|
Where Is Pension Reform Going in China? Issues and Options Pieter BOTTELIER Introduction The critical importance of social security and pension reform was probably not fully perceived when the first modest official steps to modify the old system were taken in 1986. Given China's gradual approach to economic reform, this is understandable. With the benefit of hindsight, however, one could argue that pension reform should have preceded SOE (State-owned Enterprise) reform. It would have been easier for China to preserve social stability today while simultaneously pushing ahead with SOE reform in all sectors of the economy, including mining, if a functioning urban social security system consistent with the requirements of a market economy had been in place. However, this would have required a level of foresight and consensus on reform priorities that would have been politically impossible in the 1980s and early 1990s. What happened in fact is that social security reform along with financial system reform lagged behind real economy reforms. Today, China's leaders are reminded almost every day that social security reform is a top priority. The widespread labor unrest that we have seen in Heilongjiang, Liaoning and other provinces in recent months could perhaps have been avoided, if adequate social safety nets had been in place. Some of the wrenching social pain suffered by many Chinese families today might also have been avoided. Social security reform in urban China today is on a critical path today. China's modernization process cannot come to full fruition until adequate social safety nets and pension provisions are functional. In this presentation I will focus in particular on pension reform and make only passing reference to other important components of the emerging social security system. With regard to pension reform, I will focus on design and implementation aspects, not on detailed rate issues, which are, of course, also important. Pension reform, as pursued by China, is not only very urgent, but also extraordinarily complex, both administratively and policy-wise. The government cannot realistically accomplish the implementation task all by itself. I will argue that public-private sector partnerships are needed for efficient and expeditious implementation. The reason for this is that in China's case, as in most other cases, public pension reform and capital market development are closely intertwined. One cannot succeed without the other. In fact it is hard to say which comes first, pension reform or capital market development. The direction in which China is steering social security and pension reforms is in my opinion the right one; only the pace and sequencing of implementation and the role of the private sector are at issue. The only basic design question worth debating, I think, is whether the funded pillar, the second mandated pillar, should be corporation-based as in some Western countries, or Government-based. I believe that a Government-based system is a more practical option for China at this time. The country's corporate culture is not yet well established. It is moreover likely that most employment growth in the coming decades will take place in numerous new, mostly small and sometimes informal, private companies. This makes a corporation-based mandated pillar hard to implement. Corporations are at this stage better suited to promote voluntary retirement schemes under the optional third pension pillar. The combination of defined benefit and defined contribution elements in a mandated, dual pillar social pooling and funded individual account system, as per State Council Documents # 26 of 1997 and # 42 of 2000[1], is the right way to go. In implementation, however, China is still looking for the right balance between public administration and private sector support. Once the right mix has been found, it is likely that shared interests and market synergies will contribute to greater speed and efficiency in implementation. Development of a third, voluntary pension pillar based on private and group life insurance policies or corporate retirement schemes, does not require a lot of Government intervention beyond proper licensing and regulation. The third pillar is already taking off as is evidenced by the spectacular growth of the life insurance business since the registration of AIG (American International Group) in Shanghai in 1992 and the formation of many JV (Joint Venture) life insurance companies thereafter. When the State Council first mandated a two-pillar model for comprehensive urban pension reform in 1995 (which was made nationally uniform in 1997), open urban unemployment was not yet a serious problem in China. With the intensification of SOE reform after 1995, unemployment soared. Furloughed workers will soon put additional pressures on the country's fledgling unemployment insurance scheme. In the area of health and disability insurance, pressures are also building up. In fact, all dimensions of social security reform today demand urgent and equal attention. The challenges facing China's reformers in this area are daunting and the stakes are very high. Public-private sector partnerships I see significant potential and needs in a number of areas: Community-based support schemes. It may seem strange that I start the list with non-commercial, local community-oriented activities, not managed by private companies or for profit. I believe strongly that at this stage of China's economic and social transition and for many years to come, community-based schemes have an important role in supplementing or compensating for the shortcomings of the emerging public schemes. Many migrants from rural areas and their families are not entitled to benefits under existing official social security schemes, but are nonetheless in need of some degree of social protection in the urban areas where they live, because the option of returning to the farm is becoming increasingly unrealistic for them. This is also important for the stability and the security of the communities in which they live. Ultimately they should be covered under official schemes, but for the time being community-based initiatives offer the best hope. This applies also to the rapidly growing population of towns and villages with an urban character that are not classified as "urban" and therefore not covered by official social security nets. I see an increasingly