cfr - darista fininfra paper

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Building the Financial

Infrastructure for Middle

Class EmergingEconomies

A Paper from the Project on Development,

Trade, and International Finance

Jane DArista

A Council on Foreign Relations Paper


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The Council on Foreign Relations, Inc., a nonprofit, nonpartisan national organization found-ed in 1921, is dedicated to promoting understanding of international affairs through the freeand civil exchange of ideas. The Councils members are dedicated to the belief that Amer-ica's peace and prosperity are firmly linked to that of the world. From this flows the mis-

sion of the Council: to foster Americas understanding of other nationstheir peoples, cultures,histories, hopes, quarrels, and ambitionsand thus to serve our nation through study anddebate, private and public.

THE COUNCIL TAKES NO INSTITUTIONAL POSITION ON POLICY ISSUESAND HAS NO AFFILIATION WITH THE U.S. GOVERNMENT. ALL STATE-MENTS OF FACT AND EXPRESSIONS OF OPINION CONTAINED IN ALL ITSPUBLICATIONS ARE THE SOLE RESPONSIBILITY OF THE AUTHOR ORAUTHORS.

From time to time, books, monographs, reports, and papers written by members of the Coun-cils research staff or others are published as a Council on Foreign Relations Publication.Any work bearing that designation is, in the judgment of the Committee on Studies of theCouncils Board of Directors, a responsible treatment of a significant international topic.

For further information about the Council or this paper, please write the Council on For-eign Relations, 58 East 68th Street, New York, NY 10021, or call the Director of Commu-nications at (212) 434-9400. Visit our website at www.cfr.org.

Copyright 2000 by the Council on Foreign Relations, Inc.

All rights reserved.Printed in the United States of America.

This paper may not be reproduced in whole or in part, in any form (beyond that copyingpermitted by Sections 107 and 108 of the U.S. Copyright Law and excerpts by reviewersfor the public press), without written permission from the publisher. For information, writePublications Office, Council on Foreign Relations, 58 East 68th Street, New York, NY 10021.


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CONTENTS

Foreword v

Acknowledgments vii

Introduction 1

Building on Past Structures and Programs 3

Building on Existing Structures and Trends 12

Structuring Pension Funds in EmergingEconomies for Growth and Development 19

Reforming the International Monetary and

Financial Architecture to Promote DomesticDemand-Driven Growth in Emerging Economies 30

Conclusion 40


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FOREWORD

In the wake of the 1997-98 financial crises in emerging economies,many prominent thinkers focused their energies on what went wrong,how it could have been prevented, and what reform measures arerequired for the future. While some concentrated specifically onfinancial markets within the economies in question, others exam-

ined the larger system-wide implications.The Council on ForeignRelations Project on Development, Trade, and InternationalFinance convened a Working Group in an attempt to look at theproblem from both levels, to investigate the problems in the

world economy that led to the crises, and to propose policyoptions calculated to prevent future large-scale disturbances.

Specifically, the goal of the Working Group, which began in

1999, was to promote discussion of different perspectives about thenecessity for change in the world economic system, and to lookat concrete forms that change might take.These included, but werenot limited to, discussions about reforming the internationalfinancial architecture to facilitate a transition from export-ledgrowth to internally or regionally demand-driven development strate-gies that offer the populations of the developing world an improved

standard of living.One of the Working Groups several undertakings was to com-mission papers from the participants on a broad range of subjectsrelated to the international financial architecture.The authors comefrom a variety of backgrounds, and their papers reflect a diversi-ty of perspectives. However, we believe that all of them provideuseful insights into international financial architecture, and thatthey represent collectively factors that should be considered by bothU.S. and international economic policy makers.

Lawrence J. KorbMaurice R. Greenberg Chair, Director of Studies

Council on Foreign Relations


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ACKNOWLEDGMENTS

The Project on Development, Trade, and International Financewas made possible by the generous support of the Ford Founda-tion. This project was directed by Walter Russell Mead, SeniorFellow for U.S. Foreign Policy at the Council on Foreign Rela-tions, with the close assistance of Sherle Schwenninger, the

Senior Program Coordinator for the project.The members of theWorking Groupa collection of more than thirty experts froma wide range of backgroundsparticipated in several sessions at

which they provided key feedback on each of the papers. DavidKellogg,Patricia Dorff, Leah Scholer, Benjamin Skinner, LaurenceReszetar, and Maria Bustria provided editing and productionassistance.


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Building the Financial Infra-structure for Middle Class

Emerging Economies

INTRODUCTION

The export-led growth model for emerging economies is drivenby their need to service external debt and build foreign exchangereserves. It has foundered in the aftermath of financial crisescharacterized by collapsing currency and asset values, widespread

bankruptcies in real and financial sectors, rising unemployment,and negative growth rates.1 In many developing countries, a high-er volume of exports is needed to earn the same income that pre-

viously sufficed to meet external obligations. As a result, profitsand wages have fallen, lowering earlier gains in per capita incomeand threatening past improvements in income distribution, edu-cation, and life expectancy.

The sustainability of the export-led growth model is alsothreatened by dramatic increases in the current account deficits,external debt, and domestic debt ratios of the major globalimporter/consumer.2 As U.S. ability to maintain its role becomesless certain, fewer countries appear to be willing or able to absorbmore imports or to accept current account deficits.Continued slowgrowth in Japan, the second-largest national economy in the

1Blecker, Robert A,The Diminishing Returns to Export-Led Growth,DiscussionPaper (New York: Council on Foreign Relations, October 1999).

2Blecker, Robert A, The Ticking Debt Bomb: Why the U.S. International Finan-cial Position is Not Sustainable, Briefing Paper (Washington, D.C.: Economic PolicyInstitute, June 1999).


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global system, would hamper its ability to assume some of the bur-den carried by the United States, even if its own adherence to anexport-led growth model were not in itself a major inhibiting fac-tor. Continued restructuring, high levels of unemployment, andconstrained monetary and fiscal policies within the EuropeanCommunity also do not suggest robust increases in demand forimports of goods and services in the near future.

Diminishing returns to the export-led growth strategies thatemerging economies have followed (and have been encouraged tofollow) during the last two decades will require the development

of new strategies to promote growth. Both developing and devel-oped countries will need to reintroduce domestic demand-drivengrowth as a policy objective. However, emerging economies willrequire more than a shift in the direction of macroeconomic pol-icy to stimulate demand. Also required will be the developmentof domestic capital markets and financial systems like those in indus-trialized countries, which are capable of mobilizing and channeling

domestic savings to expand internal economic activity.That, in turn,will require changes in global capital markets and financial infra-structure to support and encourage reinstatement of a role for domes-tic demand-driven growth in the global economy and particularlyin emerging economies.

The choice of an economic paradigm necessarily has impor-tant social and political consequences. Export-led growth strate-

gies have tended to increase income gaps across and withincountries as wage levels succumbed to the pressure to maintain com-petitiveness. Domestic demand-driven growth strategies havegreater potential to reinstate conditions for rising wages andreduced income disparities. If that potential were realized, the result-ing expansion of middle classes in emerging economies like thosethat have characterized North American and European societies

would strengthen the viability of democratic institutions andbuild more stable societies. Perhaps the very least that can be expect-ed of societies in which per capita income is rising and a major-ity of the population holds a rising share of total income is thatthey provide opportunities for escape from poverty unmatched bysocieties with other income distribution patterns. Building such


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societies in emerging economies may be the only means to redressthe immense waste of human resources caused by widespread pover-ty in todays global economy.

This paper explores ways in which the institutional and regu-latory structures of financial markets can be shaped to contributeto the goal of expanding shared prosperity in emerging markets.It opens with descriptions of various strategies used by industri-alized countries to achieve economic and social goals by using mon-etary tools and public financial institutions to allocate credit to preferredsectors.The following section discusses the shift in financial flows

from banks to securities markets in industrialized countries andin many emerging economies. Given the increased use of pensionfunds as a primary channel for collecting and allocating savingsflows in both developed and developing countries, the paperfocuses on ways in which these pools of private savings can be struc-tured to (1) broaden and deepen capital and financial markets, and(2) support demand-driven growth policies and promote equali-

ty in income distribution.It proposes a more balanced division betweengovernment and private institutions in (1) making decisionsinvolving the allocation of credit; (2) using expanding ownershipof financial assets as the means to promote wider participation inoverseeing and assessing the performance of the financial sector;(3) exercising corporate governance; and (4) shaping macro-eco-nomic policy decisions.

