Pension Funds and Insurance Companies

Pension funds and life insurance companies are long-term investors whose investment process consists of strategic asset allocation decisions—which determine broad portfolio distributions across asset classes, such as bonds and equities—as well as tactical asset allocation that involves deviations from the basic asset categories to exploit short-term profit opportunities.⁴ Finally, security selection refers to the choice of individual assets to be held within each asset class. The asset allocation decisions are driven by the preferences of the pension fund trustees or insurer’s investment committees, which take into account the risk/return trade-offs of different portfolios as well as the nature of their liabilities and regulations.

The importance of liability considerations is apparent in the different asset allocation decision of defined benefit versus defined contribution pension funds. In defined benefit plans, the plan sponsor guarantees an agreed level of retirement benefits to the plan members. The plan sponsor, hence, bears the risk that the returns from the investment portfolio may not be enough to cover the pension fund liabilities, or funding gap risk. The plan sponsor can minimize this risk by choosing financial assets that match the plan’s liabilities: domestic assets are better for matching domestic liabilities than foreign securities (Davis and Steil, 2001). In contrast, the retirement benefits in defined contribution plans are tied up to the pension fund portfolio performance. Regardless of whether the asset allocation is decided by the pension plan sponsor, or by the pension plan member, as is the case in the 401 (k) pension plans in the United States, the investment risk is borne exclusively by the pension plan member. Therefore, the appropriate investment strategy in defined contribution plans is to maximize the expected return of the portfolio for a given level or risk, as suggested by modern portfolio theory (Davis and Steil, 2001). Some authors (Blake, 2003) argue that pension funds offering defined contribution plans would invest more in equities and in foreign securities (including emerging markets) than pension funds offering defined benefit plans.

The analysis above is supported partly by the historical evolution of asset allocation in some of the mature market pension funds. For instance, in the United States defined benefit plans covered 87 percent of pension plan participants in 1975 but only 20 percent in 1999.⁵ At the same time, foreign investment in 2002 increased to more than 12 percent from less than 3 percent in 1986.⁶ In the United Kingdom, in contrast, defined benefit plans covered up to 85 percent of all plan participants in 1999 (Association of British Insurers, 2000). After the release of the Myners report in 2001, stricter regulations were introduced to encourage a closer matching of assets and liabilities. Surveys by the William Mercer Company show that pension funds met the requirements by increasing the domestic bond allocation to 12.5 percent in 2003 from 9.5 percent in 2000 while reducing their domestic equity allocation to 38 percent from 47 percent. The foreign equity allocation, however, remained steady at 25 percent.

Despite these arguments favoring diversification, current investment levels in emerging markets by pension funds are relatively small. In the United States, a survey by Greenwich Associates (2003) indicates that large public pension funds do not invest in emerging market bonds. Furthermore, these funds’ allocation to emerging market equities is estimated to be around 1 percent of assets.⁷ In Japan, foreign investment by the government pension fund has been limited only to mature markets. In the United Kingdom, Kimmis and others (2002) report that emerging market securities represented around 2 to 3 percent of pension assets.

Investment regulation does not appear to be a major impediment to investing in emerging market securities. A recent survey by the OECD shows that only Germany and Italy imposed tight investment limits on foreign securities (Yermo, 2003a). In Germany, pension funds only can invest up to 10 percent of assets in foreign equity and 10 percent in bonds from non-European Union countries. In Italy, the ceiling on foreign equity and bonds of non-OECD countries is 5 percent of assets. Pension funds, however, can invest up to 50 percent of assets under management in OECD emerging market countries such as Mexico, Korea, and the EU accession countries. In contrast, there are no investment limits in the United Kingdom and the United States (see the section on local pension funds). Countries that do not place investment limits on foreign securities rely on the “prudent man rule” or prudent investor rule. The rule requires pension fund managers to make sensible investment decisions based on what is perceived as best practice among other large and prudent institutional investors.

A primary obstacle to increased asset allocation to emerging markets is the risk aversion of pension fund trustees. The repeated occurrence of financial crises in emerging markets has reduced the diversification benefits from emerging market investments and heightened the perception that emerging markets are excessively volatile. As a result, pension fund trustees have become wary of investing in emerging markets for fear of facing substantial short-term losses. In the United Kingdom, risk aversion among trustees seems to have been encouraged by regulations designed to strengthen U.K. pension funds, such as Minimum Funding Requirements and a new accounting standard, FRS17, that encourage a closer matching of assets and liabilities (Kimmis and others, 2002; and Blake, 2003).

In the United States, fear of litigation over serious short-term underperformance increases the risk perception of pension fund managers.

Pension fund trustees in the United Kingdom tend to rely heavily on the advice of external consultants for selecting the fund’s asset allocation and on external asset managers for security selection. Their asset allocation methods and fund management styles do not favor investment in emerging market securities. The reliance on third parties is explained partly by the fact that a substantial fraction of the funds’ trustees lack investment expertise.⁸ Some asset and liability management models used for asset allocation require the availability of long time series and tend to discourage asset classes that are relatively young and underresearched—such as emerging market securities. The two main styles of fund management are balanced mandates and specialists mandates. Balanced mandates measure manager performance relative to a peer group while specialists mandates use a customized benchmark, making it difficult for managers to invest in any asset class that others are not investing in or that is not included in major indices.

The increasing allocation to emerging market securities, including from pension funds in continental Europe, are reportedly outsourced to specialized asset managers—many of them in the United Kingdom. According to analysts, this delegation of asset allocation and security selection has conflicting implications: it improves the quality of the decision-making process and ensures adequate discrimination across emerging markets, but the quarterly appraisals of managers encourage a short-term focus on performance objectives, defeating to some extent the long-term horizon of pension funds.

Emerging market investment is also affected by non-economic factors. Foremost among them is the requirement that pension funds invest only in a number of “permissible countries” that satisfy “socially responsible” investment conditions. A recent study by Wilshire Associates commissioned by Calpers, the largest public pension fund in the United States, used both traditional market indicators and country factors to select permissible equity markets (Wilshire Associates, 2002). Market indicators include market liquidity and volatility, market regulation, the adequacy of the legal system, investor protection rules, capital market openness, settlement proficiency, and transaction costs. Country factors include political stability, transparency, and “productive” labor practices.⁹ In 1999, Calpers’s exclusion of some Asian countries from the list of “permissible” countries caused a brief sell-off in these countries’ stock markets as investors tried to front-run a possible sell-off by pension funds. In February 2003, stock markets in Malaysia and Thailand benefited from the inclusion of these countries in the permissible country list. More recently, Argentina, Peru, and Turkey failed to meet Calpers’s criteria and were excluded from the list.¹⁰ Although another pension fund is reportedly considering the use of similar criteria to select countries to invest in, analysts do not expected the practice to spread to others. Socially responsible investment guidelines are also used in countries other than the United States. For example, in the United Kingdom, 19 percent of private sector funds and 31 percent of public sector funds reported taking into account ethical considerations in their investment decisions (Targett, 2000).

