World Economic and Financial Surveys

Global Financial Stability ReportMarket Developments and Issues

September 2004

International Monetary FundWashington DC

© 2004 International Monetary Fund

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Preface ix

Chapter I. Overview 1

Risks in the Period Ahead 2Policy Conclusions for the Short and Medium Term 3Issues for the Long Term: Reforms of the Pension Industry 4Policy Issues for the Pension Sector 5Capital Flows Between Emerging and Mature Markets 5

Chapter II. Global Financial Market Developments 8

Overview 8Developments and Vulnerabilities in Mature Markets 10Developments and Vulnerabilities in Emerging Markets 18Emerging Market Financing 25Banking Sector Developments in Emerging Markets 30Structural Issues in Mature Markets 45References 79

Chapter III. Risk Management and the Pension Fund Industry 81

Why Pension Funds Are Important for Financial Stability 82The Funding Challenge 88Key Influences on Pension Funds’ Financial Management 97Asset Allocation and Risk Management 109Conclusions and Policy Recommendations 115References 118

Chapter IV. Emerging Markets as Net Capital Exporters 121

Stylized Facts 122The Post-Crisis Balance Sheet Adjustment Process 129Accumulation of Reserves and Reliance on Local Markets 141Global Factors 149Conclusions and Policy Issues 154References 157

Glossary 160

Annex: Summing Up by the Chairman 165

Statistical Appendix 169

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Boxes

2.1 Stocks, Flows, and Vulnerability Assessments 132.2 Market Repositioning and Deleveraging 152.3 Financing Flows and Global Imbalances 352.4 Emerging Market Spread Compression: Is It Real or Is It Liquidity? 392.5 German Issue of Russian Federation Credit-Linked Notes 422.6 Collective Action Clauses 442.7 Russia: Recent Turbulence in the Banking Sector 462.8 Insurance Industry Update 482.9 Hedge Fund Strategy Definitions 52

2.10 Sample of Popular Energy Contracts 612.11 European Energy Trading 622.12 The Revised Basel Capital Framework for Banks (Basel II) 702.13 Recent Developments in Securitization Markets in Europe and Japan 742.14 Definition of Value at Risk 752.15 Volatility Estimation 753.1 Hybrid Pension Plans 963.2 Individuals’ Life-Cycle Savings and Global Capital Markets 993.3 The Tax Treatment of Pension Plans: a Comparison for Selected

Industrial Countries 1013.4 Proposed Risk-Based Capital System for Pension Funds in the Netherlands 1043.5 Comparison of U.S. FAS 87, U.K. FRS 17, and Proposed IAS Standards 1063.6 Defined Benefit (DB) Pensions and Corporate Finance Theory 1113.7 Economics and Pension Fund Asset Allocation 1124.1 Capital Flows to Africa and the Middle East 1264.2 Data Sources and the Trends in Bank Lending Flows to Emerging Markets 1304.3 Distressed Debt Markets: Recent Experiences in Mature and Emerging Markets 1374.4 Distance to Distress as a Measure of Balance Sheet Vulnerability 1404.5 Market-Based Insurance Mechanisms 146

Tables

2.1 Selected Local Currency Bond Spreads 242.2 Emerging Market Financing 282.3 Emerging Market Countries: Selected Financial Soundness Indicators 322.4 Exposure of Foreign Banks to Emerging Markets 332.5 Hedge Funds: Number of Funds and Assets Under Management 472.6 Leverage Estimates by Hedge Fund Strategy 512.7 Price Volatility for Energy and Other Financial and Nonfinancial Instruments 593.1 Life Expectancy at Birth: Estimates and Projections 833.2 Asset Allocation of Autonomous Pension Funds 863.3 Financial Assets of Institutional Investors, 2001 873.4 Pension Fund Holdings Compared with the Size of Domestic Market, 2001 883.5 Selected Countries: Total Outstanding Long-Term Bonds 893.6 Sources of Retirement or Replacement Income 954.1 Emerging Markets: Balance of Payments Errors and Omissions 1254.2 Bank Lending in Emerging Markets 128

