According to the majority of the seminar participants, China has the potential of hosting one of the world’s largest groups of institutional investors. However at present, its fledgling institutional investor sector is hamstrung by a set of obstacles: i) asset management business is regulated unevenly by different regulators; ii) institutional investors are subject to rigid investment restrictions; iii) lack of diversified financial instruments, coupled with poor capital market liquidity, substantially restrict the scope of balanced portfolio management; iv) institutional investors are still predominantly owned by the public sector; and v) corporate governance on institutional investors is generally weak.

Despite the country’s rapid modernization, many legacies of the planned economy remained and the “invisible hand” is not fully at work. Indeed, the lack of harmonization over market, industry and product regulatory responsibilities has slowed rational market development. Ambiguities in the legal framework and the often policy directed market developmental initiatives have also subjected the country’s institutional investors to high degrees of uncertainties. As a result, sector development is compromised and the role of institutional investors as efficient conduits between the real sector and the financial sector is weakened.

In order to promote a sound and efficient institutional investors sector, China is recommended to take note of the following guiding principles. These principles will assist China to establish identifiable sector development initiatives that can be properly sequenced and implemented. Policy-makers should be cognizant of the fact that well-founded policy initiatives will underwrite further growth in liquidity, discipline, diversity and sector sustainability.

• Consolidation of standards for asset management services
• Level playing field for private and foreign sector participants
• Availability of wider range of investment opportunities and products
• Relaxation of investment restrictions
• Increased role of banks in supporting the institutional investor sector

Specifically, China can adopt a general strategy to build well-capitalized, creditworthy and efficient investment management institutions in the country. This would involve steps to substantially improve the corporate governance of all financial institutions offering investment management services and to strengthen their institutional capacity; the latter includes ensuring that proper internal controls and internal audit functions, risk management systems, management information systems and external audit function are all in place and functioning appropriately. It also would involve ensuring that the managers and employees of investment institutions have adequate professional skills and that they are subject to a system of controls and incentives that promotes prudent behavior and acting in the clients’ best interest.

For the purpose of efficiency, simplicity and fairness (ensuring a level playing field), common standards would be applied to all investment management institutions that manage discretionary investments of others, including insurance companies, pension funds, investment fund managers, TICs and securities companies. A thorough and coordinated review of existing regulations would be sought with the aim to upgrade them where deficient and to harmonize them for all classes of investment management institutions. Similarly, action would be taken to harmonize the professional qualification requirements of employees who advise clients or make investment decisions on their behalf. The necessary professional skills involve investment analysis and portfolio management.

Efforts to strengthen the governance and institutional capacity of investment management institutions will not be sufficiently successful so long as those institutions remain under government ownership, as almost all are today. Like commercial banks, only few examples exist internationally of successful government-run investment management institutions. Thus, ownership diversification and privatization of existing institutional investors will be integral to building a substantial professional institutional investor base; promotion of new entry, including foreign participation; and creation of level playing field for all institutional investors, regardless of ownership.

To this end, particular emphasis would be given the next few years on increasing foreign participation in the institutional investor market. The goal would be to transplant a critical mass of technology and skills sufficient to rapidly and markedly upgrade the capacity of institutional investors in China. A goal would be to rapidly train a new flank of Chinese investment professionals to lay the foundations for a strong domestic segment of the institutional investor industry.

These general strategies and actions aside, additional steps would be taken to induce increased securities demand by institutional investors. Fixed-income mutual funds would be promoted as a means to increase demand for longer-term government bonds. The proposed strategy essentially is to promote the emergence of new classes of mutual funds that would appeal to the growing demand of investors having less risk appetite and longer investment time horizons. Liberalization of interest rates in the primary government debt market would be an essential prerequisite.

To create demand for infrastructure bonds, action would be taken to relax investment restrictions currently applied to different types of institutional investors. China currently employs a restrictive system of investment options under which investment managers are permitted to invest only in those areas explicitly listed. The list often contains limited options vis-à-vis international practices, restricting institutional investors’ ability to craft diverse and balanced portfolios. A thorough and comprehensive review would be sought, the aim being to rationalize, harmonize and liberalize the investment restrictions currently in place. In particular, investments in long-term infrastructure bonds meeting defined information disclosure standards and risk characters would be permitted for all classes of institutional investor. A complement to expanding the range of permissible investments would be to improve regulatory requirements on disclosure of risks and probable returns.