Large public pension funds approach alternative investment opportunities with caution, and, while pension funds are increasingly interested in alternative investment opportunities, actual allocations are still relatively small. A large public pension fund, for instance, has approved an allocation of up to $1 billion for hedge funds, but has managed to implement only half of that amount. The investment officers have noted that investing in hedge funds is time-consuming because of the opacity of hedge funds’ investment strategies, and that the size of most hedge funds is too small for the pension fund industry asset allocations.

The asset allocation decisions of insurance companies are heavily influenced by the profile of their liabilities. As noted in Chapter III, the relative shares of equity and fixed-income allocations vary considerably among different mature market insurance sectors. However, the need to limit the mismatch that would arise from a large share of contracts that generate fixed-income-type obligations leads many insurers to make a significant portfolio allocation to bonds. Similarly, the importance of matching assets and liabilities would suggest that the insurers also tend to have lower shares of foreign assets than other institutional investors.

The strategic asset allocation of mature market insurance companies vis-à-vis emerging market securities also depends on their size and geographical presence. Global insurance companies tend to follow their insurance business—that is, issuance of local policies—and match locally the liabilities of their subsidiaries in emerging markets. That is, they invest in local securities and try to extend duration as much as possible in the local market, providing support to the development and stability of emerging market securities markets. An example of this support was provided during the recent turbulence in Hungary’s local bond market. The subsidiaries of two large global insurers are the largest holders of Hungary’s 10-year local bonds, and their need for duration and a buy-and-hold attitude contributed to support the market during the November 2003 sell-off by leveraged players (see Chapter II, Box 2.2).¹¹

Medium- and small-sized mature market life insurers that do not distribute their insurance policies in emerging markets tend to perceive the asset class as an opportunity to diversify and enhance yields. Some of them reportedly have a higher share of their portfolio allocated to emerging market securities (5 to 10 percent of total assets, compared with around 1 to 3 percent for the large ones), and although they are of the buy-and-hold type, they are not tied to any particular emerging market by the nature of their liabilities and hence may constitute a less stable segment of the investor base. They reportedly do most of their investment decisions in-house, but in some cases they do not have the resources to do the research needed to invest in emerging markets.

The major constraint to investing in emerging markets is the insurance companies’ own ratings, which have been under pressure over the past few years.¹² In contrast, losses from emerging market investments have been small, even though insurers did not emerge totally unscathed from Argentina. Typically, equity and credit losses have been mitigated by selling other bonds whose prices have risen in a declining interest rate environment. Also, many European life insurance products offer policyholders a guaranteed minimum return and some participation in investment results above the guaranteed rate. Guaranteed returns on life policies, combined with the collapse in equity prices and the low interest rate environment, have also had a negative impact on the insurers’ balance sheets (Wilson, 2003). As a result of these losses and balance sheet weaknesses, life insurance companies are operating in a risk-averse mode and are keeping their allocations to emerging markets stable.

As a result of the combined pressures from the need to enhance yields and the preservation of their own ratings, some insurance companies have invested indirectly in emerging market securities through the purchase of structured products. These include principal-protected notes with large coupons—associated sometimes with emerging market securities—securitization of emerging market future flow receivables or CDOs (collateralized debt obligations), with investment-grade ratings. They are considered promising avenues for investing in emerging markets, but actual investments are still relatively small. Moreover, market participants note that bad experiences with some CDOs in 1998–99 have made the instruments a difficult “sell” with management. Nevertheless, some asset managers consider that emerging market CDOs—backed by both sovereign and corporate bonds—can potentially widen the emerging market investor base. They noted that adequately structured CDOs, with long lock-in periods that ameliorate redemption risks, have delivered annualized returns above 20 percent over the last two years. The outstanding recent performance of some emerging market CDOs, compared to the poor performance of high-yield CDOs, has attracted the attention of European insurers and pension funds.

Mutual and Hedge Funds

Between 1993 and 2001, the assets under management of mature market investment companies increased more rapidly (174 percent) than that of any other institutional investor (Table 4.1). As a result, the proportion of total assets under management of all institutional investors held by mutual funds rose from 22 percent in 1993 to 32 percent in 2001.¹³ Mutual funds are investment companies that combine the assets of investors—individual and institutional—and collectively invest those assets in equities, bonds, and money market instruments.¹⁴ Globally, mutual funds take on a variety of structures. Mutual funds are “open-end” investment companies if they are required to redeem outstanding shares at any time, upon demand, and at a price determined by the current value of the funds’ net assets, known as the net asset value (NAV). In contrast, a “closed-end” mutual fund issues a fixed number of shares that trade on the stock exchange or the over-the-counter market. Unit trusts buy and hold a fixed portfolio of equities, bonds, or other securities; units in the trust are sold to investors who receive their proportionate share of dividends and interest paid by the respective investments. A unit trust has a stated date for termination, upon which investors receive their proportionate share of net assets.¹⁵

Mature market mutual funds have grown for a variety of reasons. In some countries, the growing importance of defined contribution pension systems has increased the placement of funds with mutual funds by both individual and institutions. Indeed, Davis and Steil (2001, p. 17) estimate that about 30 percent of mutual fund assets under management reflect placement of funds by other financial institutions, notably pension funds. Moreover, financial market deregulation and capital account liberalization have allowed foreign mutual funds to enter previously closed markets. Tax considerations have also played a role, especially in countries where retail investors have been allowed to create tax deferred retirement accounts.

The growth of mutual funds has been viewed by most analysts as a positive development because the industry has provided investors with diversified investment opportunities and professional asset management services. However, from the perspective of financial market stability, concerns have arisen at times about the ability of mutual funds to meet large scale redemptions (see Davis and Steil, 2001, pp. 278–82). While retail investors are likely to hold more diverse views than the asset managers of a relatively small set of large institutional investors, market analysts argue that retail investors can be subject to fads (such as the TMT episode during the 1990s) and that this may lead mutual funds to focus on a single approach to investing. Since households can often switch funds at a low cost, a concern has been that a withdrawal from a favored investment style could generate large-scale redemptions, and trigger an asset sell-off.

Mutual funds can address large-scale redemptions through on-balance-sheet liquidity and/or forced sales of securities. The amount of liquidity held by a mutual fund is a portfolio decision, but holding large amounts of liquid assets will generally reduce a fund’s performance.¹⁶ As a result, largescale redemptions have typically been met by forced sales of assets, which at times have put strong downward pressure on already declining asset prices. One means of mitigating the effects of large-scale redemption on mutual funds has been to establish a family of different funds so that investors can shift to another fund within the family (for example, from equities to a money market fund). However, some analysts argue that concerns about mass redemptions are inconsistent with the fact that, in mature markets, mass redemptions of mutual fund shares have been relatively rare.¹⁷ For example, on October 19, 1987, when U.S. equity prices fell sharply, only 3.2 percent of equity transactions were associated with sales of equity fund shares (Davis and Steil, 2001, p. 280). In part, this reflects the fact that a significant proportion of equity mutual fund shares were held for retirement purposes. Nonetheless, the recent mutual fund scandal in the United States saw relatively large redemptions from funds accused of improper trading activities. Between September and December 2003, one firm lost about 12 percent of its assets under management, mostly from institutional clients.

