The impact of pension reform on China's capital markets

Talk of economic reform in China has been the norm for the best part of 40 years but there are now growing signs that the reforms are finally beginning to snowball. This can be seen everywhere from the yuan being included in the global currency basket to loosening of restrictions for foreign investors on the domestic capital markets. But perhaps the most dramatic of the changes yet may be witnessed in the reform of the country’s pensions system. China’s pension system is loosely based on the 5-pillar model proposed by the World Bank. It instead controls a 4-pillar system, which can be divided into state, private and private combined with state (see below)[1]. Pillar II of the Chinese framework, referred to as Enterprise Annuities, are currently undergoing quite rapid reform, which may have significant implications for Chinese fund investment industry as well as the economy at large. Enterprise Annuities Enterprise Annuities (EA), as China’s private pensions are termed, are the equivalent to 401(k) pensions in the United States. Recently, the Chinese Ministry of Finance, its Ministry of Human Resources and Social Security, and its Administration of Taxation issued a circular[2] which provided new tax incentives for these pensions – effectively the first time that these pensions have been the subject of any tax incentives. The number of EA plans held by the Chinese population is still under 100,000 although growing quite rapidly. This represents less than 5% of the Chinese population. Until recently, only 58 licenses had been awarded to institutions to issue these pensions[3]. However, in January 2016, the China Construction Bank (CCB) received the first EA in just under a decade. It’s unlikely that it will be the last to be issued EAs either. This is just the latest step in what’s becoming an avalanche of reform. In 2010, the “2010 revision” set new limits for the riskiness of the assets held by EAs. The composition of EAs previously had to be at least 20% in liquid assets; from 2010 onwards, this provision was decreased to just 5%. And where fixed income had previously been set to greater than 20% of their composition, it could now amount to anything under 95%. Furthermore, in 2013, non-EA supplementary plans were converted to the EA format. Above all, it is the new array of tax incentives in EAs to both employers and their employees, which stand to make the pension funds grow so significantly in the coming years. Employee contributions of up to 4% of annual pay are exempt from individual income tax. This percentage jumps to 8.3% of annual pay for the employer’s contribution, providing a real incentive to make pensions a significant part of a firm’s salary provisions. The performance of EAs over the past ten years has been steady by Chinese standards, if not spectacular (see below)[4]. What’s significant however, is that as part of the new regulation, the returns are all exempt from income tax. Likewise, the effect that deregulating pension funds and allowing them to partake in domestic and international equity markets will increase the incentive to partake in equity investments. To put the size of the transformation in context: Only about 2% of China’s population have invested in the stock market compared to close to 50% of the US population[5]. Put in different term, China’s investment management industry has approximately $3.2tr in assets, of which less than 6% are from pension assets. According to the OECD, pension assets in the United States alone amounted to $14.7tr in 2014. Clearly, the opportunity for growth here is quite phenomenal and more than likely represents the largest opportunity in investment management for this generation. Year 2007 2008 2009 2010 2011 2012 2013 2014 Return (%) 41 -1.83 7.78 3.41 -.78 5.68 3.67 9.3 Precedents for Pension Reform China is not the first country to reform its pension system, allowing to look at precedents in order to scale the potential size of the changes in dollar terms. The 401(k) was introduced in the United States in 1978 but only really took off in the 1980's, as a way employees could take advantage of tax incentives on deferred income. As of mid-2014, 401(k) plans held approximately $4.5tr in assets and represented nearly 18% of the $24tr total US retirement assets[6]. At around the same time that the United States was reforming its private pension system, Chile was doing the same. In 1981, it overhauled its pensions system such that it workers had to contribute 10% of their salaries to 401(k)-style funds, known as AFPs, which invested their funds in domestic and foreign equity and fixed income assets[7]. The model allowed Chile to build its pool of retirement capital to over 60% of GDP. If the same were to happen in China, the private pensions fund would be worth in the region of $7tr. In Argentina, wide scale pension reform arrived in the 1990's. In 1993, the government revised the existing pay-as-you-go scheme with a 401(k)-style system which aimed to promote not only labor formality and tax collection but also to provide deeper larger funds for the capital markets (more of which later)[8]. However, implementation of pension reforms in Argentina serves as a warning to the Chinese ministries looking to develop their own private pension system. The design of the system in Argentina combined with falling levels of employment, led to a significant fall-off in people taking up the options for pensions. Knock-on benefits for Capital Markets The inevitable growth of China’s EA funds, combined with public pensions new ability to invest up to 30% of their funds in equity will bring huge capital inflows to China’s capital markets. China Business News estimates that the public pension funds alone will mean that around 2 trillion yuan ($310 billion) will pour into the domestic equity market. This figure can be safely doubled when the private funds are taken into consideration – by some estimates, the private pension fund is set to reach 4 trillion yuan by 2020, making it the second biggest supplementary corporate income market in Asia after Japan. The extra capital that will flow to China’s capital markets have significant implications. As of February 2016, the Shanghai Composite has a market capitalization of approximately $3.5tr. With the additional funds provided by state and private pension funds estimated above, this could growth to as much as $4.5tr by 2020 (assuming that not all the funds flow to the Shanghai composite) – in effect, the pension funds may be providing a one-off bonanza for investment managers looking at Chinese equities. But aside from the one-off bonanza, the pension funds are likely to have an added and far more lasting effect: less volatility in Chinese equities, greater depth of capital pools and more efficiency in stock prices. [1] Reproduced from the Society of Actuaries, 5th SOA Asia Pacific Annual Symposium [2] See: “Caishui no. 103.” [3] Leckie, S. (2014), Retirement issues and solutions in China: What the UK can offer. All Party Parliamentary Committeees [4] Reproduced from the Ministry of Human Resources and Social Security [5] http://www.investopedia.com/articles/investing/092415/chinas-stock-markets-vs-us-stock-markets.asp [6] https://www.ici.org/policy/retirement/plan/401k/faqs_401k [7] https://www.ssa.gov/policy/docs/ssb/v68n2/v68n2p69.html [8] http://www.forbes.com/sites/pensionresearchcouncil/2015/04/27/argentinas-pension-policy-in-the-last-20-years-chronicle-of-a-death-foretold/#44b40ff84898

