact on capital market development. For the participant and the capital market as a example, empirical analysis by Calatan et. a1 guarantor, CIFs transfer the investment risk (2000) found that the positive externalities to the investor. In return for accepting risk, arising from the development of contractual investors in CIFs gain considerable savings institutions were less likely to advantages, including a higher degree of risk materialize if those investors were permitted diversification, lower transaction costs, to hold only non-marketable government professional management, investor bonds. In contrast, a strong causality from protection and flexibility. To achieve these contractual savings to stock markets and comparative advantages, CIFs require a deep, liquidity was observed in market-based wide and liquid capital market supervised by systems in which the 'prudent investment competent regulators under a reliable legal rule' is a norm (Vittas 1998). These and regulatory framework. CIFs only observations support the conclusion that develop successfully where legal systems simply increasing the size of provide for clear and fair mechanisms of institutionalized assets does not asset ownership and transfer and for redress automatically lead to development of capital markets. 3 TODAY'S INSTITUTIONAL LANDSCAPE Overview China, Bank of China, China Construction Bank, and Agricultural Bank of China-are 20. Institutional investors in China today the dominant players in the PRC financial include commercial banks, pension funds, sector, accounting for 86 percent9 of total insurance companies, collective investment bank assets and 66 percent10of total local funds, securities companies, and trust and currency loans. investment companies. Underground, or privately placed, funds also exist. Banks 21. The four state commercial Economist Intelligence Unit (2002). banks-Industrial and Commercial Bank of 'O As of December 31, 2002: PBC website, bank annual reports.  22. Second-tier nationwide commercial non-banking activities, including the banks" are much smaller than the four state securities business. Following the separation commercial banks. Many of these banks, of banking from non-banking, the People's however, are more profit-oriented with Bank of China (PBOC) required banks to better management. In fact, some small- gradually shed their ownership of non-bank and medium-sized regional banks are financial institutions. emerging as innovative players in banking. For instance, Nanjing City Commercial 24. The separation principle--sometimes Bank has played a marked role in dubbed the 'Chinese Glass-Steagal1'-refers government-bond trading. to banks being permitted to offer only non- bank financial products produced and 23. Banks are tightly restricted in their managed by others. Banks thus cannot ability to offer clients anything other than design, produce, market and manage deposits, non-tradable government savings products that they regard as appropriate for certificates or, as a new product offering, their own customers and that their own marketable government bonds. l2 While customers will trust as a result of the bank's banks can and do distribute, on an as-agent reputation. basis, insurance policies and investment funds produced and underwritten by other 25. To date, although banks have played non-bank institutions, they are specifically a dominant role in collecting and mobilizing prohibited from engaging in the securities public savings, their role in deploying those business or owning or investing in non-bank savings and advising their customers has financial institutions13. Prior to this ban, been limited, both by the Law and by the which is contained in the Commercial burden of lending to SOEs at interest Banking Law of 1995,the four largest state- rateMightly controlled by PBOC and State owned banks had involved themselves in CouncilAhat are low and undifferentiated by assessments of credit risk, which in turn I' Important banks in this tier include: Bank of has promoted artificially low interest-rates Communications, China Merchants Bank, for money instruments and short-term Guangdong Development Bank, Shanghai Pudong deposits. Development Bank, Shenzhen Development Bank, China Everbright Bank, Huaxia Bank, and China Minsheng Bank (nation's first private bank). 26. The general population, nevertheless, believes that bank deposits are fail-proof, 12Beginning in June 2002, selected large commercial banks were allowed to have over-the-counter bond and .thusare prepared to accept low interest- dealings with individuals and corporations, holding rates in return for 'secure' capital. This has custodian accounts for them. In the past, the lack of a resulted in limited savings choices, with sub-depository system impeded banks' ability to trade bonds with retail investors. conservative and risk-averse savers " The PRC Commercial Banking Law of 1995 (including those who might otherwise be (Article 43) states that a commercial bank shall not more risk inclined) trapped in bank deposits, engage in trust investment or stock business; any since few alternatives exist for short-term investment in non-bank financial institutions or savings. enterprises is also prohibited. The Securities Law of 1998 (Article 6) similarly states that securities companies must be established separate from banks, 27. Commercial banks are key investors trust companies and insurance companies. The of government and quasi-government Insurance Law of 1999 (Article 104) states that securities. As of December 2002, the insurance companies are not allowed to use their country's financial institutions had built up fi~ndsto set up institutions dealing in securities or loan and marketable securities portfolios of invest in enterprises.  Rh4B 14 trillion and Rh4B 2.3 trillion Pension Funds respectively. The marketable securities 29. In developed countries that have portfolio is largely comprised of PRC funded pension schemes, l5 schemes of government bonds and financial policy various sorts (defined benefit, defined bonds 14. The risk-free characteristics of contribution and personal, whether these securities, coupled with stringent employer-sponsored segregated schemes or restrictions on foreign investments, has insured schemes) are the most significant caused this portfolio to swell over time. long-term investors in capital markets. As Depending on the size of their foreign of end-1999, US pension assets posted 47.5 currency deposits (which is growing with percent of all institutional assets.16 In the the surge in foreign reserves), the four state- UK, in the same period, pension assets owned commercial banks and the larger accounted for nearly 50 percent of all commercial banks also invest in foreign institutional assets. l7 In China, pension bonds on their own account, as well as on schemes should also be important capital behalf of clients. market participants. 28. With the emergence of securities 30. Until the late 1980s, an urban- and investment funds, commercial banks started state-owned enterprise-based pay-as-you-go to develop their custody business as a new (PAYG) system provided a generous source of fee-based income. The custody pension, i.e., 80 percent of a worker's total business is the business area closest to the salary in addition to health, housing and securities business that is permissible for basic welfare support (so-called "iron rice PRC commercial banks. So far the market bowl"). A shift to a market economy is dominated by the four state-owned rendered many SOEs, facing increasing commercial banks and to a lesser extent, competition from the private sector, unable Bank of Communications. Following to pay their retirees the promised full approvals by PBOC and CSRC in November pension benefits. More fundamentally, 2002, China Everbright Bank and China demographic change has made the pension Merchants Bank also entered the market. obligation~whosoever should bear them-very costly to fulfill. 31. After years of experimenting with municipal pooling and individual accounts, China's government introduced a nationwide basic pension system in July 1997. l8 Under the new system, which l 5US, UK, Netherlands, Denmark and Switzerland all have substantial fully-funded schemes. Germany, France, Spain and Italy still rely largely on taxpayer- funded PAYG schemes, although all these countries, notably Germany and Spain, are taking tentative steps towards a higher degree of funding. 16 The Conference Board (2000). "UKOfficeofNational Statistics. l4Offered by China Development Bank and the l 8The State Council's Document No. 26: "Decision Export-Import Bank of China. on Developing Unified Basic Old Age Pension  combines social pooling with individual percentage point every two years up to an 8 accounts, local governments, not SOEs, percent ceiling. The enterprise's assume responsibility for pension contribution rate will gradually decrease administration. This two-tiered single-pillar from 7 percent to 3 percent of wages. system was intended to settle into the following pattern: 33. Retirees who have contributed for at least ten years will receive the basic pension (a) Basic pension benefit (social pool): benefit aid the individual account benefit, A pay-as-you-go (PAYG) defined benefit estimated to provide a replacement ratio of system, operated at the provincial level, some 58.5 percent for the average employee. which will provide 20 percent of the Those who retired before the reforms were workers' average wages in respective implemented will continue to receive localities from the previous year as a pensions at approximately 79 percent of subsistence-level defined benefitL9 replacement rate (see Table 1). (b) Individual account benefit: A mandatory defined contribution scheme Table 1. Combinationof Social Pooling with contributions directed toward with IndividualAccount individual accounts, which, in Target theory, should be funded. It would Replacement Contribution Rate (based entitle retirees to a monthly Composition Contributor Rate on local annuity equal to the accumulated average individual account contributions wages) divided by 120. Basic 20% of total Pension employerlenterprise 20% payroll 32. Contribution rates vary by Benefit 11%ofthe provinces and municipalities. In wages, (6% general, the enterprise contribution employer & Account by employer, 38.5% employee rate to the social pool is 20 percent Benefit 5% by 1 I I1 of total wages. However, 1 I employee) - enterprises must contribute employer (rates vary across regions) approximately Pension 20% additional social security costs of Source: Sun (2004) some 14 percent of total wages. 'O This heavy contribution burden not only hurts 34. In terms of account administration, their competitiveness but also leads to the current pension system remains highly widespread non-compliance. Total fragmented, managed by some 5,000 local contributions to individual accounts are set social insurance agencies. The local social at 11 percent of wages, with individual insurance agencies administer and manage employee contributions starting at 4 percent both social pooling and individual accounts of wages and gradually rising by one schemes in-house, including collection 21 , record keeping and reserve management. System for Enterprise Employees," promulgated in For disbursement, four state commercial 1997. 19Employees with less than 15 years of service will not be eligible for social pooling distribution but the balance in their individual accounts will be paid out 21Currently both local social insurance agencies and in one lump sum. local tax bureaus share collecting duties. Eventually, 20 These include: unemployment (2 percent), medical however, local tax bureaus are expected to assume (6 percent), and housing (6 percent) at minimum. full responsibility for the collection.  