From the perspective of emerging markets, the categories of crossover equity investors include global equity funds (which invest primarily in equity securities traded worldwide, including U.S. companies) and international equity funds (which invest primarily in equity securities of companies located outside the United States). Dedicated equity funds include emerging market funds (which invest primarily in companies based in developing markets around the world). Meanwhile, regional equity funds (which invest in companies based in a specific part of the world, and may comprise both mature and emerging markets) could represent either dedicated or crossover accounts, albeit more benchmark indices are available for the former.¹⁸ Within the fixed-income universe, crossover investors include global bond funds (which invest in debt securities worldwide, and may invest up to 25 percent of assets in companies located in the United States) and international bond funds (which must invest at least two-thirds of the portfolio outside the United States). Emerging market bond funds invest primarily in the debt of less-developed regions.

Equity allocations overseas by U.S. funds—amounting to $359 billion out of $2.7 trillion total equity funds in 2002—have continued to surpass debt allocations by far (see Table 4.2). Of this amount, dedicated emerging market accounts represented $13.7 billion in 2002—or around 4 percent of total U.S. equity mutual funds—and appear relatively insignificant compared with the size of local equity funds in emerging markets. This allocation appears in line with the MSCI All Country World Index (ACWI), which has assigned a weighting of around 4 percent to emerging market equities. Moreover, total allocations by U.S. mutual funds, both dedicated and crossover, to other countries’ debt—including both mature and emerging markets—in 2002 remained very small (less than $21 billion) as a proportion of total net assets of all U.S. bond funds (of $1.2 trillion). Indeed, the size of the U.S. allocation was dwarfed by the total size of local bond mutual funds in emerging markets.

Table 4.2.

U.S. International Mutual Funds: Total Net Assets

(In billions of U.S. dollars)

Source: Investment Company Institute.

Table 4.2.

U.S. International Mutual Funds: Total Net Assets

(In billions of U.S. dollars)

Investment objective		1996	1997	1998	1999	2000	2001	2002
Equity funds
Emerging markets equities		14.0	16.0	12.7	22.1	15.4	13.7	13.7
Global equities		105.2	137.5	159.8	236.4	228.0	183.0	140.9
International equities		134.1	164.9	187.2	276.2	262.1	206.3	183.7
Regional equities		31.8	27.9	32.0	50.5	37.2	25.8	20.2
Subtotal		285.2	346.4	391.6	585.3	542.7	428.8	358.5
	Total U.S. equity funds	1,726.1	2,368.0	2,978.2	4,041.9	3,961.9	3,418.2	2,667.1
Bond funds
Global general bonds		17.5	16.1	15.9	14.9	12.7	12.4	13.2
Global short-term bonds		5.4	6.1	5.7	4.0	3.3	2.7	3.2
Global other bonds		2.8	3.8	3.3	4.0	4.0	4.0	4.7
Subtotal		25.7	26.0	24.9	22.9	19.9	19.1	21.1
	Total U.S. bond funds	645.4	724.2	830.6	812.5	811.2	925.1	1,125.1

Source: Investment Company Institute.

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Table 4.2.

U.S. International Mutual Funds: Total Net Assets

(In billions of U.S. dollars)

Investment objective		1996	1997	1998	1999	2000	2001	2002
Equity funds
Emerging markets equities		14.0	16.0	12.7	22.1	15.4	13.7	13.7
Global equities		105.2	137.5	159.8	236.4	228.0	183.0	140.9
International equities		134.1	164.9	187.2	276.2	262.1	206.3	183.7
Regional equities		31.8	27.9	32.0	50.5	37.2	25.8	20.2
Subtotal		285.2	346.4	391.6	585.3	542.7	428.8	358.5
	Total U.S. equity funds	1,726.1	2,368.0	2,978.2	4,041.9	3,961.9	3,418.2	2,667.1
Bond funds
Global general bonds		17.5	16.1	15.9	14.9	12.7	12.4	13.2
Global short-term bonds		5.4	6.1	5.7	4.0	3.3	2.7	3.2
Global other bonds		2.8	3.8	3.3	4.0	4.0	4.0	4.7
Subtotal		25.7	26.0	24.9	22.9	19.9	19.1	21.1
	Total U.S. bond funds	645.4	724.2	830.6	812.5	811.2	925.1	1,125.1

Source: Investment Company Institute.

The improving credit quality in emerging markets, as evidenced by the number of credit upgrades in 2003, has infused confidence in traditional high-grade crossover investors. For instance, recent institutional mandates to invest in emerging debt are widely considered a stable source of funds, as they are generally seen as longer-term, strategic allocation decisions. As more emerging market sovereigns receive an investment grade rating over time, and an increased proportion of global investment portfolios are committed to these countries and are included in core benchmarks, capital flows to these countries are expected to become less volatile. Already, more than 40 percent of the Emerging Market Bond Index Global (EMBIG) is represented by investment grade issuers (see Figure 4.1).

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Composition of Emerging Market Debt¹

(Percent of countries)

Sources: Moody’s; Standard & Poor’s; and J.P. Morgan Chase & Co.¹ Based on EMBIG group of countries. Data for 2004 are as of March 2, 2004.

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Among retail investors in the United States, crossover funds in both equity and debt asset classes have benefited from new net flows in 2003. On balance, equity funds have been more attractive to investors than bond funds, with international equity funds in receipt of net cash inflows of almost $14 billion for the year, while dedicated emerging market equity accounts posted net inflows of almost $5 billion.

Generally, institutional inflows are viewed as a more stable source of assets under management, compared to the retail flows that have been fuelling the growth of emerging market bond funds over the past year (see Box 4.2 for a summary of some empirical evidence on the behavior of mutual funds during crisis periods). The less sophisticated retail investors are seen to be more likely to pull out their investments quickly during a market event. For instance, analysts argue that most European institutional investors are said to prefer to follow buy-and-hold strategies unless their views on a country turn excessively negative.

Additionally, the large size of some portfolios, high transaction costs, and lack of liquidity in emerging markets prevent excessive trading and practically force fund managers to adopt a buy-and-hold approach, which sometimes makes tactical asset allocations in emerging markets rather difficult.

Another type of closed-end fund that has been active in emerging markets is the hedge fund, which is typically a private unadvertised mutual fund whose investors are wealthy indivictuals and institutions.¹⁹ Another major difference from conventional mutual funds is that they are allowed to take leveraged positions and are not subject to regulatory reporting requirements. Following the demise of several large macro hedge funds during 1998–2000, the hedge fund industry growth picked up again: the total assets under management of U.S.-based hedge funds almost doubled during 2001–03. The total size of the global hedge fund industry is now estimated at around $725-$750 billion compared to around $300 billion in 1997.²⁰ The universe of European and Asian hedge funds, though much smaller than the U.S. hedge fund industry, has been recently expanding at an even faster pace. The total assets under management of the Asia-focused hedge funds rose to $22.4 billion as of mid-2002 from about $12 billion at the end of 2000, while the assets of European hedge funds increased to $112 billion as of mid-2003 from $46 billion at the end of 2000.²¹

As with the mutual fund industry, the recent growth of the hedge fund industry has been supported by increased allocations toward hedge funds by other institutional investors (such as pension funds, endowments, and foundations). The search for “alternative” investments has reflected (1) a general dissatisfaction with traditional “benchmark-based” portfolio management amid poor performance of global markets in recent years; (2) the growing asset-liability mismatches of many institutional accounts in mature markets and, hence, the need to pick up yield; and (3) the aggressive marketing efforts of investment consultants. Indeed, many institutional investors prefer to invest in hedge funds through funds of hedge funds, because of lower monitoring costs, easier scaling of investments, and better opportunities to diversify across a larger number of styles/managers. As a result, the number of funds of funds has continued to expand rapidly over the past two years, while their ability to allocate the growing institutional investments efficiently has not been tested yet.