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4.3 Debt Securities in Emerging Market Countries 1284.4 Capital Flows in Crisis and Non-Crisis Countries 1314.5 The Post-Crisis External Debt Adjustment in Selected Emerging Markets 1364.6 Reserves and Related Ratios for Selected Countries as of End-2003 1434.7 Derived Portfolio Investment Liabilities by Nonresident Holder: Equity and

Debt Securities 1514.8 Derived Portfolio Investment Liabilities by Nonresident Holder: Short- and

Long-Term Debt Securities 152

Figures

2.1 One-Month Federal Funds Futures Rate 102.2 Strip Curve Interest Rate Expectations 102.3 Selected Central Bank Policy Rates 112.4 Ten-Year Government Bond Yields 112.5 Long-Term Inflation Expectations 122.6 Implied Volatilities 122.7 High-Grade Corporate Bond Spreads 172.8 High-Yield Corporate Bond Spreads 172.9 Equity Indices 18

2.10 Twelve-Month Forward Price/Earnings Ratios 192.11 Net Foreign Purchases of U.S. Financial Assets 202.12 Emerging Market Debt Spreads 202.13 Observed and Forecast EMBI+ Spreads 212.14 EMBI Global Spreads vs. Eurodollar Interest Rate Expectations 212.15 Emerging Market Debt Returns 222.16 Spread Differentials in Emerging Market Debt 222.17 Differentials Between Corporate and Emerging Market Spreads 232.18 Emerging Market Credit Quality 232.19 Correlations of MSCI World and Emerging Market Indices 242.20 Brazil: Local Market Spreads over U.S. Treasuries 242.21 Turkey: Local Market Spreads over German Bunds 252.22 Brazil: Portfolio Investment in Local Currency Debt Instruments 252.23 Brazil: Nonresident Holdings of Government Debt Instruments 262.24 Turkey: Portfolio Investment in Local Currency Debt 262.25 Turkey: Nonresident Holdings of Government Debt Instruments 272.26 Cumulative Gross Annual Issuance of Bonds, Loans, and Equity 272.27 Quarterly Net Issuance 292.28 Cumulative Gross Annual Issuance of Bonds 292.29 Cumulative Gross Annual Issuance of Equity 302.30 Cumulative Gross Annual Issuance of Loans 302.31 Foreign Direct Investment to Emerging Markets 312.32 Emerging Market Countries: Bank Market Valuations 342.33 Total Number of Energy Options and Futures Contracts 602.34 Selected Energy Prices 632.35 United States: Household Net Worth 652.36 United States: Household Debt as a Percentage of GDP 65

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2.37 Euro Area and United Kingdom: Ratio of Household Debt to GDP 662.38 Japan: Household Net Worth 662.39 United States: Debt to Net Worth Ratio of Nonfinancial Corporations 672.40 United States: Cash Flow of Nonfinancial Corporate Business 672.41 United States: Financing Gap of Nonfinancial Corporations 682.42 Euro Area and United Kingdom: Ratio of Nonfinancial Corporate Debt to GDP 682.43 Japan: Capital to Asset Ratio of Corporate Sector 692.44 Japan: Corporate Debt and Cash Flow Relative to GDP 692.45 Selected Countries: Banks’ Return on Equity 732.46 Large Complex Financial Institutions (LCFIs) and Commercial Banks:

Market Risk Indicator (MRI) 762.47 Entire Portfolio: Market Risk Indicator (MRI) and Diversification 762.48 Difference Between Undiversified and Diversified Value at Risk 772.49 Selected Countries: Value at Risk Sensitivity 772.50 Large Complex Financial Institutions: Market Risk Indicator (MRI) and

Credit Risk Indicator (CRI) 783.1 Life Expectancy at Birth 833.2 Remaining Life Expectancy at Age 65 833.3 Median Age of Population, by Country 843.4 Dependency Ratio for Selected Countries 843.5 Asset Allocation of Autonomous Pension Funds, 2001 883.6 United States: Ratio of Assets to Projected Benefit Obligations (PBOs) for

the Fortune 500 903.7 Netherlands: Funding Ratio of Pension Funds 913.8 Japan: Employee Pension Funds 923.9 United States: Distribution of Corporate Defined Benefit Pension Plans by