banks and the Postal Savings Bureau are implementation remains a source of entrusted. skepticism, however. Evidently because of low compliance and transitional costs, many 35. According to the State ~ouncil's local pension pools are still running deficits Document 26 of 1997, individual accounts even after contributions to individual were to be funded at 11 percent, with accounts are diverted to supplement the employee contributions to start at 4 percent deficits in the PAYG first tier,2srequiring of wages (in 1997) and rise by one subsidies from the governments-provincial percentage point every two years up to the 8 and central alike. percent target. The remaining balance is to be funded by enterprise contribution^.^' In 37. To adjust pension liabilities across theory, individual accounts could have provinces, the central government annually opened a new chapter of funded pension arranges a special fund transfer with general schemes in China. In practice, however, budget revenues of the national treasury. individual account accumulations have been For example, the Ministry of Finance widely used to pay retirees and to support (MOF) had to allocate RMB 48 billion (0.4 the unfunded liabilities of the PAYG percent of GDP)26in 2003 to finance the pensions, preventing any real accumulation pension gap at the national level (Table 2).27 of funds in most provinces. Some municipalities accumulate reserves but in Table 2. Government Subsidy to the most jurisdictions, individual accounts are Basic Pension System (RMB billion) I I I I I I I "empty" with no separate funding. In this sense, the overall public pension system, consisting of social pooling and individual accounts, is currently running on a de facto Source: Sun (2004) PAYG basis. 38. In 2001, State Council Document No. 36. Document No. 26 also envisaged 42 introduced a pilot program in Liaoning, pooling the redistributive basic pension one of the most financially burdened benefit contributions at the provincial level provinces in northeast China. One salient first, and then at the national level. By the feature of the program involves the end of 2001, all provinces have reportedly separation of the individual accounts from either put in place pooling mechanisms2]or the rest of the system and their mandatory established adjustment funds to level out full funding with 8 percent individual surpluses and deficits across contributions. Similarly, the management of cities/counties. 24 The outcome of actual individual accounts is required to be separated from the administration of the - - - PAYG system. The resulting deficits in the 22When the system first started in 1997, individuals contributed 4 percent of the average wage, with enterprises picking up 7 percent to make it 11 percent. Currently average individual contribution 2sIn 2001,28 out of 31provinces registered deficit. rate stands around 6 percent, lowering enterprise 26MOLSS Development Statistical Report (2002). contributions to individual accounts to about 5 *'Thistransferprocess isfarfromsmooth. Giventhe percent. poor recording system at the sub-national level, MOF 23Notably a portion (5 percent to 10percent) of such is legitimately concerned about both false reporting hnds at the citylcounty level is elevated to the and moral hazard by local governments. Not provincial social insurance agencies to level out knowing the extent of the actual provincial-level surpluses and deficits across cities/counties. pension shortfall, MOF is generally reluctant to 24MOLSS Development Statistical Report (2001). transfer central budget to local governments.  PAYG system will be covered by improved Table 3. Multi-Pillar Pension System in compliance efforts, within-province fund the Making I reallocation, and most importantly, fund Target Contribution Composition Contributor Replacem transfers from the national budget. Rates ent Rate I 30%of total 39. The Liaoning pilot" represents a Basic Pension employed payrollltax 30% Benefit enterprise 1 general policy direction toward eventually exempt 1 1 1 building a new multi-pillar pension system 1 determinedby under which government's excess burden in I Local Pension local Jocal , 0-10% the generous PAYG first pillar is alleviated, Fund government in while the hnded second pillar (individual I 1 I the future 1 i 8%of accounts) and the voluntary third pillar Individual employee wagesltax 0-20% (particularly corporate pensions) play a Account I exempt bigger role. The new system envisages that minimum 8%of total wages/4% the central government will provide Corporate employer & tax deferral, minimum benefits to all covered urban 0-25% Pension Fund employee other 4%tax enterprise members nationwide, while local deferral in the governments will provide their own Source: Sun (2004). supplementary public schemes that are subject to the same contribution ratio 40. The prospects for the second and nationwide, but linked to local income levels. third pillar pension funds, however, will Given the great disparity in income levels largely depend on the means by which the across the country, the ultimate pension state covers the pension shortfall. Aside package will also vary greatly under the new from the historical pension deficit of up to scheme. Specifically, the combined level of RMB 3 trillion in the PAYG pillar, "empty" benefits offered by both the central and local individual accounts make up RMB 600 governments would not exceed 40 percent of billion, with annual increments of RMB 100 average wage at retirement (see Table 3). billion. 29 If local governments stop borrowing from the second pillar individual accounts to finance the first pillar PAYG deficits, thereby helping individual accounts accumulate, as envisaged in the new multi- pillar system, the PAYG shortfalls will likely increase accordingly. This means that the central government will likely have to increase budgetary transfers to fill the bigger gaps, leading to an increasing fiscal deficit and placing a greater strain on the national budget. 41. In an effort to address the medium to long-term issue of unfunded pension 29 Sun (2004). The historical pension deficit could decrease substantially should the government reduce 28It is scheduled to be expanded to the neighbouring the target replacement rates of the PAYG system as Jilin and Heilongjiang provinces. envisaged.  liabilities, the Chinese government portfolio equity investment, owing to the established the National Social Security volatility of the equity market and to the low Fund (NSSF)~'in September 2000. NSSF share quality of some of its listed companies. does not form part of the mainstream state In January 2003, the Council awarded 11 pension pool, but is being built up as a equities and fixed-income portfolio reserve fund to cover potential unhnded management mandates to six qualified 32 liabilities in the PAYG system resulting domestic fund managers. This decision from an aging population and an increasing marked the historical beginning of pension dependency ratio. fund participation in the equity market to - - anchor the otherwise highly speculative and 42. The NSSF is to be hnded by short-term oriented market. As a result, the budgetary transfer by the central NSSF has managed to build a balanced government, proceeds from the sales of state portfolio of bonds (47.7 percent), bank shares, and other sources such as receipts deposits (41 percent), and equities (11 from national lotteries. The State Council percent) as of July 2 0 0 4 . ~ ~ decided in June 2001 to sell a portion of state shares during initial public offerings 44. In June 2003, the State Council (IPOs) to finance pension shortfalls. decided to transfer some SOE equities Specifically, when SOEs (including directly into the NSSF for funding purposes. companies listed overseas) launched IPOs or China's government holds two-thirds of issued additional stocks in the secondary listed SOE shares and hundreds of those market, they were to sell state shares-up to non-listed. 34 The first to be expectedly 10percent of the total hnds to be raisedLto replenish the NSSF. However, the sell-off 32Fund management companies or other institutional of state shares, being widely unpopular, was investors are qualified if they (a) meet minimum blamed in part for the subsequent equity paid-in capital requirements (RMB 50 million for a market decline. Thus the government fund management company, but not yet decided for suspended the sell-off in October 2001. other institutional investors); (b) have a minimum of two years experience in securities investment; (c) 43. Another important objective of the demonstrate &od corporate governance; (d) have no record of severe irregularities; (e) have sound internal NSSF is to participate in the development of management; and (f) have control systems and the institutional investment sector in China. qualified staff for investment business. Since its inception, the NSSF has grown to a 33 In December 2002, the corresponding numbers value of RMB 132 billion (1.17 percent of were: bank deposits (76 percent), government bonds GDP) as of December 2003. Although the (22 percent), and equities (2 percent). 34 In terms of share ownership of state-owned regulations3' would permit up to 40 percent enterprises (SOE), three different types of shares are of NSSF's assets to be invested in equities, issued in China: individual. legal person, and state. the NSSF Council in the past opted out of Legal person shares are held by domestic institutions (joint stock companies, NBFls, and SOEs with at least one non-state owner). The ultimate owner of 30 The NSSF is a public agency under the State the state shares is the State Council. Unlike the norm Council and is primarily supervised by the MOF. in equity markets elsewhere, state shares and legal The Council of the NSSF, which includes the finance person shares, which account for roughly 65 percent vice-minister as an ex-officio member, is the highest of the total number of shares issued, remain non- decision-making body of the Fund. tradable, in principle, even after a company is listed. 3'"Provisional Regulations on the Management of State shares can only be transferred to other Investment by Social Security Fund" issued by the institutions via private negotiations, and legal person Ministry of Finance and the Ministry of Labor and shares used to be only transferable via private Social Security. placements.  transferred are those drawn from the 187 for regular investment flows into the capital central government enterprise groups which market in China. Some municipalities are include the nation's best known utilities and running considerable surpluses. 37 Total infrastructure firms (e.g., steel, reserve accumulation of individual accounts petrochemical, telecommunication, and is estimated at 0.8 percent of GDP. '" power). Beyond that, it is still unclear Reserves are mostly invested in bank which type of assets would be covered by deposits or government bonds. On the framework (e.g., listed vs. unlisted, implementation, no clear governance central government vs. local government structure exists for the individual accounts, enterprises, etc.). with trustee responsibility for ensuring correct investment policy and allocation of 45. On balance, the NSSF holds great benefits. Selected regions along China's potential to amass huge reserves, l5 and prosperous east coast, e.g., Guangdong would become a dominant institutional province and Shanghai municipality, will investor in China. However, it remains to be witness robust growth of individual seen how long the government, facing account^.