To create greater investment demand for equities, actions would be taken strengthen the professional capacity of institutional investors to manage equity portfolios with a longer-term investment horizon. Of particular relevance are life insurance companies and pension funds having long-term investment horizons. Once appropriate institutional capacity is put in place, investment restrictions applicable to institutional investors would be further relaxed to permit investment in equity securities.

Complementary actions would be taken to promote greater foreign portfolio investment, whether under the new QFII regime or otherwise. Tapping into demand for Chinese securities by international investors would be leveraged both to increase the absorptive capacity of the capital markets for a wide range on instruments and to create an independent source of pressure for improved instrument design and pricing, better corporate governance, improved infrastructure project design, and the like.

The workshop is intended to bring together all stakeholders involved to discuss current issues and future directions in promoting institutional investors in China.

The workshop also featured a country case study, Korea’s insurance sector, which is one of the largest in emerging economies and has recently accomplished significant post-crisis restructuring.

In the lead presentation, Yongbeom Kim, Senior Financial Economist of the World Bank, noted China has one of the biggest savings in the world, but China’s institutional savings make up less than 10 percent of GDP, one of the lowest worldwide. Thus there is a huge potential unrealized for institutionalizing household savings. He argued that China faces indeed strong reasons to develop its capital markets to effectively address key economic agendas: i) SOE reform will require increased initial public offerings and strong corporate governance; ii) banking sector restructuring will need efficient debt capital markets to be developed; and iii) China intends to mobilize its pension shortfalls through the sale of state shares which in turn depends on the absorption capacity of its capital markets. Citing two recent research papers by World Bank, Mr. Kim stated that institutional investors play an instrumental role in capital markets development: i) they provide stable demand for equities and bonds, especially those with long term maturities - by so doing, institutional investors act as a countervailing force to the dominant position of commercial banks and thus promote competition and efficiency in the overall financial system; and ii) institutional investors also stimulate financial innovation.

On the other hand, he stressed, capital market itself needs to be deepened and diversified for institutional investors to thrive: the relationship stands to be two-way and interactive. In this context, two unique and salient characteristics of the PRC equity market are ill-suited for institutional investors. First, unlike the norm in equity markets elsewhere, state shares and legal person shares, accounting for 65% of the total number of shares, in principle remain non-tradable even after a company is listed. This limits availability of free floating shares. The other salient feature is the predominance of small-cap stocks. The Chinese equity market is one of the world’s least concentrated markets. In most of the world’s equity markets, easily over 50% of market value is occupied by the top 5% of listed stocks (by capitalization) in the respective markets. The corresponding figure in the Chinese equity markets is as low as 5.2%, less than one-tenth of the 68% average observed in six other selected exchanges.

Mr. Kim also argued that a lack of variety in financial instruments makes it difficult for institutional investors to actively manage their portfolios. Insurance companies and pension funds want to increase holding of corporate bonds, but issuance of corporate bonds is subject to special government approval, something not easily obtained. In addition, interest rate control on corporate bonds does not allow spreads to be determined by creditworthiness of an issuer. The homogenous credit ratings of the small universe of outstanding corporate bonds (predominately triple-A rated at the back of strong government affiliation and guarantee arrangements) further highlights poor credit diversification and restrictive investment channels. Foreign portfolio investments are also prohibited under the current regulatory regime. Likewise, the Company Law does not allow firms to issue such innovative products as exchange bond or bond with warrants.

In a following presentation, Mark St Giles, a World Bank Consultant, provided guiding principles to develop a sound and efficient institutional investors sector. Three points were particularly noteworthy:

• Common standards would be applied to all investment management institutions that manage discretionary investments of others, including insurance companies, pension funds, investment fund managers, trust and investment companies and securities companies. A thorough and coordinated review of existing regulations would be sought with the aim to upgrade them where deficient and to harmonize them across all classes of investment management institutions. Similarly, action would be taken to harmonize the professional qualification requirements of employees who advise clients or make investment decisions on their behalf. The necessary professional skills in investment analysis and portfolio management need to be substantially upgraded.
• Efforts to strengthen the governance and institutional capacity of investment management institutions is not likely to be sufficiently successful so long as those institutions remain under government ownership, as almost all are today. Like commercial banks, only few examples exist internationally of successful government-run investment management institutions. Thus, integral to building a substantial professional institutional investor base are ownership diversification and privatization of existing institutional investors; promotion of new entry, including foreign participation; and creation of level playing field for all institutional investors, regardless of ownership.
• Action would be taken to relax investment restrictions currently applied to different types of institutional investors. A thorough and comprehensive review would be sought, the aim being to rationalize, harmonize and liberalize the investment restrictions currently in place. In particular, investments in long-term infrastructure bonds meeting defined information disclosure standards and risk characters would be permitted for all classes of institutional investors. A complement to expanding the range of permissible investments would be to improve regulatory requirements on disclosure of risks and probable returns.