The final section of the paper outlines the changes needed inthe international monetary and financial architecture to permit theshift from export-led growth to growth strategies that rely on theexpansion of domestic demand.It concludes that public sector sup-port for major changes in both international and national finan-cial structures will be required to ensure a resumption of balancedgrowth in the global economy.

BUILDING ON PAST STRUCTURES AND PROGRAMS

Monetary and financial policies and tools were widely used to pro-mote economic and social objectives by industrialized countries


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in the post-World War II period and had been used by the Unit-ed States during the 1930s. In some countries, direct governmentexpenditures supplied loans and grants. Others used the financialsystem to allocate funds to preferred sectors and lower the inter-est rates paid by those sectors for credit. Although the various strate-gies chosen were also used to increase financing for exports, theprimary objective in many industrialized countries was to favor bor-rowing sectors such as housing, agriculture, small and medium sizedbusinesses, and underdeveloped regions.The objective was also toincrease the total supply of savings and promote balanced economic

growth. In all cases these strategies constituted systems that exer-cised a substantial degree of public control without public own-ership.3

Countries used various types of controls to achieve the differ-ent objectives. Direct controls specified the kinds of assets insti-tutions could hold to ensure that institutions would channelcredit to a preferred sector. One example would be federally char-

tered U.S. savings and loan institutions, created by legislation enact-ed in 1934. Indirect controls provided credit incentives by using strategiesthat altered the relative rates of return on investments in favoredsectors by lowering their cost of borrowing. Techniques used toimplement indirect controls included asset reserve requirements,government borrowing in capital markets for relending to favoredsectors, and government savings institutions (such as postal sav-

ings banks) designed to compete with private institutions in cap-turing savings flows for onlending to preferred sectors.

While the various techniques used tended to have featuresthat accommodated both the governments economic or social pri-ority and the characteristics of the national financial system, theyhave common elements that permit them to be adapted to the needsof other countries. In general, the following descriptions of nation-

al experiences with particular strategies show how effective these

3U.S. House of Representatives, Foreign Experience with Monetary Policies to PromoteEconomic and Social Priority Programs, Staff Report of the Committee on Banking andCurrency (Washington, D.C.: U.S. Government Printing Office, 1972).


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strategies can be in promoting the goals of shared prosperity anddomestic demand-driven economic growth.

The U.S. Reconstruction Finance CorporationThe Reconstruction Finance Corporation (RFC) was organizedand began operations in February 1932, one month after theenactment of the legislation authorizing its establishment. It waspatterned on the War Finance Corporation, created during World

War I, which provided a precedent for government assistance toprivate enterprise. Its initial capital was $500 million, but it had

unlimited authority to borrow from the U.S. Treasury. It wasalso permitted to retain earnings for expansion of its activities, andit remained outside the congressional appropriation processthroughout its active life (193254). At the time of its liquidationin 1957, it had disbursed $40 billion in loans and purchases of stocksand other obligations, and had made commitments for many bil-lions more in guarantees for loans made by private financial insti-

tutions.4

The original legislative directive to the RFC was to extend aidto agriculture, industry, and commerce by making direct loans tobanks, trust companies, and other financial institutions.Subsequentemergency legislation (1935) authorized the RFC to make directloans to solvent businesses unable to obtain credit from other sourcesand to recapitalize the financial system by buying the stock of banks,

insurance companies, agricultural credit corporations, and nation-al mortgage associations. A further extension of its powers (1938)authorized the RFC to purchase the securities and obligations ofany business enterprise and thus to provide both capital and cred-it when it could not be obtained from other sources.

During its first two years of operation, the majority of the RFCsloans were to banks and trust companies ($3.3 billion out of $3.9

billion), with preference given to small state banks. While theseefforts and the creation of the deposit insurance program in 1933helped stabilize the banking system, they were not sufficient to reignite

4The discussion of the RFC is based on a study written by the present author and insert-ed in the Congressional Recordby U.S.Rep.Wright Patman (D.Texas), Chairman of theHouse Banking and Currency Committee, on August 4, 1969.


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an expansion of lending. Part of the problem was that the tradi-tional maturity of commercial bank lending was one year or less.Most small businesses needed more secure lines of credit and eas-ier repayment schedules. Thus, in 1935 the RFC itself became themajor lender to small business, and 70 percent of its loans had amaturity of five years or more.The RFC set a precedent that effect-ed a permanent extension in the terms of business lending. As itsloans to businesses declined during the war years, commercial banksbegan to issue term loans.

Another substantial component of RFC lending was to agri-

cultural agencies, most of which were part of the public agricul-tural credit system that had been established in earlier periods ofdistress for this sector. Credit programs exercised by these agen-cies (Federal and joint-stock land banks, regional and other agri-cultural credit corporations) were augmented by loans from theRFC rather than by direct lending. But the particular contribu-tion of the RFC was to make loans to finance the sale of U.S. agri-

cultural surpluses abroad.Mortgage lending also became a major component of RFC financ-

ing. Its original directive was to make loans to private mortgageloan companies. However, in 1935, it was also authorized to sub-scribe to the capital stock of those companies. In addition, it cre-ated its own mortgage lending subsidiary, the RFC MortgageCorporation. In 1938, it capitalized a second subsidiary, the Fed-

eral National Mortgage Association, which was transferred to theHousing and Home Finance Agency in 1950 and remains in exis-tence as a government sponsored enterprise today. The mortgagelending program focused on residential mortgages but also financednineteen large housing projects and made loans for income-pro-ducing properties. The RFC disbursed over $1.7 billion throughits two subsidiaries during the life of the program, $1.3 billion of

which was disbursed by FNMA as financing for 414,499 mortgagesduring the twelve years that it was an RFC subsidiary.Other RFC programs provided financing for public works, includ-

ing the purchase of bonds from the Metropolitan Water Districtof Southern California, and making loans for the San FranciscoOakland Bay Bridge, the Pennsylvania Turnpike Commission, for


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drainage and irrigation, and numerous other projects. It also cap-italized and made loans to the newly established U.S. Export-ImportBank , made disaster and relief loans, refinanced the debts of pub-lic school facilities and, in 1934, paid the salaries of teachers in theChicago school system.

In the 1940s, the RFC was the critical agency in financing conversion to the war effort. Through eight new subsidiaries, itfinanced plant conversion and construction; acquired, construct-ed and operated its own war plant facilities;made subsidy paymentsto stockpile strategic and critical materials; administered the war-

damage insurance program; and engaged in many other activitiesin conjunction with other government agencies. More than 80 per-cent of the RFCs activities during this period were unrelated toits normal lending operations, and about half ($20 billion) of itstotal loans were disbursed during the war. At the end of the war,it shifted into a new role in financing reconversion. Almost halfof its total business loans were disbursed after June 1948, and

lending to businesses peaked in 1949. Lending for residentialmortgages reached its highest level in 194950, and the RFCprovided additional assistance to veterans by making a market inVeterans Administration-insured loans.

Like any other financial institution, the RFC sustained loss-es. Overall, however, it was a profitable institution with earningssubstantial enough to pay dividends to the Treasury on its capi-

tal stock. It was able to assist the Treasury in 1941, when the pub-lic debt was approaching the limit,by directly issuing its own securitiesand using the funds to buy the stock of the Federal home loan banksto provide the government with additional funds. Congression-al support for the RFCs activities diminished after the war, how-ever, and the degree of discretion and flexibility that had been thehallmark of its lending programs was curtailed on the grounds that

it should no longer be permitted to compete with private sourcesof credit. It was argued that the Corporations countercyclicalrole was no longer justified in the inflationary environment of thepostwar period.The winding down of its activities began as earlyas 1947 and continued until its final closing in 1957. Still, many ofits programs survived in other forms. The most notable contin-


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uations are small business lending, shifted to the newly created U.S.Small Business Administration, and the FNMA.