^' These regions are less burdened increasing pension shortfalls, would leave by pension obligations originating from the the NSSF untouched. Currently, it is large poorly-performing SOE sector and unclear how and when the government will have also experienced greater economic distribute the NSSF to subsidize the pension growth. However, so long as individual shortfalls of provinces/municipalities. accounts are managed by local government staff who may lack financial expertise, the 46. Further, the unique funding source of funds of second pillar individual accounts the NSSF would somewhat limit its net will likely exhibit inertia toward bank impact on the stock market. Unlike typical deposits and government bonds, limiting funded pension schemes elsewhere that their impact on capital market development. collect contributions from participants, China's NSSF would be funded mainly 48. Voluntary supplementary schemes of through state share sales proceeds, i.e., the various sorts that offer personal pensions or potential supply of a portion of such shares small group pensions for companies are still to the local equity markets. '"herefore new in China. Legal and regulatory even though some of the NSSF reserves frameworks for enterprise pensions were, at would be reinvested in shares of different most, scant until recently. As of end-2003, listed companies, the Fund's impact on China had some 20,000 enterprise pension demand in the equity market would be funds with 6.6 million participants, the partially offset, or in some extreme cases be combined total reaching RMB 30 billion outweighed, by supply pressure in the equity (0.25 percent of GDP). The funds from market. 37 Guangdong (RMB 10 billion), Liaoning (RMB 10 47. Clearly, the second and third pillar schemes are potentially substantial sources billion), Jilin and Heilongjiang (RMB 6 to 8 billion each): MOLSS estimation. 38 Mark Dorfman (2002). The ratio would be equal 35Sun (2004) estimates the NSSF to grow up to RMB to RMB 93 billlon in terms of 2003 GDP. 1 trillion in five years. 3')Sun (2004) estimated that the annual increase of 36 If the sales involve block sales to strategic the second pillar could amount to around RMB 100 investors or M&As. the shares will not be billion, provided that the funds would be no longer immediately supplied to the secondary equity market diverted to the PAYG pillar. a tall order at the for portfolio investment. moment.  voluntary schemes are usually invested in services as a trustee, an investment manager, bank deposits and government bonds. and a fund administrator, but a custodian Voluntary contributions to the plans, up to 4 business must be separated from other percent of wages, are tax deductible under pension-related businesses. Investment the Liaoning pilot. Employers are restrictions include: bank deposits and encouraged to match employee contributions. money market instruments (minimum 20 Employers can establish supplementary percent), fixed income securities (minimum schemes utilizing in-house expertise. 20 percent, maximum 50 percent), and Financial institutions, including life equity-related products (30 percent). insurance companies, can initiate and manage these schemes. Sponsors of the 50. The significant improvement in legal voluntary funds include large SOEs and and regulatory frameworks notwithstanding, foreign joint ventures. the development of this sector will remain modest, as the impediments include: 1) a 49. The new direction toward reduced heavy financial burden for enterprises on government involvement in public pension existing and additional social security programs-a likely path considering the contributions, which include unemployment, limited fiscal ability of the central medical and housing; 2) under-development government-will allow private pensions to of the capital markets; and 3) employees' play bigger roles. 40 Along this line, the perception that social security is the Ministry of Labor and Social Security, in responsibility of the government, rather than collaboration with financial regulators, of the employer.42 As evidenced in other promulgated key regulations4' on corporate countries, tax incentives are instrumental to pensions in early 2004 which became promote the corporate pension fund sector. effective on May 1, 2004. According to the The current contribution rate of 4 percent to regulations, corporate pension funds are corporate pensions appears to be too low based on a defined contribution scheme and vis-a-vis international experience. The rate an individual account. Pension assets are should be increased to around 10 percent, separated from trustees' other assets and while allowing a 50 percent tax deductibility kept with a custodian, which is a up to that level as a compromise. It is also commercial bank. A licensed institution, important to ensure that pension usually being either a specialized pension contributions are deductible from social management company or a fund security charges (payroll taxes). Given that management company, can provide multiple the personal income tax is low in China but payroll taxes are high, the latter provision of 40 tax deductibility is of greater importance. This new approach is subject to divergent views within the government: The MOF has held the view that prematurely promoting the third pillar corporate Insurance Companies pension hnds could be detrimental to the basic 51. The role of insurance companies in pension system, given the poor compliance with the development of capital markets in China Pillars I and I1 by private sector companies. Also, MOF argued that expanding the Liaoning Pilot to could be potentially significant. In the US, other provinces is a higher priority than promoting for example, insurance companies account the corporate pension funds. Along this line, MOF for nearly 30 percent of the institutional has expressed skepticism about granting tax market, while in continental Europe, they incentives for corporate pension contributions. 41"Provisional Measures on Corporate Pension" and "Provisional Measures on Management of Corporate 42MOLSS estimates the annual increase to be as big Pension Fund." as RMB 50 to 80 billion: Sun (2004).  play an even greater role with nearly 40 accounts being frozen; insurance policies are percent. believed to be better protected. 52. As of end-2003, 50 insurance 55. Under the "Provisional Regulations companies (27 life and 23 non-life) are on Investment in Insurance Companies" licensed. Of those licensed, 37 are foreign- issued by the China Insurance Regulatory invested insurance companies operating Commission (CIRC) in 1999, 'banks' and through joint venture or branch operations. 'securities institutions' are excluded from Combined assets of insurers stand at RMB the definition of qualified shareholders 912 billion (7.8 percent of GDP), making "unless the relevant laws or regulations have the insurance sector by far the largest otherwise stipulated or have gained State institutional investor in China. Council approval." 53. In 2003, total premium income 56. Currently, most established life aggregated RMB 388 billion (life: RMB 301 insurance companies are believed to be billion, non-life: RMB 87 billion), up 27 operating with substantial negative equity. percent over 2002. Insurance premiums This situation is a result of the fact that, have been growing at an average compound prior to 1999, insurance companies could rate of 43.5 percent per annum between only invest in government bonds and bank 1985 and 2 0 0 0 . ~The~ reason for this growth deposits. At the same time, they were lies not with any particular tax advantage, a required to offer guaranteed returns over the factor that often drives insurance elsewhere, life of the policy (up to 20 years) and but more with the fact that insurance is, in guaranteed surrender values. Given the the well known phrase, "sold, not bought." progressive cuts in interest rates (bank Insurance salesmen exceed 1.5 million deposit rates have fallen from 11 percent in nationwide and are largely motivated by 1997 to 1.98 percent to date) insurance their sales commission; their meager salary companies were faced with an impossible is seen as a retainer rather than wage. investment management situation, burdened with outstanding guarantees of returns far 54. Despite this strong growth, in 1999, exceeding that of market rates subsequently insurance premium was only 1.5 percent44of available. GDP, compared with 11.3 percent in South Korea, 8.6 percent US, 6.9 percent Taiwan 57. More recently, there has been some and 4.7 percent Hong on^.^' Insurance is relaxing of the strict rules governing predominantly sold as a savings product investment by insurance companies. New rather than some protection-form product. regulation^^^ that became effective in March In other words, insurance policies are used 2000 and to a lesser extent January 2003 as a means to accumulate capital rather than have been used by the CIRC to liberalize as a household safety-net. Insurance investment restrictions to a limited extent. policies also appear attractive to wealthy The following relaxations have occurred or entrepreneurs who fear that any perceived may occur: malpractice may result in their bank 43China Statistical Yearbook, 2000. 46"Regulations for the Administration of Insurance 44It increased to 3.3 percent as of 2003. Companies" enacted by the CIRC on January 13, 45Swiss Re Economic and Research Consulting. 2000 and subsequent amendments on October 2002.  (a) In 1999 the CIRC permitted insurance percent, respectively 47 . This investment companies to invest 5 percent of their composition of PRC insurers is a stark assets, and later up to 10 percent, in contrast to those observed in Europe and investment funds, investing largely in North America, where bonds and shares equities. This investment limit was usually account for two-thirds of total raised in January 2001 to 15 percent for investment. a select group of 6 insurance companies and 12percent for 2 others. 59. Further, in China, unlike in other countries, the life insurance business is (b) Plans for licensing special investment dominated by one company, China Life, funds whose investors are limited to which held a 56.6 percent market share in insurance companies (which would be 2003, followed by Ping An with 23.5 prohibited from managing such); rather, percent. Foreign entrants, focusing mainly those permitted would be fund on prosperous coastal enclaves, still management companies licensed by the represent a small proportion of the market China Securities Regulatory with less than 2 percent of total premium Commission (CSRC). income. (c) Permitted investments are expanded to 60. The combination of restrictive include bank deposits, government investment regulations and virtual monopoly bonds, financial debentures, corporate by China Life has meant that product bonds (double-A or higher rated bonds innovation has been lacking. One exception issued by central government has been the introduction of unit-linked enterprises), securities investment funds policies, 48 notably by Ping An, which and repos. reports growth in its new premium income in excess of the industry average as a result. (d) In October 2002, certain investment- related negative clauses of the 61. Another innovation has been group "Regulations for the Administration of and personal pensions (third pillar type), Insurance Companies" were amended, which may offer a choice of investment although no new permitted investments portfolios, conceptually similar to the US were introduced. 