BRIC-ing it

Note: This article was ghost-written for an asset management firm and used on Seeking Alpha. As an addendum, Goldman Sachs ended its BRIC fund in November 2015, meaning the BRIC acronym was technically laid to rest by the investment bank before it reached 15 years.

It's almost 15 years since Goldman Sachs' then chief economist, Jim O'Neill, coined the term 'BRIC.' The idea was that four countries (Brazil, Russia, India and China) were going to be the growth drivers for the 20th century. The idea was catchy, convincing and caught on. Soon, there were more acronyms and groups of countries doing the rounds: MINT and Next 11 were two that spring to mind, but probably none were as notorious as the BRICs.

As of 2015, the BRICs aren't nearly as popular with future gazers as they once were. True, China did experience several years of double-digit growth after the acronym was invented but you didn't need an economist to tell you that would happen. Russia, India and Brazil have fluctuated between star performers and dunces of the class: in short, typical emerging market economies. All in all, a pass mark for the BRIC prediction but better predictions have been made.

Chalking up another BRIC

It’s almost 15 years since Goldman Sachs’ then chief economist, Jim O’Neill, coined the term ‘BRIC.’ The idea was that four countries (Brazil, Russia, India and China) were going to be the growth drivers for the 20^th century. The idea was catchy, convincing and caught on. Soon, there were more acronyms and groups of countries doing the rounds: MINT and Next 11 were two that spring to mind, but probably none were as notorious as the BRICs.