The hedge funds most active in emerging markets are global funds, dedicated emerging market funds, macro funds, and event-driven funds (distressed securities and merger arbitrage).²² Macro hedge funds are the “classic” opportunistic hedge funds that take positions whenever they see apparent macroeconomic imbalances that are not properly reflected in asset prices; they use leverage and derivatives, and their investment horizon can be either short (under one month) or long (more than 12 months). Global hedge funds typically use a top-down/bottom-up approach in that they tend to be stock-pickers in the markets that they like based on macroeconomic analysis. Dedicated emerging market hedge funds are similar in their investment strategies to global hedge funds, but tend to focus on specific regions. Event-driven funds try to profit on asset price movements around special events, such as mergers or acquisitions (merger arbitrage) or default (distressed securities).

In normal times, hedge funds are generally cautious about investing in locally traded assets in emerging market countries because of the relatively high cross-border risk, though they may at times do so when there is a clear trend in credit dynamics and an upside potential in local instruments is perceived to be higher than that in the foreign currency denominated bonds.²³ Indeed, the hedge funds’ activities in many emerging markets are often constrained by the lack of infrastructure for borrowing/lending securities (or explicit regulatory constraints on short selling), lack of derivative instruments, thin markets, and high concentration of liquidity in a few instruments. In such markets, hedge funds often tend to have a long bias and use strategies similar to those employed by mutual funds. Although at present hedge funds’ exposures to most local emerging equity and bond markets are relatively small compared to that of other institutional investors, hedge funds will likely become a bigger part of the crossover investor base for emerging market instruments going forward,²⁴ especially given the recent rapid expansion of the global hedge fund industry, and in particular that of dedicated emerging market hedge funds.²⁵

In considering hedge fund activities in both primary and secondary markets for emerging market claims, analysts have debated the role of hedge funds as a source of either liquidity and/or potentially destabilizing trading strategies. The impact of the hedge funds’ activities on price dynamics depends on the funds’ strategies and investment horizon. Given that hedge funds, by nature, are more nimble than traditional “real money funds” and tend to trade more actively, they generally contribute to higher turnover and better liquidity in markets in which they participate. For example, as a result of the exit of hedge funds and proprietary trading desks of investment banks from the South African foreign exchange spot and swap markets after the tightening of capital controls in the second half of 2001, the average daily turnover fell by over 40 percent. At the same time, the bid-ask spreads widened and the implied foreign exchange rate options’ volatility increased. Also, since hedge funds typically have lock-up periods and do not experience redemption pressures similar to those faced by retail mutual funds, they are better able to invest in less liquid securities and also to withstand periods of high volatility. Thus, hedge funds are less likely to be forced to sell into a falling market and can, at times, maintain contrarian positions during extended periods. All of the above suggests that hedge funds can and, in fact, do play a positive (or even stabilizing) role in various markets. However, because hedge funds have fewer investment restrictions than other institutional investors, they are perceived to have an “edge” over other investors as well as the ability to manipulate markets. Another concern is that since hedge funds use leverage, they may have to unwind positions at times of market stress, exacerbating selling pressures and volatility.

The finance literature has covered extensively the types of trading strategies that could play a role in destabilizing market dynamics. Such strategies include various momentum strategies, such as positive-feedback trading, which involves selling an asset after its price falls or buying an asset when its price rises, and herding—that is, imitating the behavior of other market participants instead of trading on one’s own private information. Positive feedback trading can be a result of dynamic hedging, an application of a “stop-loss” rule (i.e., liquidating a position when investor’s losses reach certain critical level), or a decision to unwind a leveraged position because of the inability or unwillingness to meet the margin calls (a shortfall in collateral on the margin account due to a decline in asset price).²⁶

However, both academic and market research that analyzed the hedge funds’ activities during the emerging market currency crises of 1994–98 found little evidence that hedge funds consistently used “positive-feedback” strategies (Brown, Goetzmann, and Park, 1998; Fung, Hsieh, and Tsatsaronis, 1999; Fung and Hsieh, 2000; and Eichengreen and Mathieson, 1998) or other strategies that could have had a destabilizing impact on market dynamics. In addition, these studies found no evidence that hedge funds earned abnormal profits during the Mexican or the Asian currency crises. The analysis of hedge fund positioning in several more recent emerging market currency crisis episodes yielded similar conclusions (see the Appendix to this chapter).

With regard to herding, hedge funds are generally perceived to be less likely to “herd” than other investors, such as mutual funds and pension funds, because they tend to be relatively well informed and their performance is not measured relative to any benchmark.²⁷ A related concern is that hedge funds and proprietary trading desks (often referred to as “smart money”) are often “imitated” by other investors.²⁸ Although market participants may at times attempt to mimic hedgefund strategies, hedge funds are usually reluctant to reveal their portfolio allocations because of concerns that the replication of their portfolios by other traders may erode profit margins. There are, however, circumstances when hedge funds may use trading strategies that require a coordinated effort of many market players to be successful. The most obvious example is a speculative attack against a currency peg/band. In this case, hedge funds would (if and when they initiate the attack) actually prefer to be followed by other market participants, because their actions may help to generate a critical mass that is needed to break the peg. Then, for example, the leaked information about position (s) of certain large hedge fund(s) vis-à-vis an emerging market currency may serve as a trigger for similar position-taking (or herding) by other investors, especially if hedge funds are perceived to be better informed than the rest of the market (see, for example, Corsetti and others, 2004).

As far as market manipulation is concerned, the evidence against hedge funds presented in various sources has been mainly anecdotal. For example, the Market Dynamics Study Group of the Financial Stability Forum, which was asked to assess concerns of authorities in Australia, Hong Kong SAR, Malaysia, New Zealand, Singapore, and South Africa about the possible destabilizing impact of highly leveraged institutions (proprietary desks and hedge funds) in the foreign exchange markets of these countries during 1998, “was unable to reach a conclusion on the extent to which manipulation and collusion might have occurred in the six economies and whether market integrity was compromised.” (Financial Stability Forum, 2000, page 125).

One form of market manipulation that hedge funds have been frequently suspected of is the trade-based manipulation. For instance, speculators can establish positions in two related markets (e.g., spot and future markets or primary and secondary markets) and by aggressively selling/buying in one market (at a loss) induce the less informed players to take certain actions that would move the price in a related market in the direction that would allow speculators to more than offset their losses (see, for example, Kyle, 1984, on tradebased manipulation in spot and future markets; also, the many accounts of the Hong-Kong SAR “double play”). One of the more recent complaints about hedge funds manipulating markets by simultaneously taking positions in different market segments comes from emerging market debt fund managers. According to some market participants, after shorting some sovereign bonds in the secondary market, hedge funds would often try to induce an upward shift of the sovereign yield curve by obtaining a sizable amount of a “new” bond just issued by the sovereign in the primary market and almost immediately selling it in the secondary market (El-Erian, 2003). Such strategy could indeed be profitable, if the gains from shorting the “old” bond more than offset the losses incurred when flipping the “new” bond (the latter can be either because of the relative sizes of the short and long positions or because of a relatively large price fall of the illiquid “old” bond).