Funding Ratio, 2003 923.10 Estimated Valuation Effects on Projected Benefit Obligation (PBO)

Funded Ratios 933.11 United States: Assets Under Management of Private Pension Schemes 934.1 Capital Flows to Emerging Markets 1234.2 Private and Official Outflows/Inflows of Residents and Nonresidents in

Emerging Markets 1244.3 International Equity Issuance and FDI in China vs. All Other Emerging

Market Countries 1294.4 Capital Flow Trends for Crisis and Non-Crisis Countries 1324.5 Cumulative Net External Debt Issuance: Crisis vs. Non-Crisis Countries 1334.6 Selected Emerging Market Crisis Countries: Sudden Stops, Asset Prices,

and GDP 1354.7 Distance to Distress in Selected Emerging Market Crisis Countries 1414.8 Reserves to Short-Term Debt Ratios and Sovereign Default Probabilities 1454.9 Welfare Effects of Self-Insurance Policy 147

4.10 Global Imbalances 1484.11 Net Private Capital Flows to Emerging Markets and Foreign Purchases of

G3 Bonds and Stocks 1484.12 Risk-Adjusted Rates of Return 1494.13 Emerging Market Mutual and Hedge Fund Assets 153

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The following symbols have been used throughout this volume:

. . . to indicate that data are not available;

— to indicate that the figure is zero or less than half the final digit shown, or thatthe item does not exist;

– between years or months (for example, 1997–99 or January–June) to indicate theyears or months covered, including the beginning and ending years or months;

/ between years (for example, 1998/99) to indicate a fiscal or financial year.

“Billion” means a thousand million; “trillion” means a thousand billion.

“Basis points” refer to hundredths of 1 percentage point (for example, 25 basis pointsare equivalent to !/4 of 1 percentage point).

“n.a.” means not applicable.

Minor discrepancies between constituent figures and totals are due to rounding.

As used in this volume the term “country” does not in all cases refer to a territorialentity that is a state as understood by international law and practice. As used here, theterm also covers some territorial entities that are not states but for which statisticaldata are maintained on a separate and independent basis.

The Global Financial Stability Report (GFSR) assesses global financial market developments withthe view to identifying potential systemic weaknesses. By calling attention to potential fault lines inthe global financial system, the report seeks to play a role in preventing crises, thereby contribut-ing to global financial stability and to sustained economic growth of the IMF’s member countries.

The report was prepared by the International Capital Markets Department (ICM), under thedirection of the Counsellor and Director, Gerd Häusler. It is managed by an Editorial Committeecomprising Hung Q. Tran (Chairman), W. Todd Groome, Jorge Roldos, and David J. Ordoobadi,and benefits from comments and suggestions from Charles R. Blitzer and L. Effie Psalida. OtherICM staff contributing to this issue include Renzo Avesani, Nicolas Blancher, Elie Canetti, JorgeChan-Lau, Peter Dattels, Toni Gravelle, François Haas, Anna Ilyina, Markus Krygier, William Lee,Chris Morris, Jürgen Odenius, Kazunari Ohashi, Li Lian Ong, Lars Pedersen, Magdalena Polan,Manmohan Singh, Juan Solé, Rupert Thorne, Laura Valderrama, and Yingbin Xiao. Other con-tributors included Robert Gillingham, Peter Heller, and Dominique Simard of the Fiscal AffairsDepartment; a staff team of the Monetary and Financial Systems Department that included RobertCorker, Anne-Marie Gulde, S. Kal Wajid, Sean Craig, Gianni De Nicoló, Jan Willem van derVossen, and Kalin Tintchev; and Kenichiro Kashiwase and Laura Kodres of the ResearchDepartment. Martin Edmonds, Ivan Guerra, Silvia Iorgova, Anne Jansen, Oksana Khadarina, YoonSook Kim, Ned Rumpeltin, and Peter Tran provided research assistance. Caroline Bagworth,Cynthia Galang, Vera Jasenovec, Elsa Portaro, and Ramanjeet Singh provided expert word process-ing assistance. Jeff Hayden of the External Relations Department edited the manuscript and coor-dinated production of the publication.