Credit allocation techniques in other industrialized countries 5Swedens credit allocation program from 195070 focused on pro-

viding steady credit flows to housing. It used asset reserve require-ments to achieve the objective of constructing a countercyclicalshield against finance problems for this sector.6 One measure ofthe programs success was as follows: during periods when tightmonetary policy lowered the flow of funds to the industrial sec-

tor, financing for housing did not dry up, but continued to increase.When a government uses asset reserve requirements to achieve

policy objectives, it decides what share of total credit flows shouldgo to a preferred sector. Then it requires all financial institutionsto hold that percentage of their total portfolio in assets thatfinance that sector. If an institution does not hold the total per-centage of assets required, the remainder must be entered on the

balance sheet as reserves. The choice is to make an interest-earn-ing loan to the preferred sector or an interest-free loan to the gov-ernment.The authors of the 1972 House Banking Committee reportthat describes these techniques note that asset reserve requirementsare simple and straightforward, do not require an elaborate reg-ulatory framework and, unlike the U.S. savings and loan structureused to promote housing in this period, do not discriminate

between small and large savers.7

In a small country like Sweden, asset reserve requirementscan be implemented on a voluntary basis by using moral suasionand negotiating the targeted shares with different financial sec-tors. There were many mortgage lenders in Sweden during thisperiod: mortgage banks, housing credit societies, savings banks,

5This section is based on a study prepared for the U.S. House of Representatives Bank-ing and Currency Committee under the direction of Professor Lester C.Thurow, Assis-tant Professor Robert Engle, Laura DAndrea, Raymond Hartman, and Charles Pigottof the Massachusetts Institute of Technology. Entitled Foreign Experience with Mone-tary Policies to Promote Economic and Social Priority Programs, it was published as a Com-mittee Print in May 1972

6U.S. House of Representatives, ibid., 1972.7U.S. House of Representatives, ibid, 1972.


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the Post Office Bank and commercial banks. The major lendersissued bonds to obtain funding, and their liabilities could be pur-chased and held by other financial institutions (insurance companies,for example) to satisfy their reserve requirements.

Ita

lyis a postwar example of a country that used governmentborrowing and relending to achieve economic and social objec-tives.This is an allocative technique that, in general, shifts the costsof supporting preferred sectors onto taxpayers rather than savers.In the Italian model, the central bank did not play the major rolein the program, as did the Swedish central bank. As the program

implies, however, fiscal and monetary policy were closely related,and the Bank of Italy had considerable influence in formulatingthe credit policies that welded the two policy tools together.

The policies themselves were implemented through special cred-it institutions that intermediated between private sources of fundsand private borrowers, using public funds to provide credit incen-tives.Special credit institutions collected funds from securities mar-

kets. The buyers of the securities were private investors andcommercial banks. About half of the funding came from banksthat used savings held in deposits to provide long-term credit byrolling over their investments. The Bank of Italy supported thismaturity transformation by issuing the securities of the special cred-it institutions and allowing them to be pledged by banks as col-lateral for four-month renewable advances.

Like several U.S. programs in the post-World War II periodhousing loans to veterans, loans to small and minority business-es and to students, for examplethe Italian program achieved itsobjectives by directly subsidizing interest payments to lower thecost of borrowing to favored sectors. Most of the subsidies werefor industry, but primarily to small and medium sized industries,and for the industrialization of Italys southern region, known as

the Mezzogiorno. In the 1950s, the Mezzogiorno had remainedan underdeveloped country within the borders of a country thathad become heavily industrialized. Per capita income was 47 per-cent of that in the North. Most of the essential infrastructure forindustrialization and social progress was missing: adequate roads,telephone lines, electrical generating plants, irrigation systems, etc.


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The first goal of the program was to modernize and increaseproductivity in agriculture, the regions dominant sector. Estab-lishing new industrial facilities was emphasized in the 1960s.Overall, the programs lending priorities reflected the belief thatgrowth in output was the best way to alleviate high levels ofunemployment in this very poor region.

Because of its emphasis on the South, the primary objective ofItalys economic program was developmental. In addition to theCassa per il Mezzogiorno, the governments Credit Mobiliaregroup included institutions that specialized in industrial credit and

credit to public works projects; others that specialized in realestate and agricultural credits; and still others that operated as spe-cial departments in the commercial banks. The range of eligibletypes of credit included loans to artisans, to depressed and moun-tainous regions in north central Italy, for disasters and natural calami-ties, and for hotels and tourism.

From 1960 to 1970, the Italian program succeeded in raising the

flow of credit to the South and other depressed regions.Since thenthere have been major transformations and growth in these areas.

There are still disparities in the Souths proportionate share in totaloutput and income relative to the North and Central regions, butthe progress that has been made attests to the success of thisnations efforts to take responsibility for development within itsown borders.

Japa

ns system of credit allocation is often referred to as the uniquemodel for Asia. It could be argued, however, that what was uniqueabout it was the way it adapted the U.S. RFC structure to bothaccommodate and reform the existing Japanese financial system.Rather than having the government borrow to finance support forlending by private financial institutions, the Japanese program chan-neled private savings through government owned or controlled finan-

cial institutions.Then it lent them to private financial institutionsfor onlending to the industrial sector. A critical objective of thisstrategy was to distribute credit across the entire industrial sectorto promote the emergence of more promising industries. Thatconstituted an important financial reform that weakened thezaibatsu system in which financial institutions were committed to


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lend within a conglomerate structure. But the overall goal of thestrategy was to maximize economic growth. That objective wasthe overriding social priority of the government throughoutthe postwar period.Thus, investment in housing, for example, wassignificantly lower than in other G-7 countries. However, therate of economic growth was substantially higher.

Personal savings were the primary source of loanable funds inthe Japanese economy, and a large share of savings was held in postalsavings accounts.These funds were not loaned out by postal sav-ings institutions, but rather channeled directly to the Treasury and

reloaned to other financial intermediaries that specialized in spe-cific sectors. These specialized public institutions would thenreloan their funds to private financial intermediaries. In turn, theintermediaries would loan the funds as directed to private com-panies in the form of short-term notes that usually were rolled overautomatically and were assumed to be long-term commitments.

This financing strategy had important consequences for the struc-

ture of the Japanese financial system and the relationship betweenprivate companies and the government. Because the volume of lend-ing was so large,companies were deeply in debt to the government.Equity and bond markets were little used and high debt levels con-strained companies ability to retain earnings for investment.

While seemingly long-term, the maturity structure of loansallowed the government to shift funds from stagnant to high-growth

sectors. Such a shift occurred in the 1970s when the governmentrecognized the extent of global overcapacity in the shipbuildingindustry and downsized the Japanese sector. But the short-termstructure of the lending allowed it to implement that decision grad-ually and with minimal disruption to the private financial sector.

The strategies that made the Japanese lending system so suc-cessful resulted in the government taking a primary role in cred-

it decisions. As Japanese companies and banks moved abroadand gained access to alternative sources of credit in external mar-kets, the system was weakened and, in the view of many, becamecounterproductive. The loss of direct government control wasnot replaced by a system of effective indirect controls such as thosethat had been provided by monetary policy and financial regula-


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tion in other industrialized countries. The explosion of creditthat led to the stock market and real estate bubbles in the 1980scould not have happened under the earlier lending system. But it

would appear that such consequences are inevitable as liberaliza-tion dismantles old paradigms without providing adequate poli-cy and regulatory infrastructure for the new systems that are to taketheir place.

BUILDING ON EXISTING STRUCTURESAND TRENDS

One of the more profound changes that has occurred in financialmarkets during the last two decades is the rise in securities mar-kets as increasingly important channels for both domestic and inter-national private investment flows. In many industrialized countries,a growing share of private savings are placed in pension plans and

other institutional pools that invest those funds directly in secu-rities rather than placing them in the hands of intermediaries suchas depository institutions. In Canadian, German, Japanese, U.K.and U. S. financial markets, assets of institutional investors morethan doubled as a percentage of GDP from 1980 through 1995.8

In the United States, the share of total financial sector assetsheld by institutional investors rose from 32 percent in 1978 to 54

percent in 1998. At the same time, the share of depository insti-tutions fell from 57 percent to 27 percent .9

Similar trends are occurring in emerging economies.The num-ber of countries characterized as emerging markets by the WorldBanks International Finance Corporation (IFC) and that have estab-lished stock markets rose from 31 in 1985 to 48 in 1994, while thenumber of listed domestic companies rose from 8,916 to 19,397. Mar-

8Bank for International Settlements, 68th Annual Report(Basel: BIS, June 1998), andInternational Monetary Fund, International Capital Markets: Developments,Prospects, andPolicy Issues (Washington, D.C.: International Monetary Fund, 1995).