Pension Funds and Insurance Companies

A number of emerging markets have introduced pension reforms that are leading to an important increase in assets under management of private asset managers. Following the lead of Chile, which initiated the reform drive in Latin America, several other countries in Latin America and, more recently, in central and eastern Europe have adopted variants of a funded, privately managed, defined contribution personal accounts retirement system.²⁹ Assets under management of private pension funds in Latin America have grown from around 4 percent of GDP in 1997, to around 9 percent of GDP in 2002 (see Table 4.3). Chile’s assets under management have reached 54 percent of GDP after 22 years of operation of the fully funded system, while the other countries are just in the early stages of asset accumulation (see Table 4.3). The growth of assets under management has been particularly rapid in Mexico, Peru, Uruguay, Hungary, and Kazakhstan.

Table 4.3.

Pension Fund Assets

(In percent of GDP)

Sources: IMF, International Financial Statistics; Federacion Internacional de Administradoras de Pensiones (FIAP); Central Provident Fund (Singapore); Employees Provident Fund (Malaysia); Financial Supervisory Authority (Hungary); Mandatory Provident Fund (Hong Kong SAR); and IMF staff calculations.

Table 4.3.

Pension Fund Assets

(In percent of GDP)

		1991	1992	1993	1994	1995	1996	1997	1998	1999	2000	2001	2002
Latin America
	Argentina	n.a.	n.a.	n.a.	0.2	1.0	2.0	3.0	3.9	5.9	7.2	7.7	11.2
	Bolivia	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	0.8	2.5	4.0	5.8	6.3	7.3
	Colombia	n.a.	n.a.	n.a.	0.0	0.3	0.8	1.3	2.1	3.3	4.3	5.3	6.7
	Costa Rica	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	0.7	0.8
	Chile	18.3	22.6	26.0	28.2	31.2	33.2	32.8	38.5	42.2	46.1	52.5	53.5
	El Salvador	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	0.4	1.7	3.7	5.8	7.6
	Mexico	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	0.2	1.4	2.4	2.9	4.4	5.0
	Peru	n.a.	n.a.	0.1	0.6	1.1	1.7	2.6	3.1	4.7	5.2	6.8	8.0
	Uruguay	n.a.	n.a.	n.a.	n.a.	n.a.	0.2	0.9	1.7	2.8	4.0	5.6	7.2
Subtotal		1.1	1.4	1.5	1.9	3.2	3.6	4.0	5.2	6.3	7.0	8.2	9.2
Europe
	Bulgaria	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	0.3	0.3	0.8
	Hungary	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	1.3	2.1	3.1	3.9	4.5
	Kazakhstan	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	1.3	2.7	4.2	5.6	6.0
	Poland	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	1.5	2.4	3.5
Subtotal		n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	0.4	0.6	2.0	2.9	3.8
Asia
	Hong Kong SAR	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	0.4	0.4	0.4
	Malaysia	38.5	40.3	41.5	42.6	43.4	45.4	45.9	51.1	53.9	52.3	55.9	56.5
	Singapore	61.7	63.4	55.5	53.5	55.5	55.8	56.2	62.2	64.1	60.3	63.8	64.9
Subtotal		21.7	23.8	22.5	22.8	24.9	25.3	23.5	20.8	21.5	20.5	21.6	21.5
Total		6.3	6.9	6.7	7.1	9.6	10.2	9.8	9.8	11.0	11.4	12.6	14.2

Sources: IMF, International Financial Statistics; Federacion Internacional de Administradoras de Pensiones (FIAP); Central Provident Fund (Singapore); Employees Provident Fund (Malaysia); Financial Supervisory Authority (Hungary); Mandatory Provident Fund (Hong Kong SAR); and IMF staff calculations.

View Table

Table 4.3.

Pension Fund Assets

(In percent of GDP)

		1991	1992	1993	1994	1995	1996	1997	1998	1999	2000	2001	2002
Latin America
	Argentina	n.a.	n.a.	n.a.	0.2	1.0	2.0	3.0	3.9	5.9	7.2	7.7	11.2
	Bolivia	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	0.8	2.5	4.0	5.8	6.3	7.3
	Colombia	n.a.	n.a.	n.a.	0.0	0.3	0.8	1.3	2.1	3.3	4.3	5.3	6.7
	Costa Rica	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	0.7	0.8
	Chile	18.3	22.6	26.0	28.2	31.2	33.2	32.8	38.5	42.2	46.1	52.5	53.5
	El Salvador	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	0.4	1.7	3.7	5.8	7.6
	Mexico	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	0.2	1.4	2.4	2.9	4.4	5.0
	Peru	n.a.	n.a.	0.1	0.6	1.1	1.7	2.6	3.1	4.7	5.2	6.8	8.0
	Uruguay	n.a.	n.a.	n.a.	n.a.	n.a.	0.2	0.9	1.7	2.8	4.0	5.6	7.2
Subtotal		1.1	1.4	1.5	1.9	3.2	3.6	4.0	5.2	6.3	7.0	8.2	9.2
Europe
	Bulgaria	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	0.3	0.3	0.8
	Hungary	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	1.3	2.1	3.1	3.9	4.5
	Kazakhstan	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	1.3	2.7	4.2	5.6	6.0
	Poland	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	1.5	2.4	3.5
Subtotal		n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	0.4	0.6	2.0	2.9	3.8
Asia
	Hong Kong SAR	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	n.a.	0.4	0.4	0.4
	Malaysia	38.5	40.3	41.5	42.6	43.4	45.4	45.9	51.1	53.9	52.3	55.9	56.5
	Singapore	61.7	63.4	55.5	53.5	55.5	55.8	56.2	62.2	64.1	60.3	63.8	64.9
Subtotal		21.7	23.8	22.5	22.8	24.9	25.3	23.5	20.8	21.5	20.5	21.6	21.5
Total		6.3	6.9	6.7	7.1	9.6	10.2	9.8	9.8	11.0	11.4	12.6	14.2

Sources: IMF, International Financial Statistics; Federacion Internacional de Administradoras de Pensiones (FIAP); Central Provident Fund (Singapore); Employees Provident Fund (Malaysia); Financial Supervisory Authority (Hungary); Mandatory Provident Fund (Hong Kong SAR); and IMF staff calculations.

