Transcript Enlarging the Investor Base – developing institutional

Enlarging the Investor Base
– developing institutional investors –
September 25-26
Shanghai, China
Noritaka Akamatsu
The World Bank
Issues

In emerging markets, the domestic institutional investor sector
tends to be small compared to:
– that in developed countries, or
– their own banking sector.
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Its ability to mobilize domestic long-term resources is limited,
and so is the domestic demand for bonds.
Excess liquidity in the global market brings portfolio investment
flows into emerging markets which can cause overheating of
the stock market (when flowing in) and a crash of the market
and currency value (when flowing out).
 Need to develop the domestic institutional investor sector as
well as the bond market to:
– mobilize resources to finance investment, and
– stabilize the equity market.
Institutional investors

Insurance companies
– Life and non-life
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Social security and pension funds
– Public PAYG social security fund (1st pillar)
– Compulsory, competitively managed pension funds (2nd pillar)
– Voluntary private pension funds (3rd pillar)
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Investment funds
– Foreign and domestic funds
– Different legal forms (e.g., contractual, corporate, etc).
– Income funds, growth funds, mixed funds
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Banks
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Corporate treasuries
Causes of their business

Except investment funds, they all have reasons to exist other
than mobilizing investable funds.
– Insurance companies are there to provide life and non-life
insurance services while social security and pension funds are to
provide health insurance and old age financial security.
– Banks mobilize deposits and extend credits while corporate
treasuries finance the companies.
 Mobilization of investable funds is only the secondary reason.

Unless the policy/business environment is supportive for their
primary (liability side) business, they will not grow.
– E.g., insurance companies will not grow unless there is demand for
insurance services.

They compete in some aspects while supporting each other in
some other aspects. Thus, their development depends on each
other to some degree.
Banks

The largest and best established financial institutions in most
start-up / emerging markets in Asia. Thus,
– They tend to have a large capacity to invest (and trade) bonds
despite their short-term liabilities, thus strongly driving the
development of the emerging fixed income market.

Prudential requirements matter in motivating their investment
in and trading of bonds. E.g., capital requirements for
– risky assets (preference for Government bonds over corporate
debt unless the yield spread justifies.)
– Liquidity risk, interest rate risk, maturity mismatch / duration gap.

The possibility of repo / reverse is critical to allowing their
sound management of fixed income portfolio (including market
making for bonds), thus affecting their demand for bonds.
Banks
– continued
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Banks also provide custody services for other institutional
investors although their corporate lending business is a close
substitute of corporate bond investment and, therefore,
compete with other institutional investors.
Banks increasingly understand the need to diversify their
income base by developing fee income sources so as not to rely
excessively on interest income.
– Custody services, asset management services, etc. even for money
market / fixed income funds.
– Market making to provide liquidity for bonds to facilitate other
institutional investors to invest in them.
 Critical to have banks capable of providing competent account
management services for other institutional investors.
– Sound electronic data processing capacity is required.
Investment funds

Unlike other institutional investors, they are purely a vehicle to
mobilize funds for investment.

Income funds / money market funds are a deposit substitute
and compete with bank deposits.
– Fund managers owned/controlled by banks may not be
encouraged to develop income or money market funds.
– Independent fund management companies can promote
competition (e.g., foreign or state-owned)

However, they enable small investors to benefit from
professional investment management at reasonable cost.
– Higher brokerage fees for small investors can encourage their
migration to professionally managed funds instead of having own
brokerage accounts.

Insurance companies and pension funds often outsource their
asset management to an investment management company
Investment funds
– continued
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Open end funds (as opposed to closed end funds) allow
investors to readily redeem / liquidate the investment at market
value, thus considered to offer better protection for investors.
However, open end funds can be subject to a run.
– An interest rate rise depresses the net asset value (NAV) of a fixed
income fund and can cause redemption panic by investors.
– Illiquid market can worsen the run by not allowing the funds to
meet redemption demand (can trigger a market crash or high
volatility).
– Illiquid market makes valuation difficult and could allow
manipulation of NAV unless the market is equipped with sound
pricing rules / practice.
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Closed end or interval funds may be more suitable for volatile,
illiquid, thin market.
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Avoid multiple taxation of their income, and provide for
effective regulation of investment managers
– provide for comprehensive regulation for all institutional investors.
Insurance companies
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Life insurance companies tend to have longer term liabilities
than non-lifes, thus able to invest in longer term debt and
equity.
Certain non-life insurance is often made mandatory (i.e., auto
insurance, housing mortgage indemnity insurance, etc.), thus
providing for steady growth of the insurance business.
If the environment is supportive, the insurance premium
income can grow 2-3 times the real growth rate of the
economy in an emerging market.
Life insurers can often provide annuity for pensioners by
managing a portion of retirement fund on behalf of the
pensioner, thus growing further.
– There need to be pension / provident funds to provide a lump sum
retirement allowance for retiring workers.
Social security and
pension funds

Public PAYG social security fund (1st pillar)
– provides minimum old-age financial security (typically with some
degree of defined benefit).
– Pensioners rely on contribution by younger working class.
– Demographic change (e.g., aging of the population) can make a
PAYG scheme unsustainable, thus forcing a shift to a funded
scheme (with defined contribution).

Shift from PAYG scheme to funded schemes with defined
contribution (2nd pillar).
– Can accumulate a significant investable funds (e.g., 30-40% of
GDP). Fund accumulation continues many years (e.g., 30-40
years).
 The shift tends to generate a big impact on the demand for
investable assets including bonds.
Illustrative accumulation by 2nd pillar schemes
(projections for the case of Russia)
Implications

If 2nd pillar pension schemes should be introduced, it should
be carried out in parallel with the implementation of aggressive
capital market development measures. Otherwise:
– The fund accumulation can overpace the generation of pension
investable assets, and therefore, the pension funds may be forced
to invest overseas.
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During the rapid accumulation phase, the funds tend to buy
and hold the assets with little trading, thus constraining the
bond market liquidity.
The funds should be diversified into different types (e.g.,
income, growth and mixed) to suit the investment needs of
different generations. Otherwise, the funds tend to show
herding behavior, amplifying the market volatility.
– The management of the funds should be made competitive (by
private fund managers).
Foreign institutional
investors

All the above from overseas.
– Investment funds, insurance companies, pension funds and banks.
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Look for high yield while demanding transparency.
Avoid withholding tax as they are taxed in their home
countries.
Both long-term funds and short-term speculators (e.g., hedge
funds) come to emerging markets.
– The latter has demanding clients behind and are under pressure to
invest the money quickly and show results in short-term.

Need sound / effective regulation and supervision of their
activities to monitor capital flows across the national border.
Conclusions

Building of the domestic investor base will take time while the
foreign portfolio investment needs to be well monitored.
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Domestic institutional investors support as well as compete
with each other.
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The development of contractual savings institutions (i.e.,
pension funds and insurance companies) is driven by the
demand for their liability side of business, which is in turn
driven by welfare policy.
Systematic promotion of certain institutional investors (e.g.,
introduction of 2nd pillar pension funds) must be done in
parallel with the implementation of aggressive capital / bond
market development plan.
Provide sound regulatory framework for investment / asset
managers for all institutional investors.
Thank you.