9U.S. Board of Governors of the Federal Reserve System, Flow of Funds Accounts ofthe United States (Federal Reserve Statistical Release Z.1, September 15, 1999,www.bog.frb.fed.us/releases/).


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ket capitalization jumped from $171 billion to $1.929 trillion overthe same period, and climbed from 3.8 to 14.6 as a percentage ofdeveloped markets capitalization.10

Another major development in emerging economies is theestablishment of mandatory pension systems, many of whichhave been privatized. Chile was the first Latin American coun-try to privatize its pension system, but other countries in theregion have followed suit. Peru (1993), Argentina (1994), Colom-bia (1994), Uruguay (1995), Bolivia (1997), Mexico (1997), and ElSalvador (1998) have implemented pension reforms. In 1997,

Hungary, Poland, and Kazakhstan enacted legislation mandatingthe creation of private pension plans.11 While some countrieshave shifted to a wholly privatized system, others that are imple-menting or considering reform have adopted the three pillarapproach promoted by the World Bank and also used by Switzer-land.This approach retains a government-funded first pillar to alle-

viate poverty in old age, establishes a second pillar to manage workers

mandatory contributions to provide retirement income, and advo-cates a third pillar that encourages additional, voluntary contri-butions to savings for retirement.

In several Latin American countries, the second pillar is pri-vatized as in the Chilean model.Other countries retain a governmentrole in collecting funds from employers but privatize their man-agement. Others, like Malaysia, require mandatory contributions

to a funded system but retain centralized national control.12

Mostcountries that have followed World Bank guidelines in inaugu-rating a second, privatized pillar have created individual retirementaccounts. Other basic components of reform include diversifica-

10International Finance Corporation,Investment Funds in Emerging Markets (Wash-ington, D.C.: World Bank, 1996).

11P.S. Srinivas and Juan Yermo, Do Investment Regulations Compromise Pension FundPerformance? Evidence from Latin America (Washington, D.C.: World Bank, 1999).

12Salvador Valds-Prieto, Cargos por administracin en los sistemas de pensiones deChile, los Estados Unidos, Malasia y Zambia (English summary), Cuadernos de Economavol. 31, no. 93 (August 1994).


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tion over multiple asset classes and prefunding to ensure thatthere will be adequate assets to pay benefits.13

Meanwhile, many emerging economies have also been activein developing public and private domestic mutual funds or invest-ment trusts.The IFC has invested in domestic funds in Thailand,Sri Lanka, India, Pakistan, and Kenya. It has also advised the gov-ernment of Zimbabwe in establishing a regulatory framework fora domestic mutual fund industry. But the main thrust of theIFCs program has been the establishment of international emerg-ing market equity funds to channel foreign capital into the domes-

tic markets of developing countries.Both the number of internationalfunds (953 at year-end 1994, up from seventeen in 1985) and the

value of assets under management ($106 billion in 1994) dwarf thesize of domestic funds. Nevertheless, the IFC data show thatinternational equity funds and other holdings by foreign investorsamounted to only $200 billion or 10 percent of total emerging mar-ket capitalization at year-end 1994. In a 1996 report, the IFC

asserted that,while stock markets in emerging economies were pri-marily places where local companies raised equity from localinvestors, foreign funds had played a disproportionately large rolein improving the functioning of emerging markets.14

The IFC also credits Chiles 1981 shift from a public to a pri-vate pension system for playing a sizable role in increasing the sav-ings rate and developing the countrys equity market. It argues that

lifting restrictions on investment assets was critical to its success.Like all other public pension funds, Chiles government-managedfund had asset restrictions that limited its investments to governmentpaper and bank deposits. Under the new private pension system,investments in equities were permitted. The growing pool ofassets encouraged more companies to issue stock. Issuers were list-ed to increase the share of funds raised in equity markets. By 1995,

the pool of savings in pension funds had reached 46 percent of GDP,prompting the IFC to remark that this deep pool of domestic cap-

13Srinivas and Yermo,Do Investment Regulations Compromise Pension Fund Performance?14International Finance Corporation,Investment Funds in Emerging Markets (Wash-

ington, D.C.: World Bank, 1996).


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ital helped the country weather the fallout from the Mexicanpeso crisis almost unscathed.15 It fails to mention the contri-bution of capital controls, which others believe played an equal-ly important role.

In the aftermath of the massive financial crises that have affect-ed emerging economies since 1994, the number of developingeconomies that have established stock markets has risen to 67 at

year-end 1998. However, aggregate market capitalizationwhichhad peaked at $2.3 trillion in 1995fell back to the level of 1994in dollar terms.16 Nevertheless, pools of assets valued in local cur-

rencies in both public and private prefunded pension plans, mutu-al funds, and unit trusts have continued to grow.They provide theinfrastructure for a new form of import substitution that has thepotential to raise the value of domestically held financial assets asa percentage of GDP. The levels implied would add stability tonational markets and reduce dependence on foreign investmentflows to finance development.

Pension Funds in Emerging Economies: Benefits and ProblemsDespite the number of institutions and the diversity of theirfunctions, the financial systems of many emerging economies are

viewed as weak and inefficient.Whether controlled by governmentor private owners, regulation is inadequate and institutions are under-capitalized. Banking systems in particular are easily controlled by

political interests or private oligarchs, and their loans distributedlike prizes to a favored few. While one analysis of financial devel-opments in sub-Saharan Africa concludes that stock marketshave been more difficult for self-serving governments to controlthan banking systems, markets can be dominated by the foreignsector as well as by high income domestic residents.17In such sys-tems, lack of access leads to indifference rather than outrage.

15International Finance Corporation, ibid.16Schools Brief. Stocks in Trade, The Economist, (November 13, 1999).17Leonce Ndikumana, Financial Development and Economic Growth in Sub

Saharan Africa: Lessons and Research Agenda,paper prepared for the Gwendolen CarterSymposium on African Development in the 21st Century at Smith College, September2426, 1999.


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Those excluded from opportunities to borrow in the formal sec-tor accept what they can afford to borrow from the informal sec-tor. Neither the favored few nor the excluded seem to notice theextent to which lack of access to capital and credit for the major-ity of its citizens stunts a countrys economic growth and devel-opment.

Prefunded pension fund systems have the potential to counterthese tendencies by mandating the ownership of financial assets.

The creation of individual accounts in countries that have reformedunfunded pay-as-you-go systems could, over time, significantly raise

the level of interest of participants in the soundness of financialinstitutions and the overall performance of the economy. More-over, as the pools of assets grow, ownership of companies becomesmore widely dispersed, gradually but effectively eroding the con-trol of various oligarchical structures in many emerging economies.

In some countries these benefits are already beginning to occur.In others, they are constrained by restrictions on the allocation of

pension fund assets. Investment limits are the norm for public pen-sion funds across the globe. Privatization has opened the way forinvestments in equities. However, even in reformed systems,some observers consider limits on holdings of stocks as a percentageof fund assets and of outstanding shares of individual companiesto be draconian regulations that limit returns.18While acknowl-edging the lack of managerial experience, the fragility of markets,

and the concern for soundness needed to build confidence innewly established systems, these critics argue for adopting the pru-dent person rule prevalent in private investment systems in many(but not all) industrialized countries.

The prudent person rule emphasizes diversification as opposedto restrictions on asset allocation. Its overall objective is to achievethe highest rate of return within the boundaries of acceptable risk.

Adoption of this model by emerging economies is urged tocounter the herd behavior characteristic of pension funds in LatinAmerica, for example, as well as large concentrations of assets held

18Srinivas and Yermo, Do Investment Regulations Compromise Pension Fund Performance?


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in funds that constrain liquidity. It is argued that restraints on invest-ments in foreign assets in particular should be lifted to achieve diver-sity and improve returns.19

But looking to this model as it is played out in industrializedcountries offers little hope that it would encourage diversity or restrainherd behavior. Pension funds and other institutional investors inthe major industrialized economies tend to concentrate holdingsin shares and bonds.They rely heavily on rating agencies in mak-ing investment decisions, and increasingly look to foreign stockand bond markets for additional opportunities to diversify port-

folios, moving in herd-like fashion from one national market toanother in search of the highest returns. Moreover, they have beenaccused of imposing short-term horizons on the corporate sectorbecause the goal of maximizing shareholder value has been mea-sured on the basis of quarterly or annual returns and has led to high-er levels of portfolio turnover.