important role for non-governmental organizations and charities in this area. Pension fund management. The National Council for Social Security Fund (NCSSF) was established in September 2000 to run the National Social Security Fund (NSSF) with the intention to delegate the actual day- to-day task of direct investment to qualified asset managers. Such delegation has, to my knowledge, not yet taken place. The present size of the NSSF is, I believe, of the order of Rmb 83 billion, or about $10 billion. The amount is very small in relation to the needs, but large enough to employ a number of specialized pension fund investment companies, operating in a competitive environment under the general supervision of the NCSSF. The sooner the direct investment management task can be delegated the better. JV domestic fund management businesses with 33 percent foreign ownership and 49 percent after 3 years are specifically authorized under China's WTO accession terms. The engagement of specialized pension fund management companies will not lead to improved investment results, however, as long as official investment guidelines applicable to pension funds remain as restrictive as they are today. A progressive liberalization of these guidelines, a process that was already started in 1999 for commercial insurance funds, should commence as soon as possible. At the same time, it will be necessary to promote the development of stock market index futures markets and other arbitrage instruments. With the exception of the NSSF investment in Sinopec shares in 2001, current restrictions limit the investment of pension funds to state bank deposits and government bonds. The modest average return on these instruments undermines one key purpose of a funded approach to pension reform, namely future cost reduction. Unless pension funds yield an investment return that exceeds not only the inflation rate, but also average wage growth, they will not be effective in reducing future payroll deductions in relation to a traditional PAYG (Pay-As-You-Go) system. Inflation is at present extremely low in China, or even negative, but nominal wages in urban areas have continued to rise at rates at or above current deposit rates and interest paid on newly issued Government bonds. The liberalization of investment restrictions does, of course, have to be gradual and cautious. To reduce risks for the future beneficiaries of pension funds and widen the options for fund managers, the liberalization should be extended to foreign securities as well. The system must provide not only adequate opportunities for improved returns, but also incentives for fund managers to achieve the best possible long-term results. In the present situation, opportunities and incentives are both lacking. The active participation of private pension fund investment managers in domestic equity markets will also lead to pressures for improved corporate governance and greater market stability. Pension fund managers typically take a long-term view of the corporations and mutual funds in which they invest and, unlike most individual investors, pay close attention to the performance of corporate managers. The experience in the U.S. and in Europe suggests that large pension funds can have a material influence on the appointment or removal of top managers of companies in which they own large blocks of shares. This is an example of the synergies that can be created through effective public-private sector partnerships in the area of pension fund management. There has been some argument over which agency of the Government should have the authority to license pension fund managers. Although MOLSS (Ministry of Labor and Social Security) has the overall responsibility for social security system design and implementation, the licensing of fund management companies should in my opinion fall under the relevant financial authority, i.e. CSRC (China Securities Regulatory Commission), PBOC (People's Bank of China - China's Central Bank), or MOF (Ministry of Finance). Account management. This requires specialized administrative and management skills that are often more readily available in the private sector than in China's public sector. Indeed the establishment of individual funded accounts under China's second pillar and their continuous maintenance and up-dating within national administrative guidelines, may be undertaken with the assistance of or even by private contractors. Such contractors could be stand-alone administrative service companies or they could be affiliated with private fund management companies responsible for related investment operations. This is another area in which public-private partnerships could contribute to greater speed and efficiency in the implementation of China's new pension system. The same applies to publicly sponsored health insurance schemes and unemployment insurance. Fund management cannot always be effectively separated from account management, however. If China should move to a system of decentralized private pension funds, fund and account management should be closely linked. It is in my view premature, however, to consider a Chile-style privatization of China's pension system at this time. Actuarial services and financial projections. This is another area in which private companies or individual consultants could supplement public pension systems, especially when, as at present, such systems are relatively small and not yet integrated at the national level. Local authorities often lack the specialized expertise needed for financial liability projections based on appropriate actuarial principles and information. MOLSS has to ensure, however, that private companies providing actuarial support services to local Governments meet high standards of professional competence and integrity. Pension system integration at the provincial level. This should be achieved as early as possible. The present half-reformed system is plagued by excessive fragmentation, incomplete coverage and uneven access to benefits. Most existing municipal schemes operating under the new system are too small to be viable. Non-participation by non-state enterprises and shortfalls in financial contributions remain serious problems in many areas. Only four provinces - all large municipalities - have so far succeeded in developing integrated pension systems, namely Beijing, Shanghai, Tianjin and Chongqing. Liaoning may become