401(k) product. In fact, the 1997 pension reform that allowed life insurance (e) In November 2002, CIRC abolished the companies to offer supplementary schemes verification or pre-approval requirement sparked rapid growth of the life insurance for 58 corporate actions, including those pertaining to investments in securities investment funds, purchases of corporate 47As of end-June, 2004 per CIRC. bonds and overseas deployment of funds. 48In general, unit-linked policies, popular in Britain and elsewhere, offer the minimal level of death 58. Rigid investment restrictions mean benefit necessary to qualify as life insurance policies, insurers have investment portfolios skewed with the balance of premiums invested in equity or a managed portfolio. These can expose policyholders toward bank deposits (53.4 percent), to the stock market and possibly superior returns over government bonds (18.5 percent) and a long period. Investors can be offered a range of financial policy bonds (9.6 percent), while "funds," where their premiums may be invested in investment funds and other investment make products ranging from conservative (investing largely up the remainder with 7.1 percent and 11.4 in bank deposits) through medium risk, to aggressive growth.  sector, surpassing for the first time the non- 64. Substantial revisions in the Law life insurance sector in premium income. covering insurance 51 were prepared by CIRC and submitted to the State Council for 62. As early as June 2001, leading life review in the first half of 2002 and insurance companies started to establish a subsequently endorsed by the NPC in semi-independent in-house asset October 2002. Salient features of the management department which was amendment are as follows: structured as functionally and physically separated from the rest of the business. This (a) More flexibility in product design and was originally conceived as a preparatory pricing: The basic insurance clauses and move for granting permission to insurance premium rates will be no longer companies to invest directly in equities. determined by CIRC. Rather, insurers will be granted more flexibility to price 63. In 2003, the debut of the PICC and design new products. Insurance Asset Management Co., Ltd. heralded a new era of specialized asset (b) Relaxation of investment restrictions: management by life insurance companies, The revised Law removes certain which has been expedited by the latest specific investment restrictions and regulatory change regarding corporate delegated authority to the State Council pension funds (refer to the previous section). to approve new forms of permitted This change allowed insurance companies to investments. manage corporate pension assets only by establishing a separate asset management (c) Lifting of restrictions on agents.52 The subsidiary that would specialize in revised Law states that individuals can managing not only the parent company's only act for one insurer, but institutional own capital and insurance reserves, but also agents can accept delegation from pension assets. Shortly after the regulations multiple insurers. became effective in May 2004, the nation's largest insurance company launched the (d) Business scope expansion. Property China Life Insurance Asset Management insurance companies are now permitted Co., Ltd. ,49 while Taiping Lif-the only to engage in accidental injury insurance insurer participating in the Liaoning pilot and short-term health insurance businesses. pension program4btained regulatory approval to establish a specialized pension 65. With further liberalization of management company. Other insurance investment restrictions and product companies are likely to follow suit in the innovation, insurance companies' role in the near future. development of capital markets in China will be potentially significant. 51Insurance Law of the People's Republic of China, 1995. 49Shareholders of this firminclude the newly-listed 52In a number of countries, notably in both Britain China Life Insurance Co., Ltd. (60 percent) and its and Ireland, growth in the insurance market had been parent China Life Insurance Group (40 percent). facilitated by the fact that bank branch managers 50 A specialized pension management company is acted in their personal capacity as insurance agents. allowed to become a trustee, a fund manager, and an However most banks have abandoned the practice of account administrator for a corporate pension fund, pennitting bank managers to earn commissions but not a custodian. personally from sales of life insurance products.  66. Given the fast rate of growth in the the market size of open-ended funds PRC insurance market, it is imperative to accounted for 72 percent of the total, put in place sound policy, as well as an eclipsing dormant closed-end funds. Types adequate regulatory and supervisory of fund include equity, bond, mixed, and framework. Notably the systematic risk to money market. Also available are index and financial markets from insurance company principal-guaranteed funds, while exchange- failures can be substantial (although the traded funds are in the pipeline. degree of risk will depend on the type of insurance contract being written). The Figure 1. Net Asset Value of Securities greatest growth area in China currently is Investment Funds (RMB billion) unit-linked insurance, which stipulates that market risk will be borne entirely by the policyholder, with the insurance company offering only minimal life cover. As such, unit-linked insurance will not likely a post huge systemic risk to the system. But it will be important to supervise this product in areas such as charges and the distribution mechanism. Source: Mutual Funds Research & Evaluation Center. Collective Investment Funds 69. At present, collective investment 67. The PRC collective investment fund funds are distributed through both direct industry was established in 1997 with the sales (by fund management companies) and promulgation of the "Provisional Measures third party channel sales via the extensive on the Supervision of Securities Investment branch network of commercial banks and Funds." By the end of 2003, 54 closed-end securities companies. The breakdown of and 56 open-ended investment funds were distribution among the various sales established by 49 fund management channels is about 70 percent by commercial companies, with aggregate funds under banks, 10-15 percent by securities management of RMB 171 billion (1.4 companies and 5-10 percent by fund percent of GDP). management companies. 68. Since its inception, the industry has 70. Investors are mainly retail customers seen a steady growth in size and diversity from concentrated metropolitan cities: (Figure 1). The growth has been especially Shanghai, Shenzhen, and Beijing. Figure 2 prominent since open-ended investment shows the rapid penetration of open-ended funds were introduced in September 2001. funds to retail investors.54 Participation by Closed-end funds had dominated the market institutional clients, e.g. insurance with a 86 percent share by the end of 2001, companies, is on the rise as well. but the nascent open-ended fund sector soon became the most popular form, as they are everywhere else:53B~ the end of June 2004, 53In the US, closed-end funds account for less than 2 of the total is steadily declining). In the rest of the percent of the total value of investment funds, while developed world, e.g., continental Europe, closed-end in the UK they account for some 25 percent (the funds are equally insignificant. reason for such is historical; closed-end funds' share 54Numbers are based on initial subscription.  Figure 2. Number of Fund Investors (a) Regulations on Management of (Thousand) Information Disclosure of Securities - Investment Funds (June 2004); (b) Regulations on Sales of Securities Investment Funds (June 2004); (c) Regulations on Operation of Securities Investment Funds (July 2004). 72. The new regulations on the marketing and sale of securities investment funds are of particular significance, as fund management companies and their sales agents tend to be short on ensuring the truthfu.lness of the content of promotional documents distributed to the investing Source: Mutual Funds Research 61. Ewluation Center public, while being long on making ungrounded commitments as to guaranteed 71. Since the promulgation of the returns or the safety of the fund investments, "Provisional Measures on the Supervision of especially at this early stage in the Securities Investment Funds" in 1997, there development of collective investment funds. have been major developments in the The CSRC regulations prohibit fund regulatory landscape. Most notably, the managers and their sales agents from "Securities Investment Fund Law" 5 5was engaging in malicious competition by enacted to further enhance the legal basis of lowering fees to abnormal standards, or the investment fund industry in 2003, and offering commissions or gifts. went into effect in June 2004. Thereafter various rules and regulations for 73. Originally, only securities companies implementing the Law have been and trust and investment companies were promulgated to facilitate the transparency allowed to establish fund management and market-based operations of the industry. companies.56 The current view of the CSRC is that any institution that has good credit standing and that is operating legally is a qualified hareh holder.^' Nonetheless, banks 55The scope of the draft law has long been subject to and insurance companies are banned from a variety of views and debate; specifically, should the investing in fund management companies by Law cover "special" funds (i.e.. venture capital funds, the Banking Law and the Insurance Law, industrial funds and private equity funds) or should it confine itself to legislating only the more classical, respectively. Each securities company and retail securities investment funds? Evidently it has trust and investment company cannot invest been decided that only classical securities investment in more than two fund management funds would be covered, with a separate law to be companies in China, and can be in a drafted for specialized funds (venture capital, private equity and corporate restructurings, etc.) in the future. Other key issues raised by the drafting group include the types of fund permitted (trust-type and 56 "Provisional Administrative Regulations on corporate-type); limitations on investments; and the Securities lnvestment Funds." relationship among the fund management companies, 57"Notice on Several Issues Regarding Establishment the custodian andlor the trustee. of Fund Management Companies" (CSRC, 2001).  