On the other hand, the three pillar model that emerged

from the World Banks 1994 report on old age pension programsworldwide has itself been criticized.Teresa Ghilarducci argues thatit overlooks the importance of the first pillar: social insurance.Noting the rising share of social security payments in the total incomesof U.S. middle-class retirees in the 1990s compared to the 1980s,she argues that the failure of U.S. private plans to pay adequateretirement income indicates that a mixed system is desirable only

if it is based on universal social insurance.This is important evenin the mandatory systems that have been adopted by emergingeconomies because they do not cover workers who are outside firmsin the formal sector. Moreover, the mandatory deductions in

wages are so high (13 percent in Chile, 13.5 percent in Mexico) thatthey may encourage low-income workers to opt out of the formalsector, thereby losing benefits.20

Ghilarducci also questions the assumption that high ratesof return will continue to justify the shift from pay-as-you-go

19Srinivas and Yermo, ibid.20Teresa Ghilarducci, Pension Policies to Maintain Workers Access to Retirement,

in Ray Marshall, ed., Back to Shared Prosperity (Armonk, N.Y.: M. E. Sharpe, 1999)


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public sector systems to privatized plans in emerging economies.In her view, [t]he high return to privatizing only works in an elab-orate system in which populations with different age distributionsare buying and selling each others investments. Thus, plans inemerging economies with young populations would need to be allowedto buy foreign assets to support sales of assets by aging popula-tions in industrialized countries.

But even that strategy might have adverse consequences. In theUnited States, for example, buying and selling of stocks has notbeen motivated by intergenerational differences such as the need

to support income levels of retirees. Even as middle-class work-ers poured retirement savings contributions into mutual funds andthe foreign sector bought more shares of U.S. stocks,wealthier U.S.individuals sold more than $2 trillion of direct holdings of corporateequities from 1994 through the second quarter of 1999.21These salesfrom what might be called the U.S. version of the third pillarcontributed to a sharp decline in the personal savings rate in

recent years.They also provided funding for increased consump-tion and helped widen disparities in income between the top

wealth-holders and all other income groups.Like many critics of the failure of private pension systems to

incorporate strategies to increase employment and income, Ghi-larducci notes that using pension monies for job creation wouldbe as important to workers as current stock market gains, which

primarily benefit employers.22

But creating jobs and raisingincomes will become even more important as markets for exportscontract and increased domestic demand becomes the alternativepath to growth. Most of the pension reform programs have not

yet addressed these issues. For example, Chiles 1997 reformfocused on liberalizing restrictions on instruments. It enlarged thenumber of companies in whose stocks pension funds could invest

from 30 to 200 out of a total of 300 listed companies, and it

21U.S. Board of Governors of the Federal Reserve System, Flow of Funds Accounts ofthe United States.

22Investing in affordable housing is another area that would seem to be particularlyimportant to unskilled workers, because it would improve their quality of life.


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authorized investments in project financings, securitized bonds,and venture capital funds. But it did not introduce specific poli-cy objectives to promote economic and social programs.23

Mexicos reformed pension fund law has gone further than Chilesin expanding the range of investment instruments for pension con-tributions. But it also incorporates a mission statement that cen-ters investment strategy on development and macroeconomicpolicy, by requiring investments in securities that encouragenational productive activity, create infrastructure, and generate employ-ment, housing development and regional development.24While

limited progress has been made toward achieving these goals, itis the Mexican model that has the potential to support a transi-tion to domestic demand-driven growth, transform the financialsystems of emerging economies, and support the development ofbroad-based prosperity.

STRUCTURING PENSION FUNDS IN EMERGINGECONOMIES FOR GROWTH AND DEVELOPMENT

Past models for development have tended to focus primarily onthe role of public international financial institutions and nation-al governments in mobilizing funds for investment in sectorsthat are underdeveloped or that have underutilized potential for

growth.The array of domestic development institutions in emerg-ing economies ranging from Brazil to Zimbabwe provides evidenceof how widely used this model has been. In many countries theseinstitutions have operated in tandem with nationalized bankingsystems and provided structures for credit allocation to agricultural,small business, and other borrowers. In many cases, their inabil-ity to realize growth objectives in the sectors they served was due

to the failure to ensure the necessary degree of impartiality in mak-ing credit decisions.

23Srinivas and Yermo,Do Investment Regulations Compromise Pension Fund Performance?24Srinivas and Yermo, ibid.


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But another equally serious problem was providing a source offunding for those institutions. In countries with nationalizedbanking systems, government backing meant that banks did notneed to be well capitalized. Moreover, loans were funded bydeposits. But specialized institutions required longer-term fund-ing and were usually supported directly by the government or bysales of government-guaranteed paper. As discussed above, gov-ernment paper and bank deposits tended to constitute the major-ity of instruments available for public pension funds and forprivate investment.The lack of options for investment and the low

retirement income associated with public pension plans tended toencourage capital flight among middle- and high-income house-holds. Thus, lower-income workers bore the burden of financingthe government and its financial institutions, and governments wereinduced to borrow abroad to maintain growth.

Capitalizing the Financial Sector

As the Mexican pension reform laws statement of objectivessuggests, one of the more important goals of pension reform inemerging economies should be to provide sufficient capital to finan-cial institutions. Like the U.S.Reconstruction Finance Corporationin the 1930s, pension funds should be authorized to purchase thecapital stock of banks, insurance companies, mortgage banks,agricultural cooperatives, lenders to small business, local credit coop-

eratives, regional development agencies, venture capital funds, andvarious other institutions that comprise national financial systems.Capitalizing these institutions would help create the financialstructure needed to mobilize savings and distribute investmentsefficiently and productively across all segments of these economies.

The growth of a larger and more varied financial sector will,in turn, increase the menu of financial assets in which pension funds

can invest, thus expanding opportunities for portfolio diversificationand enhancing market liquidity. Recent reforms that have priva-tized banking systems using the universal bank model have notbeen sufficient to meet this need. Institutions are undercapitalizedand, so far, have failed to introduce needed innovations. Using pen-sion funds to capitalize the financial sector will be critical in


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countries where financial crises and bank failures have wiped outthe capital base of much of the domestic system, opening the gatefor increased foreign entry. But using retirement savings to pro-

vide capital to financial institutions must be accompanied byappropriate safeguards in the form of adequate regulation, effec-tive governance, and financial guarantees as discussed below.

Bond markets are a segment of emerging economies financialsystems that have not yet recovered from the recent crises.25Thesemarkets could particularly benefit from domestic pension fund invest-ment. Like life insurers, pension funds can hold long-term debt

obligations more comfortably than banks.Thus, they can ensurethe repayment schedules necessary to fund corporations long-termcapital investments and provide ongoing funding for domestic devel-opment institutions. Bond markets are essential if domestic fund-ing is to grow relative to international sources as a share of totalfinancing for public works projects and for creating infrastructure.Overall, augmenting domestic sources of long-term debt will be

critical to the process of shifting to domestic demand-drivengrowth. The process will reduce dependence on external debtand reliance on export-led growth and will increase national own-ership of both real and financial sector assets.

Deeper bond markets are also essential for the development ofsecuritization to increase the supply of mortgage credit to mid-dle-income households, as well as to back publicly supported

affordable housing for lower-income families. Increasing andimproving the housing stock is essential to the process of raisingliving standards. Constructing and renovating housing are activ-ities that generate and maintain employment at both skilled andentry levels. Like public works and infrastructure, housing is a non-tradable good and thus a primary sector for leading the transitionto domestic demand-driven growth.

Securitization is a technique that shifts the risk of holding long-term mortgages from depository institutions to institutionalinvestors. Widely used in the United States, it has expanded the

25Jonathan Fuerbringer,The Wounds Havent Healed in Emerging-Markets Debt,The New York Times (November 28, 1999).


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volume and lowered the cost of housing finance. The process ofsecuritization involves the pooling of mortgages by originators andthe sale of shares in the pool to outside investors. Freed from thenecessity to hold mortgages in a portfolio backed by a limited amountof capital, mortgage originators can use their special skills to per-form the function of originating and servicing mortgages in an expand-ing market. As the technique implies, securitization requires a largeinstitutional investor sectorpension funds,mutual funds, and insur-ance companiesand contributes to the soundness of their port-folios by increasing the variety of investment instruments. As

was the case in the United States, however, securitization isunlikely to be developed without government support. For exam-ple, in order to support the growth of securitized mortgage pools,governments will need to develop institutions that will play therole of market makers.