This particular issue draws, in part, on a series of informal discussions with commercial andinvestment banks, securities firms, asset management companies, hedge funds, insurance compa-nies, pension funds, stock and futures exchanges, and credit rating agencies in Canada, Colombia,France, Germany, Hong Kong SAR, Italy, Japan, Mexico, the Netherlands, Poland, Singapore,Switzerland, the United Kingdom, and the United States. The report reflects information availableup to July 30.

The report has benefited from comments and suggestions from staff in other IMF departments,as well as from Executive Directors following their discussions of the Global Financial Stability Reporton August 30, 2004. However, the analysis and policy considerations are those of the contributingstaff and should not be attributed to the Executive Directors, their national authorities, or the IMF.

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PREFACE

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Over the past six months, the globalfinancial system, especially thehealth of financial intermediaries,has been further strengthened by

the broadening economic recovery. Thefinancial system has not looked as resilient asit does in the summer of 2004, in the threeyears since the bursting of the equity bubble.Financial intermediaries, banks and non-banks alike, have strengthened their balancesheets to a point where they could, if neces-sary, absorb considerable shocks (see ChapterII, pages 64–73). While it is obviously feasiblethat one or the other financial institution,such as a hedge fund or even a bank, mightsuccumb to serious mistakes in risk manage-ment or to outright fraud, such incidentsshould be isolated cases with limited, if any,contagion to the system as a whole. Short of amajor and devastating geopolitical incidentor a terrorist attack undermining, in a signifi-cant and lasting way, consumer confidence,and hence financial asset valuations, it is hardto see where systemic threats could comefrom in the short term. This positive assess-ment is focused on the financial sector, givenits potential to create fast-moving knock-oneffects through the wholesale markets. Thehousehold sector, in turn, could face certainfinancial problems going forward, despite itsimproved balance sheet position. However,from a systemic point of view, the householdsector is the ultimate shock absorber.

Consequently, market players are relativelywell prepared to deal with the long expectedtightening cycle in monetary policy. As dis-cussed in previous issues of the GlobalFinancial Stability Report published during2002, the financial system benefited cruciallyfrom two factors during the critical years 2001and 2002: a strong capital base going into therecession and a preceding paradigm shift in

risk management, most clearly among themajor internationally active banks. This trendtoward risk diversification away from banks,indeed increasingly away from the financialsector as a whole, fundamentally helped thefinancial system to weather financial shocks.As discussed later in the chapter, this seculartrend, while helpful for financial stability, mayraise problems in the future. Over the lastyear or two, the gradually strengthening recov-ery of the world economy, as well as a steepyield curve, has sharply increased profitabilitywithin the financial sector and thus enhancedfinancial stability. Strong increases in grossrevenues as well as a sharp reduction in cor-porate default rates and in nonperformingloans—both the result of the economicrecovery—are providing a strong cushion ofcomfort for the financial sector (see ChapterII, pages 73–79).

Hence, this Global Financial Stability Report,and hopefully the next ones, will focus evenmore on medium-term structural issues inthe financial system. Avoiding complacency,we are looking for fault lines that couldultimately translate into serious financialstresses some time in the future, if and whenanother downturn in economic activity wereto occur.

Over the past two quarters, corporationsand financial institutions have generallyreported robust earnings. Increases in salesrevenues combined with the results of on-going cost-cutting efforts have producedimpressive earnings growth in some coun-tries. Consequently, the balance sheets ofthe corporate and financial sectors haveimproved further, with many institutionsposting high levels of liquid assets. Insurancecompanies, especially in Europe, have alsotaken steps to strengthen their risk manage-ment capability and strengthened their capi-

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CHAPTER I OVERVIEW

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tal base. By and large, these developmentshave enhanced the resiliency of internationalfinancial institutions.