As of 2015, the BRICs aren’t nearly as popular with future gazers as they once were. True, China did experience several years of double-digit growth after the acronym was invented but you didn’t need an economist to tell you that would happen. Russia, India and Brazil have fluctuated between star performers and dunces of the class: in short, typical emerging market economies. All in all, a pass mark for the BRIC prediction but better predictions have been made.

But as faddish as the term BRIC was in the middle of the last decade, it’s equally faddish now to write them off entirely. True, there hasn’t been much good news emanating from any of the BRIC countries for the past year or two but we’re not even 20% through the 21^st century. Many of the fundamentals that Jim O’Neill attributed to the countries are still in place, meaning there are still opportunities for investors who are willing to ride out the inevitable storms. Furthermore, even if they’re out of vogue, the BRIC countries have a combined GDP of about 20% of the world economy. And close to a third of the world’s population. So, keeping an eye on their progress is not only of interest – it’s of importance.

Blackrock iShares offer a BRIC Etf (BKF), which has understandably been a poor performer for the past five years. Given how the BRIC acronym has fallen from grace, there’s every chance the ETF will be removed from the Blackrock portfolio entirely over the next few years, so it may be better to watch the ETFs offered for each individual country when investing in this group is concerned.

iShares MSCI Brazil Capped ETF (ESZS)

The Brazil ETF is trading at around half the level it was five years ago, and with Brazil facing into an economic abyss, it’s difficult to see this ETF recovering value anytime soon. However, the companies on the list here are both well diversified (Brazil Foods, AmBev, Bradesco Banking corporation, Vale mining) and not entirely dependent on the fate of the Brazilian economy. If (and it’s an ‘if’ not a ‘when’) President Rouseff finally deals with structural issues in the Brazilian economy, this ETF will almost certainly experience a bounce.

iShares MSCI Russia Capped ETF (ERUS)

When Winston Churchill famously called the future of Russia ‘a riddle, wrapped in a mystery, inside an enigma,’ he may have been understating it. Sanctions against Russia in the past two years have inevitably led to a fall in its ETF, but possibly not by as much as one might expect. The Russia ETF is inevitably heavy on energy (Gazprom, Transneft, Tatneft), but also has some of the largest food retailers in Europe in its composition (Magnit). There’s one thing you can certainly say about Russia, which should apply to its ETF: The country has weathered so many economic crises that it can surely ride out another one and come back stronger in the future.

iShares MSCI India ETF (INDA)

And the star performer of the BRICs group is… India. Unlike the first two ETFs in this group, India isn’t going through a particularly dire economic period. Its growth is still hovering at around 4% - highly respectable in global terms. This ETF is trading at around 14,000, about 40% over what it was trading for three years ago. There are several familiar names in its composition, including some tech firms (Infosys, Tata), pharmaceuticals (Sun Pharmaceutical) and consumer staples (Hindustan Unilever).

iShares FTSE China ETF (FCHI)

It’s hard not to detect an element of schadenfreude in the US Press about China’s short-term economic demise. It would be unwise of anyone to think it’s going to be anything but short-term, though. It says a lot about the expectations that China has created for itself that, despite several months of negative financial coverage, the China ETF is still up almost 30% on where it was three years ago. Conclusion? Nearly fifteen years on from Jim O’Neill’s coining of the term BRICs, China is still the one you should invest in. With prices down 33% on last year, now is not a bad time to get involved.

Conclusion

Long after popular acronyms fade away, fundamentals remain. Anyone who thought investing in four of the world’s largest emerging markets and wouldn’t get a bumpy ride was fooling themselves. The BRICs provide enough evidence of that. However, with 20% of the world economy and over 30% of the world’s population, the BRICs still represent an excellent choice for anyone who wants to take a position on the long-term. There’s a maxim here which applies almost perfectly right now: Be careful when others are greedy and greedy when others are careful. In 2015 where the BRICs are concerned, too many are being careful. It may be your opportunity to be greedy.