Private placements are another potential avenue for pension fundinvestment in emerging economies.These are a form of credit that

is negotiated directly between lenders and borrowers, often withthe assistance of a financial institution in locating and advising thetwo parties. In the United States, insurance companies haveplayed an active role as lenders in the market for private placements.

The borrowers have tended to be smaller and innovative enter-prises without standing in bond markets. Unlike bond issues,private placements can be tailored to the particular needs of the

borrower. A single placement may include short-, medium-, andlong-term tranches that will better meet the needs for growth thancredits in a single maturity range. Private placements are partic-ularly useful for developing economies, enabling them to providefunding for established private companies. Such placements canalso offer funding for public development institutions that sub-sidize private credits to small borrowers. Otherwise, the private

financial institutions granting the credits would have to passalong the higher cost of servicing many such small loans.Investing in domestic venture capital funds, as Chilean pension

funds are now allowed to do, is illustrative of a unique role thatpension funds can assume with less risk (in an admittedly riskyfield) than other investors simply because the number of partic-


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26International Finance Corporation,Investment Funds in Emerging Markets.27U.S. House of Representatives, Hearing before the House Education and Labor Sub-

committee on Labor-Management Relations, February 9, 1989 (Washington, DC: Gov-ernment Printing Office, 1989).

28Peter F. Drucker, The Pension Fund Revolution (New Brunswick, NJ: Transaction,1996).

ipants is so large and the risk can be spread more widely.The IFChas encouraged the activities of foreign venture capital funds andis promoting local funds and joint ventures using foreign management.Because venture capital investments tend to be very small, they canfund businesses that are too small for direct pension fund invest-ments, IFC officials point out. They benefit the economy bycontributing to innovation and to business and job creation.Theyare an instrument of ownership that does not require a well-developed and liquid stock market for transactions. However,they can help develop the new companies that will augment

equity markets by providing the source for initial public offeringsLike private placements, venture capital funds commitments

of patient capital require oversight.But that, in turn, provides oppor-tunities to offer technical assistance in such areas as planning, mar-keting, and reporting that microlenders and other small institutionscannot provide.26True, the potential for disproportionately largegains relative to outlays, which can cushion losses in the overall

portfolio, does not make venture capital funds risk free. Howev-er, it does justify the inclusion of a limited amount of investmentin these funds in well-diversified pension pools.

Encouraging Participation in Investment Decisions andCorporate GovernanceIt is widely recognized that pension funds are becoming the new

owners of businesses in the United States.27

Peter Drucker has describedthis development as pension fund socialism in view of the factthat ownership of a rising share of the means of production is con-centrated in the hands of institutional investors.28 Many legaland economic analysts agree, however, that the problem withthis form of ownership is the lack of legal clarity in determining

which participants control choices and exercise the responsibili-


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ties of ownership: sponsors (employers), beneficiaries (employeesand retirees), or fund managers?

In defined-benefit plans, the commitment of the employer toa contractual retirement income for the employee puts the risk ofperformance on the employer. Defined-benefit plans are gov-erned by the Employee Income Retirement Security Act (ERISA),

which authorizes the employer to act as a fiduciary (or to appointfiduciaries) and to make investment decisions that will ensure suf-ficient income to meet future contractual obligations. In state andlocal government defined-benefit plans, the sponsor/employer is

the political jurisdiction, and fiduciaries are appointed by electedofficials.

Many public and private defined-benefit plans employ outsidemanagers to make investment decisions. The larger plans usemultiple managers with different managerial skills (or styles) andconcentrations. Although fiduciaries of state and local governmentplans have assumed a major role in corporate governance during

the last two decades, it is often the money managers in the pri-vate pension fund industry that exercise this major responsibili-ty of ownership. Critics argue that numerous conflicts of interestarise from allowing outside pension fund managers to chooseinvestments and exercise a dominant role in corporate gover-nance. For example,a management firms decisions about purchasesor sales of the stock of a particular corporation may be influenced

by its role in managing the corporations pension assets. It may decidenot to sell the stock and risk losing a customer.

Another criticism is that money managers tend to emphasizeshort-term gains in order to win or retain customers. In design-ing strategies for managing defined-benefit plans, for example, fundmanagers are aware that higher earnings in one quarter or over a

year lower contributions in the next and, therefore, increase cor-

porate profits. Meanwhile, the beneficiaries may be disadvantagedover the long-term. The emphasis on short-term gains in stockprices often leads many companies to adopt management strate-gies that will produce those gains. However, such strategies short-change investment programs that have longer-term payoutse.g.,expanding plant and equipment, upgrading technology, or increas-


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ing funding for research and developmentbut are neverthelessnecessary for future growth.29

Defined-benefit plans remain a very large segment of the U.S.

pension fund industry, although the number of defined-contributionplans is now greater. Under defined-contribution plans, theemployer agrees to contribute a contractual amount based on

wage levels. The employee also contributes an agreed-upon basiccontribution that can be augmented at his/her discretion. Undersome plans, the employer pools individual accounts and selects man-agers for the pool, which usually limits discretion as to the range

of investments. Under other plans, the employee receives andmakes contributions to an individual account that can be self-man-aged or invested in a mutual fund or annuity managed by professionals.In either case, the risk of performance and the size of futureretirement income are not the responsibility of the employer.

Defined-contribution plans do offer beneficiaries more porta-bility, i.e., the ability to move an account from one employer to

another in case of a job change. They also offer beneficiariessome choice as to the amount to be contributed by the employ-ee. However, the beneficiaries role in making investment decisionsand exercising corporate governance is still highly restricted. If theircontributions are pooled either by the employer or if they have invest-ed individual accounts in mutual funds or purchased annuities, thebeneficiaries remain passive investors without active rights of

choice. Corporate governance remains passive either because it isexercised by fund managers chosen by the employer or because thebeneficiaries individual holdings in mutual funds or direct invest-ments are too small to be effective in influencing corporate man-agement decisions.

In short, there is no channel for participation in the rights andobligations of ownership in pension plans in the United States,

except in state and local government plans, union funds, andfunds administered by the Teachers Insurance and Annuity Asso-ciation (TIAA). Both union funds and TIAA funds are multi-employ-

29 Jane DArista, The Evolution of U.S. Finance, Volume II (Armonk, N.Y: M. E.Sharpe, 1994).


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er funds. Union funds are jointly controlled by employee andemployer trustees, while TIAA funds are controlled by boardmembers elected by beneficiaries.The governing structures of thesetwo types of plans, as well as the type of control exercised by pub-licly appointed fiduciaries of state and local funds, offer the onlyU.S. models for the democratization of the immense private U.S.pension plan system. At issue in the debate on U.S. pensionreform is one of the fundamental elements in a private market-based system. As articulated by Ghilarducci: Workers own andbear the risk of failure if pension funds collapse.The first princi-

ple of property rights is that risk-bearers are property ownersand have the right to some control.30

Many privatized pension systems in emerging economies facethe same issues and concerns. Given that many emerging-economy pension systems involve mandatory contributions from

wages, the importance of participation is underscored by the needto build confidence in the newer systems. Also, narrow elites in

either public or private sectors must be prevented from capturingcontrol over the allocation of assets for their own benefit. Thereis real danger that oligarchical control could dissipate the advan-tages of wider ownership of financial assets, particularly in LatinAmerica whereexcept for a few countries, including Mexicothe government does not collect contributions. In those countries,private fund managers collect and invest contributions without pub-

lic participation.31

In Chile private management has thus farresulted in uniquely high fees and charges compared to interna-tional standards.32Yet this may be the least of the conflicts of inter-est that could emerge without direct oversight by those whose savingsare at risk.

Reforms of existing and proposed private pension plans inemerging economies must address the issue of participation in ways

30Ghilarducci, Pension Policies to Maintain Workers Access to Retirement.31Srinivas and Yermo,Do Investment Regulations Compromise Pension Fund Performance?32Valds-Prieto, Cargos por administracin en los sistemas de pensiones de Chile,

los Estados Unidos, Malasia y Zambia.


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that acknowledge the tension inherent in the mandatory natureof a privatized structure. Oversight could be provided by committeesof legislative bodies;by local, regional, and/or national boards madeup of representatives elected by beneficiaries; by union funds; orby all of the above. Active public debate concerning investmentpolicies and governance issues should be encouraged in meetingsof these and other groups of beneficiaries and their representativesor advocates.