International financial markets haveremained calm so far despite the transition tohigher interest rates. During April–May, theunwinding of carry trades in anticipation ofFed tightening raised bond yields andwidened emerging market bond spreads.Nevertheless, volatility remained low in majorbond and equity markets. Despite reports ofincreased risk taking reflected in highervalue-at-risk levels, many financial intermedi-aries seem to have been able, so far, to absorbthe rise in market interest rates without visi-ble impact on their profitability. This may beattributed to strengthened risk managementat many institutions and also to the effectivecommunication strategy by the Fed. This timearound, market preparedness for a rate hikestands in sharp contrast to the surprise andvolatility that accompanied the Fed’s tighten-ing in 1994. By reducing liquidity in thefinancial system and hence the indiscriminatesearch for yield that can create financialexcesses, the Fed’s plan to restore interestrates to a “normal” level could make the eco-nomic expansion and benign market situa-tion more sustainable.

After the first hike in the Federal Fundsrate in late June, economic data have ledmarket participants to expect inflation tostay under control, allowing the Fed toremove monetary stimulus at a “measured”pace. Consequently, mature and emergingbond markets have recovered part of theirearlier losses. Interest rates in forward mar-kets suggest that future modest rate hikescould be absorbed without much negativeeffect. In particular, the need for potentiallyunsettling mortgage hedging, which mayamplify volatility in long-term rates, is muchreduced now, compared to the situation last

summer when U.S. bond yields rose abruptly.Basically, due to a record volume of refi-nancing in 2002 and 2003, most outstandingmortgages in the United States carry acoupon lower than the current long-termmortgage rate. Therefore, further rises inthe mortgage rate will not change abruptlythe prepayment risk facing mortgage inves-tors, lessening their need to hedge durationrisk.1

External financing conditions facingemerging market countries have alsoreturned to a healthy and more sustainablelevel. Even though financing costs have risenfrom the lows reached earlier this year, theyremain much lower than the average for thepast five years. After some difficulty inApril–May—especially for sub-investmentgrade borrowers—emerging market borrow-ers have since gained access to the global cap-ital markets. As about 80 percent of theexternal bond-issuing program of emergingmarket countries for 2004 has been com-pleted, some sovereigns are expected to startprefinancing their 2005 needs if market con-ditions remain favorable.

Risks in the Period AheadOverall, when conditions are as benign as

they are at the moment, the major risks—especially in the medium term—are on thedownside.

The most immediate risk is that marketparticipants may develop a sense of compla-cency, seeing how smoothly financial marketshave adjusted to the initial moves to higherpolicy rates. This may be reflected in thelow volatility observed in major stock andbond markets. Such complacency couldlead to a return of indiscriminate risk behav-ior, due to a strong tendency to “search foryield.”

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1U.S. homeowners have increased the portion of variable-rate and interest-only mortgages in new borrowing,thereby taking on more interest rate risk. However, most outstanding mortgages are long-term fixed rate, makingthe U.S. household sector somewhat interest rate insensitive.

Naturally, if U.S. interest rates were to risemore substantially than currently discounteddue to an unexpected acceleration of infla-tion, the potential impact would be lessbenign than in the baseline scenario. Thiswould be especially true if the markets were toperceive monetary policy as having fallenbehind the curve and needing to catch up.Since the correlation is high between U.S.treasury yields and bond yields in Europe andemerging markets, the spillover effect of sucha spike in U.S. yields may be widely felt—whether or not other regions are cyclicallyready to absorb higher market interest rates.In the future, and driven by increasinglyglobal asset allocation processes, these link-ages will become even stronger as the worldmoves further toward a common pool ofglobal savings.

Global current account imbalances pose acontinued risk, even though it is difficult toforecast how or when the financing of the cur-rent account deficits or the adjustment of theimbalances could become disorderly. Datathrough June show that foreign portfolio flowsinto the United States remain strong. The sus-tainability of capital flows to the United States,however, remains a matter of concern. Asharp and disorderly decline of the dollarwould, among other things, cause significantlosses to many international institutions hold-ing dollar assets or generating dollar income.But in the absence of a compelling alternativeto liquid dollar assets within a high-growtharea, it is not easy to see why investors wouldtrigger a wholesale shift away from dollarassets without undermining the rationale oftheir investment decisions.