the fifth, if the ongoing State Council-sponsored pilot scheme in that province is successful. However, it is notoriously difficult in China to effectively integrate urban pension schemes at the provincial level, in part because incentives for integration are often lacking. Moreover, the unequal hierarchical status of different municipalities within the same province tends to make effective collaboration between them difficult. The intervention of a neutral third party in the form of a competent private contractor, whose fees are in some way related to success, may be the key to achieve provincial integration in some cases. It is essential that the templates used for the development of municipal and provincial schemes are identical across China. Such templates have been developed by MOLSS with the ultimate objective of system integration at the national level in mind. National level pension system integration, however, is still a long way off. But integration at the provincial level is already a huge step forward. Let us not forget that most provinces in China are country-sized. The portability of pension rights within their borders would greatly contribute to labor mobility and the development of efficient labor markets in China. The software and hardware systems used for social security and pension administration should be compatible from the start. This principle has unfortunately not always been adhered to. The responsibility for ensuring compatibility must rest with MOLSS; technical assistance in this area from a top-notch international IT (Information Technology) firm may be needed. In this context it is important to point out that labor mobility in China is not constrained exclusively by the (already significantly relaxed) Hukou system or by the lack of pension portability. There are still significant other factors such as the as yet rather poorly developed private housing market, (due, in part, to the still too limited availability of mortgage financing) and cultural inhibitions to move within or between cities even within the same province. This latter factor threatens to make the burden of unemployment insurance greater than it otherwise would be, as is also the experience in certain European countries with overly rigid labor markets. Private health and life insurance. These are areas where private sector companies are already very active in China and don't need a lot of Government encouragement. Public health insurance coverage remains the standard, however, for most urban workers and retirees. The urban-rural divide Traditionally, the Chinese state has not provided social security in rural areas. Through the present, social security for rural populations has depended on family relations and on the possession of land or land user rights. A voluntary pension insurance scheme for farmers was introduced in the mid-1990s, but coverage and fund accumulation under this scheme have remained very limited. It is doubtful that the state can or should even try to extend formal urban social security systems to traditional farming areas in China. It is more important right now, and practically more feasible, to concentrate on strengthening the land rights of rural migrants (so that they have something to fall back on in the event urban employment does not work out), on promoting commercial crop insurance schemes, on strengthening disaster relieve programs, and on integrating rural migrants who work in urban areas on the basis of a temporary Hukou or an "urban green card" into the official social security system. China's traditional urban-rural divide has unfortunately, and to some extent unavoidably, become more pronounced under the market reforms of the 1990s. The Government should do everything within its power to improve economic security, income earning capacity, health care and education services in rural areas. But the introduction of comprehensive state-sponsored social security in rural China is at best a long-term objective. The premature pursuit of such an objective would overload the Government's agenda to the point of jeopardizing other high priority reform goals. Strengthening urban pension reform The Government has so far not succeeded in achieving the objectives of State Council Documents # 26 of 1997 and # 42 of 2000. The system remains under-funded, fragmented, incomplete in coverage and uneven in access to benefits. Individual accounts have generally not been funded - in other words, they remained "notional" - because contributions were needed to pay benefits to those who were already retired under the old system. Moreover, efforts to strengthen the NSSF through the sale of Government-owned shares in listed SOEs, as prescribed in State Council Document # 22 of June 2001 had to be suspended when such share sales were thought to have contributed to the sharp drop in share prices in the third Quarter of last year. Does this mean that China's pension reform is a failure? I believe that the problems that have been experienced so far are essentially teething problems and that China is basically on the right track towards creating a modern pension system that is compatible with the requirements of an aging population in a market economy. It would have been a miracle if there had been no implementation problems. We should not forget that the social security reform challenges facing China are unprecedented in scale and complexity. To deal with the cash flow shortages of the current semi-reformed pension system in many parts of the country, there is in the near term little choice but to increase budgetary transfers from the Center. Perhaps the best way to finance those additional transfers is to allocate a larger share of the ongoing fiscal stimulus programs - currently around RMB 700 billion per year - to supplementary social security payments and to reduce allocations for infrastructure. The net effect of such a shift on aggregate demand in the economy, and hence on fiscal stimulus, would probably be small, but the effect on social stability would undoubtedly be positive. The moral hazard risks of such transfers outside a well-defined overall framework with enforceable rules are obvious and potentially very serious. The solution for these moral hazard problems lies in moving to a financially viable national pension system with uniform contribution and benefit rates and a central pooling mechanism, as quickly as possible. In