controlling position in only one of them (so- 2004, the type of fund distribution looked as called the "1+1" rule). follows: equity (51 percent), mixed (30 percent), fixed-income (14 percent), money- 74. With open-ended investment funds market (5 percent). The global picture is introduced, more local securities companies represented in Figure 3. have been scrambling to establish fund management companies. Meanwhile, a Figure 3. Worldwide Assets of Mutual highly positive development has been the Funds publication of the long-awaited regulations (Billions euros, end of year) -- on joint ventures between domestic and 1 foreign asset managers in 2002, which permit the foreign partner initially to take up a maximum stake of 33 percent in the joint venture; the ceiling will then rise to 49 percent after three years, i.e., 2004. Some concerns have been expressed about the large amount of initial capital (RMB 300 million) that the foreign partner will need to provide, but given the substantial nature of the known foreign participants to date and the perceived potential in the Chinese -- Source: FEFSI. market, this may not prove to be a great 76. It is unusual that during a period of barrier. All in all, new entrants surged - - falling interest rates, and consequently rising during 2002-2003, registering 7 and 28, bond prices and falling equity prices, there respectively, which increased the number of has not been a greater supply of fixed- fund management companies from 14 in income funds in China. In other countries 2001 to 49 by the end of 2003, of which 9 whose equity markets have suffered during arejoint venture firms. the global bear market since early 2000, fund management companies have actively 75. Both open- and closed-end funds promoted fixed income funds as an invest largely in equities, apart from the alternative and more stable form of mandatory 20 percent in government bonds, investment. This reverses the trend that saw which was rescinded in July 2004 by the a lackluster supply of and demand for "Regulations on Operation of Securities money market and bond funds during the Investment Funds." The fact that no fixed- long bull run of the 1990s. income fund existed until recently58may be indicative of the management companies' 77. In China, it may be that the equity views of d e m a n h r lack of such culture is too strong for a move to fixed deman&in the market for bond funds. The income funds to have been contemplated, or prolonged bearish performance of the equity that there is a market perception that there market has caused an increase in asset are insufficient instruments for effective allocation to bonds exceeding the 20 percent portfolio diversification and active floor requirement; in fact, the ratio exceeded management. More likely though, investors 50 percent for select portfolios. As of June see no clear and significant advantage in fixed-income investments through the 58Huaxia Fixed Income Investment Fund, first of its intermediation of investment funds as kind, was only launched in October 2002. =  opposed to using existing direct channels (bank deposits and savings 79. Domestic fund management certificates). companies are reportedly prone to irregularities, including collusion and share- 78. The rapid growth of a fund industry price manipulation. In January 2001, the whose main form of investment vehicle CSRC criticized some fund managers for remains equity has helped domestic stock misconduct in their IPO application process. markets to reorganize in recent years around This episode indicates that getting the inside a host of large blue chips. Institutional track on IPOs has been one of the most investors are increasingly purchasing free important aspects of investment in China-a floats of select blue chips whose availability very myopic view. Such practices were, is limited, because much of the existing however, dampened by the persistent market shares remain non-tradable. Other decline and the realization that stocks may institutional investors, such as the qualified also open at below IF0 price foreign institutional investors, contributed to nurturing the value investment culture, but 80. As shown in Figure 5, the closed-end the most notable players have been only investment funds outperformed the securities investment funds whose total composite market index during 1999-2000, assets59represented 25 percent of the stock largely thanks to the government's policy of market's free floats as of end-June 2004, preferentially allocating IPO shares to the which was more than two times the number funds, which were substantially reduced in (11 percent) recorded in end-2002 (see 2001.60 The prolonged market doldrums Figure 4). Meanwhile, the average number since July 2001 sent average returns of the of stocks held by investment funds funds into negative territory for 200 1-2002, decreased from 89 in 2002 to 48 in 2003, yet still better than the market benchmark. another sign of concentration into blue chips. With the emergence of mixed funds, average returns of the funds not only bounced back Figure 4. Fund Assets Ratio to Market into positive territory, but they also Capitalization of Floating Shares registered a sizable spread over the composite market index in 2003. In fact, historical performances of China's investment funds have not fared badly vis-a- vis international experience, e.g., average performance of all US large cap growth mutual funds against the Dow Jones Industrial Average (Figure 6). One important caveat exists, however: the Dow " 6 ~ L qQ6 QQ6 Q6 Q%% Q18 Jones Index captures the main board's blue @" Qb6 0) chips, while the Benchmark Shanghai q0 Source:Mutual Funds Research & Evaluation Center Composite Index is much more broadly based. 59 Similar to common international regulations, CSRC regulations prohibit a securities investment fund from owning more than 10 percent of shares of a single company, or a fund management company from placing more than 10 percent of total assets of "Now funds' subscriptions to any particular IPO all the funds it manages into a single company. should be less than 5 percent.  Figure 5. Historical Performance of China's Investment Funds - - -- -- . -- - -- . -- - - -- P v e r a g e i n v e s t m e n t r e t u r n s ~ B e n c h ma r k S h a n g h a m e i n d e x --- --- -- . -- 1 - Source: Mutual Funds Research & Evaluation Center. . Figure 6. Average Performance of all US Large Cap Growth Mutual Funds - -- - --. -- - - - . ..- - .- BAverage fund - large growth DJI - --- I -10 L- -- - -- .--- - -- --- Source Mornlngstar and Tradetrek. 81. Performance assessment is already useful and valuable development, since it actively carried out by a number of indicates that fund managers will become specialist fund analytical companies. These subject to public scrutiny based on companies regularly publish the results of independent-source quoted statistics. This their research and the performance kind of regulation, often termed "reputation evaluations in the financial newspapers and regulation," is a valuable addition to the on company and industry websites. This is a supervision of the securities regulator and  82. means that the pressure to produce go to reach full maturity. To some extent good results is driven by both commercial their development has been held back by the and legal considerations. rather disappointing performance of China's stock markets, with which retail investors 83. If mutual funds are to become are feeling quite disillusioned. Also some mainstream savings vehicles for ordinary well-publicized scandals concerning retail investors, as they are in many investment funds and the perceived countries, it is imperative that the image of instability of many securities companies, the the industry be clean and honest. The main sponsors of investment funds, have left passage of the Securities Investment Funds an impression of relatively lax supervision Law, accompanied by detailed regulations and enforcement. Life insurance is proving and effective enforcement, could be a to be a strong competitor in the rush to milestone for boosting the healthy gather savings, since it pays higher development of the sector, while curbing commissions and is sold more aggressively. irregularities in the business. 87. The passage of the Law on Securities 84. At the same time, certain restrictive Investment Funds, which came into force in rules prevail. Fund management companies, June 2004, should considerably assist the which are licensed to manage investment future development of investment funds by funds, are prohibited from offering providing a firmer legal base. The steady discretionary management services to development of detailed regulations and individuals, although they may be permitted improved supervision by the CSRC will to manage segregated pension assets in the reinforce this, and, as the reputation of future. investment funds for honesty and transparency grows, it would be surprising if 85. Investment funds in China have investment funds did not enjoy strong grown rapidly reaching more than $36 growth over the coming years. billion in value as at June 2004. In absolute terms this is slightly less in total value than Securities Companies mutual funds in ~ r e e c e . ~If' measured as a 88. As of October 2002, 124 securities percentage of household savings deposits, in companies are operating in China, 63 of China ($1,375 billion) they represent which 18 have been licensed as only .02 percent as compared with the US, comprehensive securities companies, i.e., where holdings of money market mutual are licensed to engage in underwriting, funds alone accounted for 25 percent of total dealing, and brokerage businesses. household time and savings deposits62and According to the PRC Securities Law of where total value of mutual fund shares held 1998 (article 6), securities companies must by households (including money market be established separately from banks, trust funds) exceeded that held in household companies and insurance companies. 64 deposits. 86. So investment funds in China are 63According to the PBOC, as of 9 January 2003, these companies fall into four categories: still in their infancy and have a long way to Comprehensive (18), Brokering (27), Rectifying (25), and Transitional (54). Prior to the effective date of the Securities Law of "End 2003 Source: FEFSI. 1999, TICs were permitted to engage in securities 62End 2003 Source: Board of Governors of the brokerage business. The Securities Law of 1999 Federal Reserve System. required TICs to separate their securities business.  Further, financial institutions, with the from directly managing investment funds exception of securities companies and trust (but they can invest in fund management and investment companies, are not permitted companies). to hold shares in securities companies. 65 CSRC-promulgated "Administrative Rules 91. In practice, many securities of Securities Companies" (2002) impose companies have engaged in the discretionary few restrictions on qualification of asset management business, mainly for large shareholders except for some financial corporations. Several types of management standards, however. styles exist: withlwithout minimum guarantee return and guarantee with profit- 89. Securities companies have a narrow sharing.68The market downturn since mid- business scope in China, focusing on 2001 69 however meant that securities brokerage and dealing in equities. Revenues companies could not honor their promises, from their investment banking business only therefore resulting in huge capital losses. In account for a marginal proportion. 