Overall, global geopolitical risks continue tobe elevated and could quickly heighten riskaversion among international investors to thedetriment of asset markets—especially thoseof weak credit quality or limited liquidity. Oilprices, in particular, could spike further, con-tributing to inflation concerns and potentiallyhurting financial markets and the economicrecovery.

Policy Conclusions for the Short andMedium Term

Now that the Fed and other central bankshave successfully managed the first phase ofthe transition to higher interest rates, thetask ahead is to guide market expectations inexecuting the planned adjustment program.Recent growth and inflation data havebrought market participants over to theFed’s vision of a “measured” pace of mone-tary stimulus removal. The current benignconjunctural situation should be used by theauthorities of all countries to address weakspots in their financial systems. In particular,in countries where insufficient profitabilityhas long plagued the banks, a conducive envi-ronment should be created to facilitate theconsolidation process so as to allow the emer-gence of a profitable and vibrant bankingsector. This would help support the financialsystem to cope with the next downturn. Thebenign economic and financial conditionsalso make the task of policy coordination toreduce global imbalances all the more impor-tant and timely. According to the WorldEconomic Outlook, these measures encompasspolicies, including structural policies, toimprove the growth performance of Europeand Japan, while achieving fiscal consolida-tion in the United States over the mediumterm.

For emerging market countries, the contin-uation of benign external financing condi-tions provides an excellent window ofopportunity for maintaining strong economicpolicies and reform efforts to enhance theirgrowth potential and the resiliency of theirfinancial systems. Again, this will enable themto better deal with future shocks.

Beside the conjunctural issues, Chapter IIalso reviews several structural issues, eithermentioned in earlier GFSRs or just emerging,that could have an impact on financial mar-kets. Of particular interest are the sections onthe recent developments of hedge funds(page 45) and the growing involvement of

POLICY CONCLUSIONS FOR THE SHORT AND MEDIUM TERM

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financial market participants in energy trad-ing markets (page 58).

Issues for the Long Term: Reforms of thePension Industry

Chapter III looks at the potential systemicimplications of the growth and changes ofpension funds within the global financial sys-tem. This chapter is the second installment ina series looking at the management of risk invarious nonbanking sectors and its impact onfinancial stability.

Many countries face the challenge ofimproving the adequacy of pension provisionsto cope with rising dependency ratios (i.e., theratio of retirees to working people). For com-pany-sponsored pension funds, the quick suc-cession from overfunding during the equitymarket boom years of the late 1990s to under-funding since has given rise to various reformefforts. Among other things, these effortsinclude improvements to the valuation anddisclosure of the assets and liabilities of pen-sion funds.

Another set of measures deals with riskmanagement at pension funds and risk shar-ing between corporate sponsors and employ-ees. In terms of risk management, the focusamong industry members and regulators isshifting from asset portfolio management—frequently benchmarked to the major marketindices—to a greater emphasis on asset-liability management, particularly the dura-tion matching of assets to long-term pensionliabilities. A growing debate has ensued onthe role of governments in providing long-term and inflation-indexed bonds.2 The focuson asset-liability management has also givenrise to a lively debate within the industry con-cerning the appropriateness of equities orfixed-income instruments in matching pen-sion assets to liabilities. The outcome of suchdebate could have a considerable effect on

the equity and fixed-income asset classes, as aresult of a potential rebalancing of pensionassets. In addition, international diversifica-tion of pension assets, including to emergingmarkets, will continue to progress, drivenmainly by the uneven demographic develop-ments in different countries, as well as diversi-fication benefits. Given the already dominantsize of pension funds in mature markets, evensmall changes in asset allocations of thesefunds will have a large impact on relativelyilliquid markets, such as emerging markets.