spite of the very serious current financial problems experienced with pension reform, I believe that the basic design outlines and objectives of the new pension system are correct. In the implementation plan, however, greater emphasis should have been placed on the need to clearly separate the social pooling pillar based from the individual accounts pillar, both in the source of contributions and in system administration. There should also have been explicit provisions for the financing of the IPD (Implicit Pension Debt), either through up-front funding or through annual budget allocations. Furthermore, moving benefit payment out of the SOEs and system integration at the provincial level should have been early priorities. The ongoing pension reform pilot project in Liaoning province attempts to correct most of these shortcomings. Final results of the Liaoning pilot will not be available for some time. I am convinced, however, that the engagement of private sector financial agents in strategic partnerships with the Government is the key to achieving more efficient and speedier implementation of pension reform in Liaoning as well as other provinces. To make the new pension system financially viable, it will also be necessary to make some parametric adjustments. The pension ages for men and women (55 and 60 years for most) are too low and will eventually have to be raised, but this is probably not the right time to do it. There is too much unemployment already and many of those who are approaching retirement age under the present limits have suffered educational deficiencies during the ten-year period of the Cultural Revolution (1966-1976). A parametric adjustment that seems less problematic at this time is to change the formula for calculating the annuity for pillar 2 benefits. Assuming a 10-year average life expectancy at retirement, the current formula puts the monthly annuity at 120th of the accumulated value of the individual account at retirement. Ten years is too short. The choice of that number may have been based on the average life expectancy at birth when the new system was introduced, but life expectancy at retirement age was then and is today higher. Should
the Implicit Pension Debt be funded? A variation on the share sale scheme would be to transfer ownership of the shares to the NSSF, not for immediate disposition, but as a store of value or as security for bond issues that could be used to finance old pension obligations. The issue of Chile-style recognition bonds backed by state-owned securities would be an alternative worth considering. As long as the Government or its agencies own a large part of the shares in listed companies, potential conflicts of interest associated with such schemes cannot altogether be avoided. That problem does not go away, whether the shares are owned by the MOF or by NSSF. Using such shares for the securitization of bond issues has the advantage that their sale in the market can be phased over a longer period, reducing the risk of adverse share market reactions as were experienced last year. By my calculations, the Government still owns on average well over 60 percent of all shares in SOEs listed in Shanghai, Shenzhen and Hong Kong. The current book value of these assets is close to $400 billion. To this should be added the value of shares that the Government will retain in SOEs still to be listed and the net proceeds of Lotteries to supplement resources for social security. Although the full book value of Government-owned shares cannot be realized in the near-term, it nonetheless represents a huge store of assets which, along with other state assets, can be used to help finance China's transition to a market economy. The trick will be to find the right approach to the realization of such book values in China's unique circumstances. The securitization of bond issues with public assets, as an alternative to traditional MOF issued or MOF guaranteed bonds, deserves in my view consideration. Bond markets and debt markets in general are under-developed in China relative to equity markets. This imbalance needs to be restored to promote healthy, diversified and liquid financial markets. There is tremendous potential for rapid domestic capital market development through securitization as the experience with mortgage-backed securities in the U.S. and other countries has demonstrated. With the development of private housing markets, mortgage financing is growing rapidly, but conditions for the launching of private mortgage-backed securities are probably not yet ripe in China. Public asset-backed securities, however, could be launched more quickly. This would facilitate the management of economic transition; it would accelerate capital market development and help avoid undue stress on the budget. Ultimately, the redemption of a large part of the Government's domestic "transition debt", which includes inter alia the IPD and NPLs (Non-Performing Loans) on the balance sheet of Central Government-owned financial institutions, will require the sale of state assets. Securitizing some of those assets instead of direct sale, would also buy time for the development of asset markets, including real estate markets, and the associated canopy of legal and financial services. In conclusion, I believe that the enormous challenges faced by China in reforming the pension system, are matched by opportunities. Opportunities to simultaneously develop domestic capital markets, broaden the range of financial instruments traded in such markets, reduce instability in equity markets and improve corporate governance. To exploit these opportunities to the full, it will be necessary to engage the services of private financial and other service companies in strategic public-private partnerships. It will, of course, also be necessary to create an incentive and regulatory environment within which market competition and state supervision will both contribute to efficient and speedy implementation of social security and pension reform. Decisive progress in this area is needed for consolidating reform gains already been made and for sustaining China's modernization and growth. (The author is an adjunct professor at Harvard University. He is a former advisor to the President of the World Bank and Chair of the World Bank's mission to China.) [1] These are State Council decision documents dealing specifically with pension reform issues. |