66 In order to maintain their liquidity positions, profitability terms, strict entry barriers, securities companies competed even more coupled with rapid market expansion, aggressively for new discretionary asset guaranteed monopolistic rents to incumbents. management businesses. By so doing, they However, concentrated revenue sources bid up the guaranteed return and created a imply that profits are highly subject to vicious cycle in an adverse market market conditions. environment. One striking example was China Southern Securities, one of the 90. Prior to the promulgation of the country's largest stock brokerages, which "Notice on the Regulation of Securities applied for bankruptcy in June 2002. To Business with Clients' Power of Attorney" bail out the company, the Shenzhen in November 2001, securities companies municipal government, as majority were prohibited from operating discretionar K shareholder, reportedly had to raise RMB 2 management accounts for their clients. billion. The troubled company was Since this was an ill-defined product area, estimated to manage RMB 50 billion of however, many activities were left being funds directly and over RMB 100 billion neither legal nor illegal, and many securities indirectly.' O companies viewed it as a legitimate and essential business area. Securities 92. As of October 2002, the total funds companies were prohibited prior to 1999 securities companies managed for clients stood at RMB 51 billion (0.53 percent of GDP). Because this figure was derived from Of the 124 existing securities companies, 26 balance sheets filed by securities companies, companies have been transformed from the securities business units of TICS. it is believed to be substantially under- 65"Certain Opinions on Further Strengthening the represented. Administration of Securities Companies" (CSRC, 1999). "This 66Recent research on China's securities industry by practice has helped create a constituency China International Capital Corporation, Ltd. (July against government attempts to deflate the equity 16,2001) shows that one of China's big-ten securities market-which in turn has undermined its ability to companies earned most its revenues from brokerage execute a sale of state shares program. See Naughton (44 percent) and securities trading (38 percent) in FY (2002). 69 2000. Shanghai Stock Index was down 32 percent from 67Securities Law of the PRC December 1998, Article its peak on June 14,2001 to May 6,2003. 70 142. www.chinaonline.com, June 21, 2002.  93. In order to rectify irregularities omnibus financial arm of public surrounding the investment management organizations. Until the mid-1990s, given business of securities companies, the CSRC their universal business scope, flexible fund- introduced the "Notice on the Regulation of raising capability and minimal supervision, Securities Business with Clients' Power of TICs were highly regarded financial Attorney" in November 2001. According to institutions, dominating the PRC non-bank the Notice, securities companies must now financial sector, even though their business obtain a separate business line license from scope involved quasi-banking. CSRC to offer investment management services to clients. The appointed securities 95. The TIC sector began to encounter company must sign a power of attorney with difficulties in 1993, when the central the appointer (client) so that both share government began to restrain the accounts and cash accounts are opened overheating economy, which produced under the appointer's name. Guarantees of slower output growth, tighter liquidity minimum returns or promises of loss sharing conditions and high inflation rates. In are strictly prohibited,71though the policies January 1997, the second largest TIC, China and objectives of investment may be Agribusiness Development Trust and negotiated between the parties. In addition, Investment Corporation, filed for the Notice includes investment fund-like bankruptcy. Thereafter, several TICS began regulations, inter alia, diversification of defaulting on loans, leading to operation funds with a 10percent maximum ceiling on closures. The Asian financial crisis further securities issued by a single company, aggravated the TIC sector, and some separation of client assets, and prohibitions international TICs began defaulting on their on conflict of interest. On disclosure and foreign debt. What soon resulted was the transparency requirements, the securities TIC sector becoming one of the weakest company must provide the client a quarterly links in China's financial system. update of portfolios, and must file a monthly report on its investment management 96. TICs suffered from several common business with the CSRC. problems: Trust and Investment Companies (a) Before the mid-1990s, TICs relied on investments in property and equity 94. Trust and investment companies markets for quick returns. However, the (TICs) were one of the most important scope of such activities narrowed as the sectors in China's capital markets in the two economy slowed down its spectacular decades after 1979, when the State Council growth rates. TICs then experienced first established the China International heavy losses in the property and equity Trust and Investment Corporation (CITIC). markets. By the late 1980s, some 700 TICs were established by ministries, municipalities, (b) The success of TICs in attracting provinces and large SOEs, first as a vehicle deposits traditionally depended on their to attract foreign capital but later as an ability to offer double-digit interest rates. However, the PBOC banned all such - activities under the unified interest rate 71Despite this, many securities companies maintain that guaranteed return discretionary asset regime. TICs were then left with little management schemes stand to be a legitimate and option but to rely on the volatile and essential business area for China's transitional risky inter-bank lending market for economy.  funding. Whereas inter-bank loans have would not be allowed to engage in short maturities, most of the projects in banking businesses such as deposit- which TICs were engaged were long- taking and lending. term in nature. This mismatch exposed (b) The trust and investment business would TICs to the risk of considerable liquidity be segregated from the securities problems. business in terms of structure, regulation and operation. TICs' securities business (c) A selected and fortunate few TICs were would be spun-off and merged into new permitted to borrow long-term funds securities companies. from the international capital markets to (c) TICs should meet strict standards such finance their domestic operations. as minimum capital. Small, Proceeds were then lent or invested in undercapitalized TICs would be the original currencies to projects with consolidated or closed. predominately RMB-based revenue streams, thus creating substantial 98. According to the 1999 rectification currency mismatches for all parties plan, TICs have been undergoing a long concerned. period of restructuring, involving closure, liquidation, reorganization, merger and (d) The absence of rigorous supervision by acquisition. The PBOC announced that of regulators led to TICs being poorly the 239 then-existing TICs, only 60 would managed. As a result, TIC activities be allowed to continue operations under were often the focus of fraud, much stricter prudential regulations. The embezzlement, corruption and other latest numbers show that 50 TICs offered malpractice. 250 trust products during 2003, raising US$2.7 billion.73 (e) TICs extended loans under their own name and provided guarantees to their 99. During this process, some important numerous subsidiaries in off-balance laws and regulations were enacted. At sheet accounts. As a result, they often present, China has put in place the incurred larger liabilities than their annual reports would suggest. refers to "the business activities of a trust and investment company that accepts trust and handles 97. After 1999, the central government fiduciary matters as a trustee while being paid." The immersed itself into restructuring the TIC PRC Trust Law (2001) fails to address what the trust sector, as TICs became a potential source of business is and who can engage in that business, instability for the macro-economy. The however. To address this omission, the main purposes of the 1999 restructuring plan, Administrative Office of the State Council hastily issued the "Notice Concerning the Relevant Issues in heralded by the closure of Guangdong the Implementation of the Trust Law of the PRC" in International Trust and Investment December 29, 2001. The Notice prohibits the Corporation (GITIC), included: operation of trust businesses by legal persons other than TICs and find management companies until the (a) TICs should be restructured to become State Council formally promulgates "Administrative Regulations on Trust Institutions" (which have not "intermediary financial institutions" yet been proposed). For a comparative review of the which practice trust business.72 TICs PRC Trust Law, see Guo (2001). 73 Far Eastern Economic Review, "China-A ''According to Article 4 of the "Administrative Complete Lack of Trust: In their search for decent Rules on Management of Trust and Investment returns, Chinese investors have taken some big Companies" by the PBOC (2001), trust business risks," July 2004.  framework of a complete set of laws and leases; and other such CBRC-approved regulations on trust businesses. The businesses. Standing Committee of the National People's Congress passed the Trust Law in 104. Fourth, in performing the above trust January 2001, which became effective on and investment businesses, TICs are subject October 1, 2001. Based on the new law, to a set of regulations. For example, the PBOC issued a series of attendant term for such trusts shall not be less than regulations, notably the "Administrative one year, and the amount of a trust contract Rules on Management of Trust and shall not be less than RMB 50,000. 7' Investment Companies," which went into Further, TICs must also observe specific effect on January 12, 2001 and was asset and liability ratios in their business subsequently renewed on May 9,2002. operations. 100. Under the new regulatory framework, 105. There are also many provisions in TICs will be subject to strict licensing the Administrative Rules prohibiting TICs requirements, disclosure and transparency from conducting the trust businesses in a rules and better-defined business scopes: manner that contravenes the basic norms of a trust, e.g., a trust company must not 101. First, establishing a TIC is subject to manage trust assets for non-trust purposes, PBOC examination and approval (these or post collateral on trust assets for its own functions are now assumed by the newly- debt obligations, or co-mingle trust assets established China Banking and Regulatory with its own assets, or undertake to maintain Commission,74 CBRC). Commercial and the value of trust assets, or guarantee industrial entities, securities companies, and minimum returns, etc. (Article 31). local bureaus of the MOF can invest in TICs. According to the Rules, TICs are not Investments in TICs by individuals and permitted to take deposits, issue debt banks will be subject to special CBRC securities, or borrow in foreign currencies approvals. (Article 9). 102. Second, TICs are required to 106. Despite recent efforts by PBOC (and establish a series of internal control and risk the newly created CBRC), regulation of the management systems. TICs must submit TIC sector still needs much improvement, their operational reports and financial especially in the area of "capital trusts." statements to the CBRC. Within the TIC, a When the "Provisional Measures on 'Chinese wall' must be established between Administration of Capital Trust for Trust the trust business department and other and Investment Companies" became business departments. effective on July 18, 2002, TICs were allowed to manage capital trusts for 103. Third, TICs may engage in various individual schemes with less than two trust businesses, including the following: hundred settlers. TICs wasted no time capital trust; trust for tangible and intangible launching capital trusts in Shanghai. properties; investment fund business; However, the lack of a clear definition of intermediation of M&A activities; project public offering combined with lax finance; asset management; underwriting of supervision led to offering capital trusts to government and corporate bonds; financing 75 Article 45, the Administrative Rules on 74CBRC was officially established in April 2003. Management of Trust and Investment Companies.  