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. • 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 • 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) • Investment funds • Foreign and domestic funds • Different legal forms (e.g., contractual, corporate, etc). • Income funds, growth funds, mixed funds • Banks • 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 • 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 • 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. • Closed end or interval funds may be more suitable for volatile, illiquid, thin market. • Avoid multiple taxation of their income, and provide for effective regulation of investment managers • provide for comprehensive regulation for all institutional investors.
Insurance companies • 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. • 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. • 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. • Domestic institutional investors support as well as compete with each other. • 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.