Enlarging the Investor Base developing institutional investors September
Enlarging the Investor Base – developing institutional investors – September 25 -26 Shanghai, China Noritaka Akamatsu The World Bank
Issues n In emerging markets, the domestic institutional investor sector tends to be small compared to: – that in developed countries, or – their own banking sector. n Its ability to mobilize domestic long-term resources is limited, and so is the domestic demand for bonds. n 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). è 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 n Insurance companies n Social security and pension funds n – Life and non-life – – – Public PAYG social security fund (1 st pillar) Compulsory, competitively managed pension funds (2 nd pillar) Voluntary private pension funds (3 rd pillar) Investment funds – – – Foreign and domestic funds Different legal forms (e. g. , contractual, corporate, etc). Income funds, growth funds, mixed funds n Banks n Corporate treasuries
Causes of their business n 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. è Mobilization of investable funds is only the secondary reason. n 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. n They compete in some aspects while supporting each other in some other aspects. Thus, their development depends on each other to some degree.
Banks n 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. n 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. n 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 n 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. n 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. è Critical to have banks capable of providing competent account management services for other institutional investors. – Sound electronic data processing capacity is required.
Investment funds n Unlike other institutional investors, they are purely a vehicle to mobilize funds for investment. n 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) n 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. n Insurance companies and pension funds often outsource their asset management to an investment management company
Investment funds – continued n 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. n However, open end funds can be subject to a run. n Closed end or interval funds may be more suitable for volatile, illiquid, thin market. n Avoid multiple taxation of their income, and provide for effective regulation of investment managers – 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. – provide for comprehensive regulation for all institutional investors.
Insurance companies n Life insurance companies tend to have longer term liabilities than non-lifes, thus able to invest in longer term debt and equity. n 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. n 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. n 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 n Public PAYG social security fund (1 st pillar) n Shift from PAYG scheme to funded schemes with defined contribution (2 nd 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). – Can accumulate a significant investable funds (e. g. , 30 -40% of GDP). Fund accumulation continues many years (e. g. , 30 -40 years). è The shift tends to generate a big impact on the demand for investable assets including bonds.
Illustrative accumulation by 2 nd pillar schemes (projections for the case of Russia)
Implications n If 2 nd 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. n During the rapid accumulation phase, the funds tend to buy and hold the assets with little trading, thus constraining the bond market liquidity. n 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 n All the above from overseas. – Investment funds, insurance companies, pension funds and banks. n n n 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 are under pressure to invest the money quickly and show results in short-term. n Need sound / effective regulation and supervision of their activities to monitor capital flows across the national border.
Conclusions n Building of the domestic investor base will take time while the foreign portfolio investment needs to be well monitored. n Domestic institutional investors support as well as compete with each other. n 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. n Systematic promotion of certain institutional investors (e. g. , introduction of 2 nd pillar pension funds) must be done in parallel with the implementation of aggressive capital / bond market development plan. n Provide sound regulatory framework for investment / asset managers for all institutional investors.
Thank you.
- Slides: 15