Second session concerned promotion of the collective investment scheme which may possibly be a double-edged sword -- the fastest growing institutional investor sector worldwide but prone to irregularities such as fraud and conflicts of interest. It was noted that this sector could outgrow institutional capacities, sowing the seeds for future problems. Mr. Du Shuming, Deputy Director from Galaxy Securities, and Mr. Tao Xiuming, Senior Partner of Junjejun Law Firm, respectively discussed salient features of the mutual funds and trust businesses of China’s trust and investment companies, including serious drawbacks in investor protection.

Mr. Du reaffirmed the positive role of mutual funds in the mobilization of household deposits, investor base diversification, enhancing corporate governance and capital markets efficiency. Further advancements will, however, be hinged upon continued enhancements in the regulatory regime, information disclosure, investor education, distribution framework, corporate governance and product innovation. In the presentation on China’s trust business, Mr. Tao established that the country’s new breed of post-restructuring trust companies are keen to build up their core competencies in the trust business, underpinned by collective capital trust products. However, the lack of credit culture, deficiencies in institutional arrangements, ambiguities in the Trust Law, as well as firm-specific risk management and control issues, stand to be major challenges for the sector’s further development.

The session concluded with another presentation by Mark St Giles on lessons from international experience, especially classic failure stories of mutual funds in Russia, India, and Korea. On key building blocks for developing sound collective investment schemes, the importance of information disclosure, fair pricing of net asset value, and control of conflict of interest were extensively discussed.

Third session was devoted to a country case study of Korea’s insurance sector. In a keynote speech for the session, Jong-Koo Lee, Standing Commissioner of Korea’s Financial Supervisory Commission, stated that the financial crisis of 1997 had clearly created an opportunity for the Korean government to overhaul the basic economic structure. The sense of urgency and consensus on the need for the drastic reform enabled the government to undertake full-fledged financial and corporate restructuring programs, using public funds amounting to US$ 130 billion. As a result of the success that they achieved with restructuring efforts, both sectors have regained financial soundness. With the Korean financial system operating in line with international standards, the economy has established strong fundamentals to further promote market disciplines. As for Korea’s institutional investors, he said that Korea’s institutional investors in general used to maintain reserved stance in practicing their shareholder’s rights. They would either entirely drop their voting rights or keep neutral positions by casting shadow votes upon sensitive issues. According to his observations, this may all change and they are expected to take upon new active roles to meet the social demand by closely monitoring corporate management, and ultimately to meet their objectives of increasing share values.

Concerning Korea’s insurance sector, Seungtae Lim, Senior Economist of the World Bank, explained contributing factors to the sector’s mercurial growth. In addition, he reviewed Korea’s experience in insurance market opening since the late 1980s. Unique distribution practices enabled domestic insurers to effectively foil foreign competition. However, the flipside was that the prevailing domestic entrenchment prevented the sector from reaping the potential benefits from foreign participation, which in part contributed to the status quo that led to painful restructuring of the industry. In retrospect, he derived the following lessons from Korea’s experience:

• Upon opening market, competition should be carefully guided so as not to arise in non-productive areas
• Limitations on asset management should have been lifted more vigorously. Overly strict restrictions prevented life insurers from successfully adjusting to market changes
• Corporate governance should have been improved before allowing new entrants
• Role of supervisory authority should be strengthened for market discipline. The role of supervisory authority should be made clear in advance to provide more predictability and freedom to insurers

In a following discussion session, Craig W. Thorburn, Senior Financial Sector Specialist of the World Bank, derived implications of the Korean experience on China’s insurance market development. According to him, the Korean insurance market provides considerable comparisons of interest to those participating in or overseeing the development of insurance in China. First, the issues which arise from a lower interest rate environment and asset liabilities mismatches are common features in both countries as they are also in many other jurisdictions. This suggests that useful lessons can be learnt from an examination of how companies are addressing these challenges. Second, the competitive environment in insurance sector is recognized to require improved performance and discipline. In this respect, avoiding the risk of poor management and corporate governance will be an important challenge to be faced vigilantly.

(China.org.cn April 1, 2003)