In many emerging economies where private pension plans arealready in place, they pose a particular challenge for the future of

those economies. Analysts already foresee that shifts to fullyfunded systems will give rise to a large pension fund sector, as hasbeen the case in the United States.33Thus, pension funds have thepotential to become a powerful and comprehensive source offunding for economic policies that emphasize domestic demand-driven growth and shared prosperity. Alternatively, they may fallunder the control of elites who will use them as they have used

other financial institutions (such as banks) to cement political andeconomic control.As one analyst of financial development and eco-nomic growth has noted: Concentration of financial resources isnothing but a consequence of concentration of political power. Onecannot address the former issue without addressing the latterbecause they are intimately intertwined.34The hope in this caseis that the roles will be reversed: that the concentration of finan-

cial resources in the hands of many wage earners will result in thediffusion of economic and political power across entire populationsof emerging economies.

Protecting the Value of Contributions to Private Pension PlansEmerging economies that have established private pension plansfunded by mandatory deductions from wages are necessarily con-

cerned with soundness and performance. Both are critical forbuilding confidence in the new systems and avoiding fraud. Latin

33Valds -Prieto, ibid.34Ndikumana, Financial Development and Economic Growth in Sub-Saharan

Africa: Lessons and Research Agenda.


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American countries rely on prudential regulations, such as fidu-ciary standards, accounting and auditing standards, insider trad-ing rules, investor protection rules, and requirements for disclosure.Prudential regulations also require diversification and minimumrisk-rating of assets. They also impose limits on self-investmentand limit market power by restricting concentrations in shareownership. In addition, Colombia, Mexico, and Uruguay offer arate-of-return or benefit guarantee of second-pillar pensions, atleast in the initial years. In all Latin American countries with pri-

vatized systems, the highest priority is the safety of retirement assets.35

In the United States, by contrast, there has been little discus-sion of the safety of private pension fund assets even in the con-text of heated debates on privatizing social security.Those debatesalso tended to overlook the enormous amount of assets already heldby private pension plans at year-end 1998 ($4.3 trillion) or their sizein relation to the assets of depository institutions backed bydeposit insurance ($5.1 trillion).36While it can be assumed that state

and local government pension plans (another $2.8 trillion at year-end 1998) are backed by the taxing authority of the political juris-dictions that sponsor them, the only private plans that have publicbacking are defined-benefit plans ($2.1 billion). These plans areguaranteed by the Pension Benefit Guaranty Corporation (PBGC),

which assumes responsibility for underfunded plans of companiesthat go bankrupt, thus ensuring that contractual benefits will be

paid to retirees. Like other financial guarantees within the U.S.system, the PBGC relies for funding on premiums paid by cov-ered participantsi.e., all companies that offer defined-benefit plans.

The PBGC also has authority to borrow from the U.S.Treasury.However, private defined-contribution plansthe type of plansthat were to be established in place of social security accountshave no public or private backing to cover losses. With $2.2 tril-

lion in assets at year-end 1998, they are the fastest growing segment

35Srinivas and Yermo, Do Investment Regulations Compromise Pension Fund Performance?36U.S. Board of Governors of the Federal Reserve System, Flow of Funds Accounts of

the United States.


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of the U.S. pension fund industry and the weakest in terms of cus-tomer protection.

As pension fund systems continue to grow in both developedand developing economies, the issue of protecting the contribu-tions and earnings of beneficiaries will become more important.A minimum annual real rate of return guarantee of 2 percent suchas that offered by the government of Uruguay may be an appro-priate means of providing protection for savings deducted from

wages.37But unless the guarantee itself is prefunded, a serious mar-ket contraction would put considerable strain on governments cop-

ing with lost tax revenues and other calls on resources, such asunemployment insurance.

An alternative method of providing financial guarantees to pen-sion fund beneficiaries would be to have the contributors them-selves pay premiums into a prefunded insurance pool that wouldinvest in government securities. Premiums would be deducted peri-odically from earnings on assets in individual accounts. The fact

that such accounts already exist in many countries, and thataccounting and reporting procedures are already in place, wouldmake deducting premiums from earnings a routine matter. Giventhe growth in the size of the pension fund sector in countries withestablished prefunded systems, the pool of government securitiesbacking the system would itself grow to substantial size overtime. Even an annual deduction of 10 percent from earningsnot

contributionswould eventually provide a sizable cushion toprotect beneficiaries from losses.

In tandem with the growth in the insurance pool, the guaran-tee fund could adjust the level and coverage of benefits. For exam-ple, all contributions might be covered up to a certain amount inthe years immediately following the introduction of the insurancescheme.Thereafter, the amount of covered contributions could be

raised and coverage could be extended to include a portion of accu-mulated earnings with additional adjustments at five-year inter-

37Srinivas and Yermo, Do Investment Regulations Compromise Pension Fund Performance?


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vals. In any event, the first priority should be coverage of the valueof an individuals contribution up to the limit imposed by the aggre-gate value of the insurance pool. Setting a limit on coverage

would introduce a redistributive element to privatized plans thatdoes not currently exist.This would seem a particularly appropriateplace to introduce it, because higher income individuals andhouseholds can bear the risk of loss on mandated savings abovethe level needed to ensure adequate retirement income more eas-ily than can middle- and lower-income wage earners.

REFORMING THE INTERNATIONAL MONETARYAND FINANCIAL ARCHITECTURE TO PROMOTE

DOMESTIC DEMAND-DRIVEN GROWTH INEMERGING ECONOMIES

During the 1970s, middle-income developing countries were the

primary recipients of recycled surpluses from the Organization ofPetroleum Exporting Countries.They bought oil from OPEC coun-tries, capital goods from industrialized countries, and borrowedheavily to support the import-led growth strategy of that period.But the burden of servicing rising levels of external debt denom-inated in dollars and other strong currencies eventually became insup-portable. Oil prices rose again at the end of the decade and

existing loans had to be rolled over with higher interest rates andshorter maturities.The most burdensome element was that the for-eign exchange needed to service debt had to be earned, and theonly way to earn it was to export goods to industrialized countries

with strong currencies.The debt crisis in 1982 made clear that the heavily indebted mid-

dle-income countriesmost of which were in Latin America

would have to export their way out of debt. Foreign lending driedup. Private and public international financial institutions focusedon expanding export capacity as a sign that a country was regain-ing creditworthiness.The International Monetary Fund (IMF) insti-tuted conditions for multilateral credits that suppressed demandin these countries. Thus, imports would fall and export surplus-


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es would result in external adjustment.The export-led growth strat-egy emerged in tandem with immense resource transfers. Over the

years from 1983 through 1989, negative net outflows from Latin Amer-ica amounted to -$116 billion as heavily indebted countries usedall foreign exchange earned from exports to service external debt.38

Given the debt overhang, rising exports could not spur growthin the heavily indebted countries in the 1980s. But the export-ledgrowth strategy also failed to inhibit the growth of external debt.

The total external debt of developing countries continued togrow, rising from about $1 trillion at the beginning of the 1990s

to $2 trillion in 1999. True, the decline in debt as a share ofexports of goods and services from 186.2 percent to 160.9 percentbetween 1991 and 1998 attests to the success of the strategy in rais-ing the volume and value of exports. However, the ratio of debtservice payments to exports rose from 22.4 percent to 24.0 percentduring the same period. For developing countries in the WesternHemisphere, however, debt service as a percentage of exports

rose from 39.3 percent to 45.7 percent.39A central element in any future strategy for growth in the

global economy must involve efforts both to reduce developing coun-tries dependence on external debt and to lower the level of exter-nal debt denominated in foreign currencies.This does not meanthat these countries will not need foreign private capital and/orbilateral and multilateral flows, nor does it mean such funds

should be prohibited. But inflows must be rechanneled in ways thatminimize the burden of debt service. In addition, the system ofusing one or a few strong currencies as vehicle currencies in inter-national trade and investment and as reserve assets must bechanged. The following three proposals suggest a frameworkthrough which old and new institutional arrangements could beused to lower debt levels, provide new channels for capital inflows,

38International Monetary Fund,International Capital Markets:Developments, Prospects,and Policy Issues, 1995.