Retirement income in Asia is provided mainly through government-sponsored national provident funds.³⁰ For example, in Malaysia and Singapore the government sponsors (and to a large extent also manages) a fully funded, defined-contribution system for civilian workers, and these systems have achieved a high level of assets under management (see Table 4.3). In Korea, the national pension system is fully funded but offers defined benefits and has not reached the levels of other Asian nations. National mandatory provident funds have not contributed substantially to the development of local capital markets in spite of managing sizable assets (Holzmann, MacArthur, and Sin, 2000). Fund management in these countries is very conservative, with the result that assets are heavily concentrated in government securities. In Korea, for instance, two-thirds of the assets of the National Pension Scheme are channeled to the government as direct loans, while a large share of Singapore’s Central Provident Fund assets are invested in non-marketable government securities (Asher and Newman, 2001). Centralized fund management also may have held up the development of a competitive fund management industry and its positive impact in local securities markets (Holzmann, MacArthur, and Sin, 2000).³¹

The rapid growth of assets managed by private pension funds in Latin America and central Europe is having a positive impact on the development of local securities markets, which has so far been concentrated in local bond markets. Pension funds have contributed to government efforts to develop liquid benchmark yield curves, especially in Hungary, Poland, and Mexico. They have also supported the growth of medium- to long-term corporate bonds.³² A remarkable achievement in the case of Chile is the creation of a long-run market in corporate bonds. As documented in Cifuentes, Desormeaux, and Gonzalez (2002), the average maturity of bond issuance was between 10 and 15 years in the first half of the 1990s, and more recently it has been between 10 and 20 years, and even 30-year bonds have been issued. Most corporate bonds in Chile are indexed to the Unidad de Fomento (UF, a unit of account linked to the CPI), and analysts agree that indexed bonds have been an optimal instrument for pension funds and insurance companies. In Argentina in the second half of the 1990s and in Mexico in the last four years, the rapid growth in local corporate bond issuance has also been associated with an acceleration in the growth of pension funds’ assets under management (Roldos, 2003). Pension funds have also had a significant impact in Chile’s stock markets as well as in other financial markets and institutions.³³

The growth in private pension funds’ assets under management has contributed not just to the development of local securities market. It has also had a significant impact on the sovereign external debt markets. Brainard (2001) notes that local pension funds and their investment guidelines have become essential considerations for investors in external debt markets. Developing a local investor base for sovereign external debt reduces price volatility and hence market risk for foreign investors. Despite the short history of some reformed systems, the hypothesis that assets managed by local pension funds offer stability to foreign debt markets seems to have empirical backing (see Roldos, 2003).

The growth in pension funds’ assets under management is likely to accelerate over the next decade or so, and it is unclear whether local securities markets will be able to respond to such growth in the demand for financial assets. Projections from Salomon Smith Barney (see Garcia-Cantera and others, 2002) suggests that by the year 2015 most systems are going to reach a level of assets under management of around 25 to 30 percent of GDP, roughly the level of the average of the Group of Seven countries in 1998. Although the institutional, demographic, and financial structures differ across both groups of countries, a comparison of both experiences (Roldos, 2003) suggests that securities markets in the pension reform countries could potentially double in size (relative to GDP) in about a decade. Whether these emerging markets could respond to the increased pension fund demand with a substantial volume and enough diversity of securities, as well as with the institutions to ensure financial stability, is one of the key questions for emerging markets and one of the key challenges for regulators of securities markets and the pension industry. In particular, portfolio restrictions intended to protect workers’ future pension benefits and to foster the development of local securities markets may be preventing an adequate diversification of the funds’ portfolios and may be distorting asset values.

Although almost no pension fund in emerging markets is allowed to follow the “prudent man” rules, four of the big countries in Table 4.4 (Argentina, Brazil, Hungary, and Poland) are allowed to invest up to half of their portfolio in stocks, and another group (Chile, Colombia, and Peru) has a ceiling of 30 to 40 percent. The exception is Mexico, which, together with a number of smaller countries in the region, does not allow pension funds to invest in equities.³⁴ Actual portfolio allocations do not seem to be extremely constrained by the limits, and show as much variance as in the mature markets. While in the U.S. and the U.K. pension funds hold around 60 percent of their assets in stocks, Japan’s pension funds hold 28 percent and Germany’s almost none. Emerging market pension funds hold smaller shares of their portfolios in stocks. In central Europe, Poland stands out with a 28 percent allocation in stocks, while Hungary holds 14 percent of its portfolio in shares and the Czech Republic holds 11 percent. In Latin America, Peru’s funds hold around 31 percent of their portfolios in stocks, while Brazil’s funds hold 28 percent; Argentina, Colombia, and Chile hold less than 10 percent in shares.³⁵

Table 4.4.

Pension Funds Portfolio Limits and Actual Asset Allocation, 2001–02

(In percent of total assets)

Sources: For mature markets, OECD (2003); Davis and Steil (2001); Davis (2002); and Yermo (2003a). For Emerging Markets, FIAP; Brainard (2001); Roldos (2003); and Garcia-Cantera and others (2002).

¹Numbers refer to maximum allocation; P indicates that the prudent man rule applies.

²Data for mature markets are end of 2001 and for emerqinq markets are end of 2002.

³For 1998, see Davis (2002).

⁴In EU equity, 10 percent in foreign bonds and equities of non-EU countries. These limits are for pensionkassen, which are under the supervision of the insurance regulator. Other pensionfonds are not subject to investment limits.

⁵No investment limits for public employee funds.

⁶Securitiesof OECD countries not traded in regulated markets up to 50 percent; non-OECD securities traded in regulated markets limited to 5 percent (forbidden if traded in non-regulated markets).

⁷Only sovereign and investment grade Mexican corporate debt permitted in foreign limit.

⁸Polish Brady Bonds do not count against this limit.

Table 4.4.

Pension Funds Portfolio Limits and Actual Asset Allocation, 2001–02

(In percent of total assets)

	Equities		Foreign Assets
	Limit1	Actual2	Limit1		Actual2
Mature markets
United Kingdom	P	60.9	P		22.9
United States	P	58.8	P		11.0	3
Germany	30	0.1	30	4	7.0	3
Japan	30	27.7	30	5	22.9
Canada	—	28.2	30		15.0	3
France	—	—	—		5.0	3
Italy	P	4.4	P	6	0.0	3
Emerging markets
Argentina	49	6.6	10		8.9
Brazil	50	27.8	0		—
Chile	39	9.0	25		16.4
Colombia	30	4.3	10		—
Mexico	0	0.0	10	7	—
Peru	35	31.3	8		7.2
Hungary	50	13.8	30		2.5
Poland	50	27.6	5	8	0.3	3

Sources: For mature markets, OECD (2003); Davis and Steil (2001); Davis (2002); and Yermo (2003a). For Emerging Markets, FIAP; Brainard (2001); Roldos (2003); and Garcia-Cantera and others (2002).

¹Numbers refer to maximum allocation; P indicates that the prudent man rule applies.

²Data for mature markets are end of 2001 and for emerqinq markets are end of 2002.

³For 1998, see Davis (2002).

⁴In EU equity, 10 percent in foreign bonds and equities of non-EU countries. These limits are for pensionkassen, which are under the supervision of the insurance regulator. Other pensionfonds are not subject to investment limits.

⁵No investment limits for public employee funds.

⁶Securitiesof OECD countries not traded in regulated markets up to 50 percent; non-OECD securities traded in regulated markets limited to 5 percent (forbidden if traded in non-regulated markets).