More emphasis on risk management islikely to underpin the shift from defined ben-efit corporate pension plans to defined contri-bution plans, or to one of the hybrid plans.This shift has transferred the taking of invest-ment risk from the corporate sponsors to theemployees. Potentially, it could give rise to apublic policy issue of the role of governmentif retirees incur losses in their defined contri-bution plans due to poor investment manage-ment or market declines. This issue isbecoming quite relevant, since the contribu-tion to retirement income from state pensionsis projected to decline in many countries,while individuals’ retirement savings areincreasingly viewed as insufficient. As men-tioned above, the transfer of financial risk out-side the financial sector has supported thestability of financial intermediaries. However,once the household sector (and policymak-ers) fully understand the scope of risk theyhave incurred and what that could mean fortheir retirement income, there may be policyimplications. The next GFSR will study mutualfunds as another important nonbankingfinancial sector, and the implications thatsuch a trend could have on the financial sys-tem more broadly, including new forms ofmoral hazard (“markets too important to fall”mentioned in the April 2004 GFSR).

Overall, the growing size of pension assetsand the focus on asset-liability management

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2In an interesting development, Brazil announced plans to issue new 40-year inflation-index-linked bonds inresponse to demands from local pension funds.

should strengthen the role of pension fundsas stable, long-term institutional investors.This would tend to support financial stabilityas long as there is an adequate supply offinancial assets to meet their demands.However, changes in asset allocation of pen-sion funds would have a large impact on dif-ferent asset classes and financial markets,especially smaller ones. Understanding thesechanges in asset allocation, and the subse-quent capital flows, thus lies at the heart ofmultilateral surveillance of financial markets.

Policy Issues for the Pension SectorImportant policy issues are highlighted by

the analysis of pension funds and of thechanges required to cope with the challengeof an aging workforce. These policy issues arerelevant to mature market countries, butcould also be applicable to some emergingmarket countries.• The aging of the workforce in many coun-

tries has intensified the need to promotesufficient and stable retirement savings.First and foremost is the need to bettercommunicate the pension challenges andpolicy priorities, particularly in countrieswhere the public sector has traditionallyprovided the bulk of pension benefits.Policymakers should try to establish a broadlegal environment (and a tax environmentin some cases) conducive to savings growth.

• Within a multi-pillar approach to pensionprovisions, policymakers should try to worktoward a relatively balanced contributionfrom each pillar. As demographic and costpressures have increased on Pillar 1 (statepension), the contribution of state plans topensioners’ retirement income is projectedto decline in most countries. Therefore,measures to encourage larger contributionsfrom Pillar 2 (occupational pensionschemes) and Pillar 3 (individual savingsschemes) are increasingly important.

• Measures to strengthen risk managementby pension funds. Regulations and tax rules

should be designed to foster a closer align-ment of pension assets to liability struc-tures. Policymakers should facilitate thedevelopment of certain markets and instru-ments, including long-term, fixed-incomeand index-linked products. Such securitiesare necessary to allow pension funds tobetter match assets and liabilities, as wellas to facilitate the supply and pricing ofannuity and long-term savings products bymarket participants, such as insurancecompanies.

• Risk-based approaches to supervision and toguarantee fund premiums should beenhanced to reflect the riskiness of assetallocations. This would allow for a fairer dis-tribution of the cost of guarantee funds,reduce moral hazard, and encourage riskmanagement.

• As pension funds need to diversify interna-tionally, including to emerging markets,policymakers should aim to remove the fric-tions that continue to limit internationalcapital mobility. On the other hand, emerg-ing market countries need to strengthentheir capacity to absorb such potential capi-tal flows.

Capital Flows Between Emerging andMature Markets

Conventional wisdom suggests that capitalnormally flows from mature market countries,enjoying higher capital-labor ratios, to capital-scarce emerging market countries. Indeedthis has been the case, except for selectedepisodes, such as the current period since2000 when emerging market countries, as agroup, have become net exporters of capital(as defined in footnote 1 in Chapter IV,page 121).