39International Monetary Fund,International Capital Markets (Washington,D.C.: Inter-national Monetary Fund, September 1999).


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and alleviate the barriers to growth in demand imposed by ser-vicing foreign currency-denominated debt.40

Issuing a New Allocation of SDRsA 1987 IMF staff report affirmed that allocations for SpecialDrawing Rights (SDRs) could serve as a safety net to cope

with an international financial emergency of limited, thoughuncertain, duration. In the absence of a true lender of last resort,SDRs represent the single instrument in place at the global levelto address the problem. Moreover, new SDR allocations provide

a uniquely benign alternative to bailout loans, which compoundthe underlying inequities inherent in a global system organizedaround foreign currency-denominated debt.

Given the unprecedented amount of IMF resources already com-mitted to crisis-ridden member countries, new sources of fund-ing are urgently needed. In theory, the IMF could obtain these fundsby borrowing in private markets. But member country taxpayers

would remain the guarantor of IMF obligations. And the IMF wouldsimply perpetuate the worst features of its current crisis-responseoperations if it reloaned privately raised funds to impacted coun-tries. Debt owed to the IMF is no different than debt owed to theprivate sector in terms of the pressure it puts on countries toexport their way out of massive loan obligations.

By issuing a new allocation of SDRs, the IMF could accom-

plish three objectives. First, it could provide badly needed debt relief.Second, it would permit countries to shift from an export-led growthparadigm toward fostering deeper, stronger internal markets.

Third, it could foster conditions for a resumption of growth in devel-oping countries and in the global economy.

Ideally, new allocations should be directed only to highlyindebted poor countries (HIPCs) and to those nations that have

been hit hardest by the effects of financial crises. But changing theIMFs Articles of Agreement to direct allocations to particular coun-tries would be contentious and time consuming.On the other hand,

40A lengthier version of these three proposals was published in November 1999 by theFinancial Markets Center.


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a general allocation based on quotasa system that would distributealmost half the newly issued SDRs to G-7 countriescould bedone quickly, if agreed to by 85 percent of the IMF Board.41

In any event, allocations for debt relief should supplement theso-called equity allocations (adopted in April 1997 but not yetratified) for countries that had not become members of the IMFin 1981when the last SDR allocations were made. Allocations toHIPCs should be sufficiently large to enable them to pay offpublic and private external debt. Allocations to other countries shouldbe used to repay public debt and a needed portion of private

debt. In the case of Russia, allocations should cover all debtincurred by the former Union of Soviet Socialist Republics. In repay-ing private debt,SDR recipients would exchange the drawing rights

with central banks of strong-currency countries for foreignexchange, which would then be used to pay off private lenders.

In addition, recipient countries should retain a portion of thenew drawing rights as reserves to back a resumption of domestic

bank lending. Adding reserves to their central banks balancesheets would increase the countries liquidity, enable monetary expan-sion and thereby allow domestic banks to lend at reasonable ratesof interest. The current reliance on high interest rates to attractforeign capital and raise currency values suppresses growth incrisis-battered countries. Borrowers cant earn enough to repay theirloans, undercapitalized banking systems drain public resources, and

credit crunches deterrather than spurnew infusions of cap-ital by foreign and domestic investors.

Moreover, unless newly allocated SDRs are also employed asdomestic financial reserves, the export-led growth paradigminevitably will continue. Absent an injection of liquidity in domes-tic markets, hard-hit countries must struggle to earn the reservesneeded to rebuild financial systems capable of funding job creation

and income growth in the domestic economy. Currently, these coun-

41David Lipton of the Carnegie Endowment for International Peace has suggestedthat a large general allocation be used to create a pool of funds to defend the interna-tional financial system in time of dire threat. Liptons proposal constitutes a sensible useof SDRs allocated to countries that do not need debt relief or access to international liq-uidity.


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tries must either increase the volume of exports or borrow fromexternal sources to augment domestic liquidity.

Creating a Public International Investment Fund forEmerging MarketsThe second proposal puts forward a plan for establishing a pub-lic international investment fund for emerging markets. Structuredas a closed-end mutual fund, this investment vehicle wouldaddress the problems that have emerged with the extraordinarygrowth in cross-border securities investment transactions in the

1990s.The proposal advocates a role for the public sector in man-aging those problems.Thus, private portfolio investment, whichbecame the dominant channel for flows into emerging markets from1990-94, can promote steady, sustainable growth rather than theboom and bust cycles that so far have been its primary contribu-tion.

This proposed closed-end investment fund for emerging mar-

kets builds on existing activities of the World Banks InternationalFinance Corporation (IFC),whose mandate is to promote private-sector investment in developing countries. Private foreign port-folio investment in emerging markets has been actively promotedby the IFC since 1984, when the first country fund was structuredin Korea.The IFCs objective in promoting portfolio investment

was to integrate domestic and international capital markets.42

Initially, country funds were structured as closed-end funds butquickly shifted to open-ended mutual funds as the IFC con-cluded that exit possibilities encouraged more entry. Its Global IndexFund, formed in January 1994 to target pension funds in indus-trialized countries,adopted a semi-open structure that allowed issuancesand redemptions on the last day of the month rather than con-tinuously. As noted above, the number of country funds invest-

ing in emerging markets had exceeded 1,000 by 1994, with assetstotaling $100 billion.43

42International Finance Corporation,Investment Funds in Emerging Markets.43International Finance Corporation, ibid.


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As the IFC realized, the phenomenal growth of institutionalinvestors assets in G-7 countries suggests that foreign portfoliocapital is an ideal channel for financing long-term economicexpansion in emerging economies. To achieve this beneficialresult, however, these economies need portfolio investment inflowsthat are sizable, stable, and supportive of the policy objectives ofboth their governments and domestic enterprises. Chile has beenfairly successful in using capital controls to achieve some of theseresults by requiring foreign investors to hold securities for at leasta year. Also, Chilean companies must maintain reserve require-

ments on direct borrowing abroad. Korea, too, imposed limits onforeign borrowing by domestic companies for many years beforeits recent liberalization. Such controls are very useful but cannotaccomplish the dual task of injecting long-term private capital intodeveloping countries while deterring the destructive fluctuationsin asset prices and exchange rates associated with procyclicalsurges in foreign portfolio flows.

One innovation that might be equal to this task is to return tothe closed-end fund structure for foreign investment in emergingmarket securities, but have the manager be a public internation-al agency. The new fund could issue its own liabilities to privateinvestors and buy stocks and bonds of private enterprises and pub-lic agencies in a wide spectrum of developing countries. Both thenumber of countries and the size of the investment pool would

be large enough to ensure diversification. The funds investmentobjectives would focus on the long-term economic performanceof enterprises and countries rather than short-term financialreturns. Selecting securities in consultation with host govern-ments and representatives of pension fund beneficiaries would helpthe fund meet those objectives.

Unlike open-end mutual funds that must buy back an unlim-

ited number of shares whenever investors demand it, closed-endinvestment pools issue a limited number of shares that trade ona stock exchange or in over-the-counter markets.This key struc-tural difference makes the holdings in closed-end portfolios muchless vulnerable to the waves of buying and redemptions thatsometimes characterize open-end funds.Thus a closed-end fund


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would provide emerging markets a measure of protection byallowing the prices of shares in the fund to fluctuate withouttriggering destabilizing purchases and sales of the underlyinginvestments.

To further balance the goals of market stability and econom-ic dynamism, the closed-end fund should possess a solid capitalcushion. Between 10 and 20 percent of the value of shares sold toinvestors should be used to purchase and hold government secu-rities of major industrial countries in amounts roughly proportionalto the closed-end fund shares owned by residents of those coun-

tries. These holdings would provide investors a partial guaranteedreturn,denominated in their own currencies,while the governmentsecurities would explicitly guarantee the value of the funds cap-ital. This dual guarantee would moderate investors concernsabout potential risk.

Creating one or more closed-end funds on this model wouldreduce the need for capital controls, especially in countries that choose

to accept foreign portfolio investment solely through this vehicle.The closed-end fund would have several additional benefits as well.It would help pension plans in developing and developed coun-tries diversify their portfolios while minimizing country risk andtransactions costs. And it would help institutional investors in devel-oping countries share the cost of information and collectivelycombat the lack of disclosure by domestic issuers in those mar-

kets.These arrangements need not reinvent the wheel. Just as the

structural mechan

cfr - darista fininfra paper

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