⁷Only sovereign and investment grade Mexican corporate debt permitted in foreign limit.

⁸Polish Brady Bonds do not count against this limit.

View Table

Table 4.4.

Pension Funds Portfolio Limits and Actual Asset Allocation, 2001–02

(In percent of total assets)

	Equities		Foreign Assets
	Limit1	Actual2	Limit1		Actual2
Mature markets
United Kingdom	P	60.9	P		22.9
United States	P	58.8	P		11.0	3
Germany	30	0.1	30	4	7.0	3
Japan	30	27.7	30	5	22.9
Canada	—	28.2	30		15.0	3
France	—	—	—		5.0	3
Italy	P	4.4	P	6	0.0	3
Emerging markets
Argentina	49	6.6	10		8.9
Brazil	50	27.8	0		—
Chile	39	9.0	25		16.4
Colombia	30	4.3	10		—
Mexico	0	0.0	10	7	—
Peru	35	31.3	8		7.2
Hungary	50	13.8	30		2.5
Poland	50	27.6	5	8	0.3	3

Sources: For mature markets, OECD (2003); Davis and Steil (2001); Davis (2002); and Yermo (2003a). For Emerging Markets, FIAP; Brainard (2001); Roldos (2003); and Garcia-Cantera and others (2002).

¹Numbers refer to maximum allocation; P indicates that the prudent man rule applies.

²Data for mature markets are end of 2001 and for emerqinq markets are end of 2002.

³For 1998, see Davis (2002).

⁴In EU equity, 10 percent in foreign bonds and equities of non-EU countries. These limits are for pensionkassen, which are under the supervision of the insurance regulator. Other pensionfonds are not subject to investment limits.

⁵No investment limits for public employee funds.

⁶Securitiesof OECD countries not traded in regulated markets up to 50 percent; non-OECD securities traded in regulated markets limited to 5 percent (forbidden if traded in non-regulated markets).

⁷Only sovereign and investment grade Mexican corporate debt permitted in foreign limit.

⁸Polish Brady Bonds do not count against this limit.

There are a number of reasons to justify relatively large bond allocations in pension funds’ portfolios, but diversification arguments suggest that equities may deserve a bigger role than they currently have in some countries. Campbell and Viceira (2002) indicate that bonds—in particular, indexed bonds—should comprise a large share of the optimal portfolio of long-term investors. Besides containing the risk inherent in equities, a large allocation of government bonds helps to smooth the transition to a funded system. The recent Argentine crisis, however, has highlighted the risks involved in a concentrated exposure to the sovereign: as the government tried to decrease the cost of servicing its debt in 2001, pension fund companies and banks were forced to make asset allocation decisions that they probably would not have made in other market conditions (see Garcia-Cantera and others, 2002).³⁶ Thus, as noted in Box 4.1, an optimal asset allocation would include a non-negligible equity allocation. Indeed, despite the extended bear market in equities in the early 2000s, well-balanced portfolios have performed relatively well in the medium term. If local stock markets are unable to provide the needed instruments, local pension funds ought to seek international alternatives.

The limits to investments in foreign securities are stricter in emerging markets than in the mature markets (Table 4.4), but some fund managers appear to be reluctant to increase international allocations. Here, again, the experience of Chile is a good example. Only a decade after the inception of the private pension funds were they allowed to invest in foreign assets, up to 3 percent of their portfolio. The limit was then increased to 9 percent in 1995, 12 percent in 1997, 20 percent in 2001, 25 percent in June 2002, and has been at 30 percent since December 2003. Pension funds did not diversify abroad in a meaningful way in the first half of the 1990s, owing to high domestic assets returns. But following two years of large negative returns in the local stock market, a strong reallocation toward foreign assets began in 1997 and the funds currently hold around 25 percent of their assets abroad.³⁷ In Hungary, where the limit has been at 30 percent for several years, actual allocations are under 5 percent as a result of bad experiences with losses in the aftermath of the bursting of the TMT bubble. In Colombia, funds were allowed to invest in international equity mutual funds in April 2002, but market participants argue that allocations are under 2 percent because of a fear of not meeting required minimum returns.

The limits on international investments could distort not only portfolio allocations but also asset prices. Such limits amount to controls on capital outflows that impose a wedge, for instance, between the prices of local and foreign bonds. The case of Mexico is illustrative. In February 2003, the spread between external (swapped to pesos through crosscurrency swaps) and local bonds was around 300 basis points. Analysts consider that the wide spread was caused mainly by regulations preventing some investors, especially pension funds, from arbitraging the domestic and external curves (Abdel-Motaal, 2002). The spread compressed to around 100 basis points in September 2003. The compression was arguably driven by increased arbitrage trades by institutions other than pension funds and by the gradual phasing out of these constraints by the authorities (see Box 4.3 for details). Similarly, in Peru, Brady bonds pay much higher spreads than local corporate bonds, owing to the fact that pensions can invest only up to 5 percent of their portfolio in Bradys versus 40 percent in corporate bonds.

Box 4.3.

Pension Fund Regulations and Local Yield Curves: The Case of Mexico¹

During the past three years, it has been observed that the external U.S. dollar-denominated Mexican sovereign yield curve, when swapped into Mexican pesos using crosscurrency swaps, always carries a premium (or currency swap spread) over the domestic Mexican peso-denominated sovereign yield curve. For instance, the eight-year maturity cross-currency swap spread of 300 basis points observed in February 2003 was not unusual given the historical range of 150 to 350 basis points observed for the period 2000–02 (see the Figure). Also, the currency swap spread tends to widen with maturity. It has been widely documented that domestic corporate issuers have taken advantage of this yield curve anomaly to lower their financing costs by simultaneously issuing peso-denominated bonds and swapping the peso payments into U.S. dollars (Oswald and Sekiguchi, 2002; and Kumar, 2003).

The existence of the currency swap spread creates a carry-trade arbitrage opportunity for investors. The simplest way to execute the carrytrade arbitrage is by selling short domestic sovereign bonds and using the proceeds to buy an external sovereign bond. The coupons of the external bond are then swapped into Mexican pesos using a currency swap to meet the coupon payments corresponding to the short position in the domestic bond. Because local markets in Mexico only offer floating-for-floating currency swaps, it is first necessary to swap the bonds’ coupons into floating rate using fixed-for-floating interest rate swaps.

The long persistence of the carry-trade arbitrage suggests the existence of fundamental and technical factors that drive a wedge between both yield curves. The foremost fundamental factor affecting the cross-currency swap spread is default risk. The instruments underlying the domestic yield curve and the external sovereign curve are issued under different jurisdictions, and hence are subject to different legal regimes. Therefore, recovery rates in case of default are different for domestic and external bonds.

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Mexico: External and Domestic Yield Curves

(In percent)

Source: J.P. Morgan Chase & Co.

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It can also be argued that default risk is higher for external bonds than for domestic bonds. For instance, governments can always print money to pay off the domestic debt. They can also exercise pressure on domestic investors to force a rollover of domestic debt, as was the case in Argentina in 2001.²

The carry-trade arbitrage strategy is risky since the sovereign may default on the external bond. In this case, the investor cannot count on the coupons of the external bond to meet the U.S. dollar payments in the currency swap.