As analyzed in Chapter IV, the current epi-sode of net capital outflows follows a series offinancial crises in emerging market countriesand changes in global imbalances. There arethree main themes driving the changes ininternational capital flows, associated with

CAPITAL FLOWS BETWEEN EMERGING AND MATURE MARKETS

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the net outflow from the emerging marketcountries.

In the aftermath of crises in the late 1990sand early 2000s, emerging market countrieshave undergone an adjustment process. Crisiscountries had to reduce domestic absorptionand increased exports to generate a trade sur-plus. Many emerging market countries, notjust those in crisis, have also reduced theirexternal indebtedness. International banksadjusted their portfolios by reducing expo-sures to emerging markets. During the adjust-ment period, countries had to restructure andstrengthen their financial and corporate sec-tors, so as to restore normal financial interme-diation and growth.

Second is the unprecedented accumulationof reserves by many central banks, both tomaintain a competitive exchange rate and tohave insurance against future crises. Variousstudies point out that a high ratio of reservesrelative to external debt, particularly short-term debt, reduces the probability of debtcrises. However, the desirable level of reservesvaries from country to country, depending onexchange rate policy as well as institutionalstrengths, including the development of localcapital markets, which can facilitate corporaterestructuring.

Last but not least is the role of global fac-tors, especially the growing global currentaccount imbalances. Changes in global mergerand acquisition activities also affect capitalflows. Global risk aversion affects all assets withsimilar risk characteristics, regardless of theirgeographical locations. Conversely, abundantglobal liquidity prompts the search for yieldfor all emerging markets as an important seg-ment of high-yield assets.

During the period under study, the 2000–01subperiod was characterized by the adjust-ment effort, a reduction in private nonresi-dent capital flow into the emerging marketsdue—among other things—to risk aversion,and a large outflow from emerging marketresidents. In the subsequent subperiod since2001, reserves accumulation by central banks

has been impressive, being greater than therising current account surplus and a reboundin private capital inflows.

Going forward, as emerging market coun-tries recover their economic growth, domesticdemand could revive and lead to normaltrade developments. Reserves accumulation bymany emerging market countries may slow.Beyond a certain level, the opportunity costand policy complications of acquiring addi-tional reserves may become more evident.Finally, the increase in gross issuance ofbonds, equities, and loans by emerging mar-ket countries—at an annualized rate of $264billion year-to-date, compared to $198 billionin 2003—as well as foreign direct investmentflows suggest that international investors’appetite for emerging market assets hasreturned. Indeed, as highlighted in ChapterIII, pension funds in mature market countrieshave a long-term need to diversify a small por-tion of their assets to emerging market coun-tries. Consequently, the net capital exportingposition of emerging market countries couldprove to be a temporary development.

To the extent that emerging market coun-tries need to attract stable capital inflows todevelop their economies, policy measures canbe taken to help change the phenomenonthat emerging market countries have becomenet exporters of capital. Three sets of policyissues correspond to the three factors account-ing for the net capital outflow from emergingmarket countries.• As emerging markets are becoming more

mainstream assets in global portfolios, theyhave to compete for risk capital vis-à-visother asset classes in increasingly globalizedcapital markets. Emerging market countrieshave to establish a track record of consis-tently strong economic policies and reformsto enhance their risk-adjusted returnprospects to international investors in orderto attract stable inflows.

• Policies to self-insure against sudden stopsin capital inflows. Implementing a strongeconomic policy is a necessary condition for

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financial stability, but it may not be suffi-cient in times of global financial turmoil.Accumulating large amounts of reserves canlower the risk of debt crises, but it maybecome costly, including in terms of posingcomplications to macroeconomic stability.Implementing financial sector reforms,including the development of local securi-ties markets, can help emerging marketcountries reduce their reliance on volatile

external financing and lower the cost ofself-insurance.

• Policies designed to improve the mecha-nisms for post-crisis balance sheet adjust-ments. Of particular importance is the needto improve markets for distressed debt tofacilitate the transfer of corporate owner-ship and control, and to produce a betterallocation of resources to help revivegrowth.

CAPITAL FLOWS BETWEEN EMERGING AND MATURE MARKETS

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