retail investors without implementing proper Companies" on October 9, 2002. In this measures for investor protection. For Notice, PBOC clarified key definitions example, TICs got around the ban on new including "collective trusts." In addition, a product advertisements by asking the distinction was drawn between "securities financial press to carry a detailed story about investment capital trust" and "non-securities the product. Between July 2002 and investment capital trust," and additional February 10, 2003, over RMB 5 billion was requirements were introduced for the latter. raised from 39 collective capital trusts.76 Except for securities investment capital trusts, multiple capital trusts managed by the 107. Indeed, the regulation of capital same TIC cannot concurrently invest in a trusts is still quite rudimentary compared to particular company. This ban seems similar collective investment schemes (e.g., intended to prevent industrial capital trusts mutual funds). There is no required pre- from being effectively used as M&A tools. review of a collective trust by the regulator before a plan is offered to the public; the 109. In sum, China's TICs sector remains investment guidelines are too lenient in a state of flux. Notably, the restructuring (particularly with regard to industrial funds) process is thwarted by a combination of and there are no provisions on conflicts of complex ownership, heavy debt burden and interest; and there is a lack of regulations the need to negotiate loss-sharing and standardization on valuation, agreements among domestic and foreign redemption, and disclosure. investors and creditors under their complicated financial structures. Because 108. If the CBRC fails to develop a the serial collapse of large TICs revealed comprehensive regulatory framework and to many abusive and imprudent practices, the rigorously supervise TICS' trust business, sector will need time to rebuild public the TICs sector will be vulnerable to confidence. At the same time, the sector repeating past mistakes. 77 After watching also faces increasing competition from TICs manage the newly introduced capital securities and fund management companies, trusts as long-term infrastructure funds or as the divide between investment advisory, hybrid industrial funds, PBOC promptly fund management and trust businesses issued "Notice Concerning Capital Trust becomes blurry. Furthermore, as these Business of the Trust and Investment institutions are supervised by different regulators, there also exists room for regulatory arbitrage. Other impeding factors 76 Per Jun Ze Jun Law Offices, such schemes were for sector growth include China's weak offered by 23 TICs. credit culture, unclear registration guidelines 77 Clients of Bank of Communications, the nation's fifth biggest bank, held a sit-in early July 2004 at the for trust properties, and weak information institution's main branch in Shanghai after a trust disclosure, accounting and tax provisions. marketed by the bank on behalf of Jinsin Trust Co. of However, as long as the trust north-western Xinjiang province expired and they businesealbeit poorly-defined-is were unable to collect either the US$10.4 million in exclusively set aside for this sector, principal or the promised 5.2 percent interest due on their one-year investment. The trust company took in revamped TICs could have their chapter in an average of US$54,400 each from 191 investors. China's capital markets in the future. The sit-in highlighted not only lax supervision and poor disclosure of trust products, but also unclear regulations about what potential liability banks would face when they channel risky products into the marketplace. Far Eastern Economic Review, Ibid.  Underground Funds all companies with business operations falling under this law to be registered. 110. The so-called underground funds7g have fast proliferated in China since the 114. Also, starting in 2003, securities introduction of stock exchanges in the early companies that have acquired a special 1990s. They exist since other means by license may manage discretionary funds on which larger investors can obtain client's behalf (see our comments below at professional d.iscretionarymanagement have section 6.1 as to how these operations not been freely available, and because of the should be legally structured). rigid, bureaucratic and expensive licensing regime. 115. The preceding two measures should result in the legitimization of unregistered 111. Privately placed funds may be a funds through the intermediation of fully better description than "underground since licensed entities-TICS, securities the operation of such funds does not appear companies or fund management companies. to be illegal as such. Research into the Investors who have suffered losses in private activities of such funds79indicates that the funds managed by unlicensed entities may total value of assets managed may be as high migrate to more competent licensed service as RMB 700 billion, or 7.3 percent of GDP providers in the future. (compared to RMB 123 billion and 1.2 percent of 2002 GDP for licensed securities 116. Meanwhile, it is hard to see what investment funds), but the fact that the funds great hann such funds do, apart from the are not licensed and recorded indicates such fact that they act as short-term speculators data is thin and largely inferred. rather than as long-term investors. The research suggests virtually no attempt to sell 112. Privately placed funds are not such funds to private citizens. The main controlled in any form and are often client base of private funds consists of managed by unlicensed entities. They are wealthy enterprises and financial institutions. neither illegal nor legal, and can be seen as a Most funds have fewer than 25 participants. good example of an unintended outcome of In most countries there would be no attempt the nebulous legislative base. to regulate such funds on the basis that 113. The passage of the Trust Law in expert investors who are capable of risk 2001 has provided the opportunity to assessments and investment decision- formalize these activities, however. The making need no protection at all. There "Administrative Rules on Management of would, however, be a requirement that any Trust and Investment Companies" requires firms offering such management services be licensed, which appears to be the approach pursued by the Chinesc authorities. 78 Large existing underground hnds are basically devoted to equity market speculation and not 117. Any problem that exists may more productive investment. Underground funds likely have resulted from investment losses encourage enterprises to use their spare cash and by enterprises, which seem to be the often funds borrowed from the state-owned banks for principal participants and investors, and by speculation. In this sense, this sector is distinguished from informal credit sector characterized as breaking the fact that such investments may be through rigid monetary control and providing finance financed by inoney borrowed from the four for growth of private enterprises in China, state-owned commercial banks. Notably the particularly in prosperous coastal regions. bulk of the enterprise sector remains under 79Xia (2001).  State control, and investment losses are not to be tolerated. Thus the solution may lie in better governance of the state-owned enterprises sector (as investors) and in restraining banks (as lenders) from illegal lending to these enterprises for speculation purposes. 118. It is likely that a clearer definition of mainstream asset management and the ability of licensed entities to offer comparable portfolio management services will eventually transform unlicensed funds into legitimate undertakings. Summary of the Institutional Landscape and International Comparison 119. Given the largely unfunded pension system and fledgling collective investment funds, China's formal institutional assets registered RMB 1,338 billion (11.3 percent of GDP) in 2003, insurance companies RMB 912 billion (7.8 percent of GDP), pension funds RMB 255 80 billion (2.17 percent of GDP), and collective investment funds RMB 171billion (1.4 percent of GDP). In addition to this formal institutional investor base, large sums are believed to be managed privately by securities companies, TICS,and unlicensed entities. 120. When compared globally, as Figure 7 illustrates, China certainly has a much smaller institutional base than that of most OECD countries. But institutional investor penetration in China seems not unlike the degree observed in leading transitional economies in Central and Eastern Europe. NSSF (RMB 132billion), individual accounts (93 billion), and corporate pensions (30 billion).  Figure 7. Financial Assets of Institutional Investors (as percent of GDP in year 2001) r .- -- 250 200 4 191 United France Japan Germany Korea Czech China Poland H u n w Turkey States Republic I I Sour-ce: OECD (2004). Note: China's figure is based on 2003. 4 CHANGES IN THE INSTITUTIONAL ASSET MANAGEMENT SCENE 121. Several projects involving drafting, landscape will become increasingly complex, amending or rewriting existing laws, as shown in Figure 8.*l including the new Law on Securities Investment Funds (also under review in the National People's Congress), are in progress. This activity shows the importance the government places on the development of investment institutions. Table 4 summarizes the current situation of various financial institutions and the likely future changes to their roles. It highlights the fact that, if all the above changes are made, then asset management will be carried out by a broad array of institutions including banks, securities companies, insurance companies, trust companies and investment h d managers. At the same time, the regulatory 81Acknowledgement to Leckie and Zhang (2001) for the concept of the chart, originally prepared by the CSRC.  Table 4. Changing Scene of the Asset Management Business ( 1 1 ~ n s t i t u r l Regulator I Current Restrictions I Changes in Progress or Expected Limited participation in managing Owning NBFIs through financial holding B a n s CBRC NBFIs. Distributor and custodian companies. for fund managers. Invest up to 40% of its assets in MOLSS, equities. Appoint qualified NSSF Overseas investment MOF institutions to manage the NSSF investment. Encourage pension management by specialized financial companies. MOLSS, Increase tax incentives. Corporate Money market instruments CSRC' 'IRC7 "Regulations on Corporate Pension Funds" pension funds (minimum 20%), fixed income CBRC envisaged by the MOLSS. securities (20%-50%), and equities Ability to manage third party Relaxation of asset restrictions, including Insurance portfolios through a specialized permission to invest directly into equities. companies 1 asset management subsidiary. Limited range of assets permitted. Fund Securities Investment Fund Law More Sino-foreign joint ventures are management CSRC liberalizes investment possibilities expected to enter the market as foreign companies 1 and clarifies structure. ownership rises to 49% by the end of 2004. , Securities Discretionary asset management Less restrictive regulatory supervision over CSRC companies under strict supervision. discretionary asset management activities. Trust and Lack of clear regulation and To be more strictly licensed by CBRC. investment CBRC supervision. Engage in various trust businesses apart from companies capital trusts. Figure 8. Regulatory Structure of Asset ManagementActivities  122. Indeed, if banks are allowed to in financial institutions via various Haier participate in a wider range of activities, Group related companies. For example, either as holding companies or as owners of Group holds 66 percent of Qingdao City NBFIs, the situation will be even more Commercial Bank, and also acquired a 20 complicated. percent controlling stake in Anshan Trust and Investment and a 20 percent stake in 123. Notwithstanding the principle of Changjiang Securities through its formal legal separation of the banking, subsidiaries. Other domestic securities and insurance businesses, businesses-orient Group Industry and financial and mixed conglomerates exist in Shandong Electric Power Groupalso China in at least two sectors through holding provide integrated financial services through company structure^.^^ For example, CITIC subsidiaries/affiliates. Holdingss3 and China Everbright (Group), Ltd., offer commercial banking, investment 125. The opening up of the financial banking and insurance products both in sector under WTO will heighten foreign mainland and Hong Kong SAR through competition. Table 5 is based on financial subsidiaries. In March 2002, BOC concessions made by China under WTO International China Ltd. (BOCI China) was accession in December 2001. While foreign established in Shanghai as a 49 percent retail banks will enjoy national treatment by subsidiary of BOC International Holdings, 2007, China's WTO concessions in the Ltd., which is incorporated in Hong on^.^^ securities sector are much more limited. The "backdoor" establishment of BOCI With China's WTO membership, foreign China has therefore given it effective access firms are allowed to acquire up to a 33 to the securities industry not enjoyed by percent stake (with the ceiling to rise to 49 most peers.85 percent after three years) in joint-venture fund management companies and a 50 124. The emergence of mixed percent stake in joint-venture life insurance conglomerates is also noteworthy, and the companies. For non-life, China will first Haier Group provides a good example. The allow branching or 51 percent foreign Group's main activity is the manufacture of ownership, with wholly-owned subsidiaries home appliances, especially refrigerators. permitted in two years after WTO entry (i.e., However, the Group has a substantial stake no restriction on the form of enterprise establishment). Also, reinsurance will be - - fully liberalized. In the securities industry, 82For more information, refer to a Background Note China will allow 33 percent foreign by World Bank (2002a). investment within three years after the 83In March 2002, the CITIC obtained permission from the State Council to establish a financial accession and 49 percent afterwards. holding company, CITIC Holding Corp. CITIC Holding Corp will control the CITIC Industrial Bank, 126. On July 1, 2002, the "Regulations on Hong Kong-based CITIC Ka Wah Bank, Ltd., CITIC the Establishment of Sino-foreign Joint Securities and CITIC Prudential Life Insurance Co., Ltd. Venture Securities Companies" and "Regulations on the Establishment of Sino- 84 Other shareholders include China National Petroleum Corporation and Yuxi Hongta Tobacco foreign Joint Venture Fund Management (Group) Co., Ltd. Companies" came into effect. 85With the exception of CITIC Industrial Bank, China Construction Bank, China Everbright Bank, 127. However, strict investment which are members of "de-facto" financial conglomerates. restrictions and intense competition from  domestic firms limit major investment 129. On the other hand, current banks7 interest in forming securities joint shareholders of fund management venture companies. Furthermore, the poor companies-usually a group of securities financial health and corporate governance of companies and TIC-are reluctant to sell the domestic sector is also a deterring factor their profitable equity stakes to foreign in joint venture considerations. Currently, investors. Thus, it would seem unlikely for there appears to be no serious interest from an existing fund management company to top American investment banks, though transform itself into a joint-venture through some European and East Asian investment divestiture. Rather, foreign investors and banks are considering establishing joint- domestic securities companies-also TICS venture securities companies. In May 2003, to some extent-are expected to establish China Euro Capital, Ltd. became the new joint-venture fund management country's third Sino-foreign joint venture companies. At present, the following securities company after China International alliances are at work or in the pipeline Capital Corporation and BOC International (Table 6). (China), Ltd. The company was formed between Credit Lyonnais Securities (Asia) 130. Meanwhile, effective December 1, Ltd. (33 percent) and Xiangcai Securities 2002, the long-awaited Qualifying Foreign Ltd. (67 percent). BNP Paribas, France's Institutional Investor program, better known banking group, is also waiting for CSRC as QFII, offered foreign investors access to approval for joint venture formation the A-share market for the first time (Box 1). between its subsidiary BNP Paribas This signals a significant step toward capital Peregrine Securities, Ltd. and Changjiang market opening in the PRC. As of the end Securities Co., Ltd. (the Haier Group is also of December 2003, twelve foreign financial a major shareholder). As of May 30, 2003, institutions were licensed as QFIIs with a the proposed joint venture between Taiwan- total investment quota of US$ 1.7 billion, backed Core Pacific-Yamaichi International and eleven banks (four of them being (HK), Ltd. and Hantang Securities, stands to foreign banks) were licensed as the QFIIs7 be the last known application with the custodians. 86 QFIIs portfolios include: CSRC. bank deposits, shares, government bonds, investment funds, and convertible bonds. At 128. In contrast, despite having to take a the initial stage, bank deposits used to make minority stake in a joint venture, many up half of the total portfolios, but deceased foreign fund management companies have into one third, while two-thirds of the funds an interest in entering the fund management are currently invested in ~ecurities.~~ industry, seeing the enormous growth potential for the sector. In the fund management industry, domestic companies are required by CSRC to forge advisory alliances with foreign fund management companies. The prospect of strong sector growth has prompted foreign firms to upgrade their relationship with domestic companies from an advisory role to one of 86 Evidently both local and foreign banks are interested in building expertise in this business area, ownership participation. citing strong growth potential and the considerable fee-based income from scale operations. ''http://~~~.~~.~0m.~n/01/200407080250.htm.  Table 5. China'sWTO Commitments on FinancialServices Banking Withln two years after accession, China will permit foreign banks to provide local currency services to Chinese enterprises. Within five years from accession, China will permit foreign banks to provide local currency business to all Chinese individuals. Within five years after accession, all current unnecessary measures regarding the ownership, operation and establishment of foreign banks, as well as those concerning their branches and restrictions on issuing licenses, will be eliminated (national treatment). Geographical restrictions on local currency business of foreign banks will be phased out in stages. Within five years thereafter all geographical restrictions will be lifted. Securities Within three years after accession, foreign investment banks will be permitted to establish joint ventures, with foreign ownership not exceeding 33%, to engage (without a Chinese intermediary) in underwriting domestic shares (A shares) and underwriting and trading in foreign currency denominated securities (B and H shares, government and corporate debts). The shareholding limit will increase to 49% after 3 years of WTO entry. Foreign securities companies may engage directly in B share business. Representative offices of foreign securities companies may become special members of Chinese stock exchanges. Fund Upon accession, joint venture fund management companies may be established, with foreign Management ownership not exceeding 33%, to conduct domestic fund management business. Foreign investment shall be increased to 49% after three years. Insurance Upon accession, foreign life insurers will be allowed to hold 50% ownership in joint ventures. They may now choose their ownjoint venture partners. For non-life, China will allow branching or 51% foreign ownership upon accession and wholly owned subsidiaries in two years after the entry (i.e., no restriction on the form of enterprise establishment). Reinsurance is completely open upon accession with no restrictions. All geographic restrictions will be lifted in three years after entry. Licenses will be granted solely on the basis of prudential criteria with no economic needs test or quantitative limits on the number of licenses granted. Upon accession, foreign life insurers will be permitted to provide individual (non-group) life insurance services. Two years after entry, they will be permitted to provide health insurance, group insurance, pension insurance and annuities to Chinese and foreign customers. Source: WorldBa  Table 6. Overview of Sino-foreign JV players in December 2003 1 APPLICANT I 1 STATUS JV FUND FOR SETTING FOREIGN CHINESE PARTNER@) MANAGEMENT UP FUND PARTNER@) COMPANY MANAGEMENT .Iv Societe Gencrate Approved Fortune SCAM Fund Asset Management Fortune Trust & Investment (67%) (Oct 2002) Management (33%) Fortis Haitong Approved Fortis lnvestment Haitong Securities (67%) Investment (Dec 2002) Management (33%) Management China Electric Financial Affairs (10%) China Huaneng Financial Approved ING Investment China Merchants Fund Affairs (10%) China Merchant (Dec 2002) Management (30%) Management Securities (40%) COSCO Financia1 Affairs (10%) Approved China Great Wall Securities (33%) lnvesco Great Wall (Feb 2003) lnvcsco Asia (33%) Dalian Shide (17%) Fund Management Kailuan (17%) Approved Al lianz Dresdner Guotai Jun'an Allianz (Mar 2003) Asset Management Guotai Jun'an Securities (67%) Fund Management (33%) P - - Fujian International Trust & Approved Investment (16.7%) tlaitong (May 2003) Securities (16.7%) Hutai Securities (via acquisition) BMO Financial Fullgoal Fund (16.7%) Shandong International Group (16.7%) Management Trust & lnvestment (16.7%) Shenyin & Wanguo Securities f 16.7%) Approvcd Franklin Templeton Franklin Tcmplcton (Aug 2003) Sealand Securities (67%) Sealand Fund (33%) Management Approved BNP Paribas Asset Shenyin & Wanguo Securities SW BNP Paribas Asset 2003) Management (33%) (67%) Management 1 Approved Xiangcai Securities (37%) Xiangcai Hefeng (Sep 2003) ABN AMRO (33%) Shandong Xinyuan (30%) Fund Management (via acquisition) i Preliminary Prumerica Financial Everbright-Prumerica Everbright Securities (67%) auuroval Fund Management Merrill Lynch Preliminary Bank of China (16.5%) BOC approval BOC International China (67%) International Fund International Management Holdings (16.5%) Hantang Securities (40%) Pcnding approval ~, First State China soahem Airlines (16%) FSI Hantang Fund Investments (30%) Nanjing YPC Refining and Management Chemical (14%) - p Suzhou New District High-Tech AIG GlobaI AIG Huatai Fund Pending approval Industrial, Jiangsu Communications lnvesttnents (33%) Management Holding, and Guohua Energy JP Morgan Pending approval Shanghai International Trust and Asset Management Investment (67%) 133