The arguments above suggest that the external bond must carry a premium or spread over the domestic bond to compensate investors for taking additional default risk. However, market analysts consider that the default risk premium is not large enough to account fully for the observed spreads. According to them, technical factors, most of them associated with investment restrictions that affect Mexican pension funds (AFORES), are the main drivers of the spreads (Abdel-Motaal, 2002; and Oswald and Sekiguchi, 2002). The technical factors include a lack of repo markets; regulations on pension funds’ use of derivatives and investments in foreign currency instruments; and the funds’ portfolio duration. These factors are explained next.

The first step in executing the carry-trade arbitrage strategy is selling short domestic bonds. This step can be executed only if there is a liquid local repo market for government bonds. In practice, this market is non-existent in Mexico, as short-selling of domestic bonds is not allowed. Investors can still take short positions using buy-sell operations. These operations, however, lack enough liquidity and are viable only for investors taking rather small positions (Abdel-Motaal, Newman, and Romo, 2003).

Before December 2003, pension fund regulations prohibited the use of derivatives, including interest rate and currency swaps.

In consequence, a substantial segment of the domestic investor base is effectively barred from executing the carry-trade arbitrage strategy. Furthermore, if pension funds were fixed interest rate receivers in interest rate swaps they could exercise downward pressure on spreads even if they were not arbitraging the yield curve anomaly. Market analysts forecast that spreads will likely start compressing once pension funds are allowed to trade derivatives in early 2004.

Restrictions on foreign investment also contribute to sustain the currency swap spread. Pension funds cannot hold more than 10 percent of assets in Mexican external debt. So, even when pension funds can trade derivatives, the foreign investment restriction reduces the funds’ incentives to earn the currency swap spread.

In spite of these technical factors, the Figure shows the currency swap spread compressed from February 2003 to September 2003. This compression can be attributed partly to the exploitation of the yield curve anomaly by investors other than pension funds and partly to an extension of portfolio duration following the introduction of Value-at-Risk (VaR) in December 2002.

¹The box is based on the analysis presented in Abdel-Motaal (2002). ²Notwithstanding these arguments, the Russian default on domestic debt in 1998 shows that external debt is not always riskier than domestic debt.

Failure to adjust restrictions on pension funds’ investment policies could increase the concentration of risk exposures and magnify price volatility. In addition to restrictions on equities and international investments, most countries have also adopted tight restrictions on the percentage of a company’s capital or outstanding bonds that a pension fund can hold (Yermo, 2000). For example, in Argentina, funds can hold at most 5 percent of a company’s capital and 5 percent of its bonds. When local stock markets are small (as in most emerging markets), with a limited number of qualifying companies, rapidly growing funds will quickly reach these limits, reducing their possibilities of diversification and increasing the risk of local stock market bubbles.³⁸ Market participants expressed fears of a market bubble in the Warsaw Stock Exchange when Polish pension funds, together with local and international mutual funds, shifted their portfolios away from bonds and into local equities (Kwiecinski and Wiatr, 2003). Also, as the size of funds grows relative to the local markets, individual funds are often able to move prices. This often also results in liquidity constraints for funds, since they cannot sell assets without putting downward pressure on prices. For example, when the Chilean investment regime was partially liberalized in 1985, pension funds found it difficult to close their fixed-income position and asset allocations changed only slowly in response to the liberalization (Srinivas, Whitehouse, and Yermo, 2000).

The reduction of limits on foreign investments by local pension funds amounts to a removal of capital controls on outflows, and care should be taken about the macroeconomic consequences.³⁹ In particular, as the Chilean and Canadian experiences have shown, a sudden shift of pension funds’ allocations abroad could lead to a substantial exchange rate depreciation (Patterson and Normand, 2002; and Roldos, 2003). In Chile, the increase in the share of foreign assets, from 2 percent by end-1997 to 12 percent by end-1999, was associated with a roughly 20 percent depreciation of the peso. In Canada, an increase of the foreign investment limit from 20 percent in January 2000 to 30 percent in January 2001 contributed to a three-fold increase in capital outflows, which in turn contributed to a 10 percent depreciation of the Canadian dollar in the period January 2000 through January 2002.⁴⁰

In central Europe and Latin America, mark-to-market and minimum return requirements have encouraged herd behavior and excessive focus on short-term returns among pension fund managers. Some countries require funds to achieve certain minimum rates of return, often calculated relative to the industry average.⁴¹ This amounts to an extreme form of “peer-group” benchmarking that induces funds to move in herds, allocating their assets in a suboptimal manner and magnifying price fluctuations. Similarly, in several countries pension funds have to mark-to-market their portfolios on a daily basis for regulatory purposes—and on a monthly basis for investors. Increased focus on short-term results induce managers to behave like mutual fund managers, and there is excessive turnover in pension fund portfolios, as is the case in Hungary and Poland. Also, the use of risk management tools (such as Value-at-Risk in Mexico) leads pension fund managers to avoid volatile assets with favorable risk-adjusted returns since they increase the return volatility of the portfolio.

Herd behavior does not seem to be a problem for provident funds in Asia, as the national provident fund is the sole provider of pension benefits. However, there are concerns on the funds’ performance and accountability. National provident funds in Asia are centrally managed and, in general, follow conservative investment strategies. Empirical studies suggest that this has resulted in poor performance in several Asian funds. For instance, provident funds in Malaysia and Singapore have performed marginally better than bank deposits. In addition, the allocation of pension funds’ assets also may be excessively influenced by political interests that do not necessarily benefit contributors. For instance, pension funds in Korea were asked to contribute to a stock market stabilization plan in 2000, while in Malaysia, provident fund assets have been used to recapitalize banks and finance housing construction (FinanceAsia, October 2000). Some authors have also noted a number of challenges in the transparency and accountability of provident funds.⁴²

In contrast to Latin America and emerging Europe, local life insurance companies are the leading institutional investors in emerging Asia. This is related in part to the Asian tradition of using insurance products as savings products.⁴³ Assets under management have increased very rapidly over the past five years, particularly in Korea, Malaysia, and Singapore (Table 4.5). In Latin America, however, pension funds are the more dominant institutional investors, while insurance penetration remains low. The growth of pension funds has nevertheless contributed to the expansion of the life insurance sector, in particular with a sharp rise in the sale of annuities (see Garcia-Cantera and others, 2001). The growth of annuities markets has not been restricted to privatized systems, and Singapore has also witnessed a rapid growth in recent years, as a result of the reform of regulations governing withdrawals from the Central Provident Fund (see MacKenzie, 2002).

Table 4.5.

Assets Under Management by Insurance Companies¹

(In percent of GDP)

Sources: National regulators; and IMF staff estimates.

¹Both life and general insurers.

²Life insurers only.

Table 4.5.

Assets Under Management by Insurance Companies¹

(In percent of GDP)

	1998	1999	2000	2001	2002
Asia
Korea	25.8	29.4	30.2	34.0	35.8
Malaysia	13.6	15.1	14.9	20.5	21.0
Philippines	3.5	3.7	3.8	3.7	4.0
Singapore	18.5	23.3	24.4	34.1	37.6
Thailand	5.8	6.5	6.6	7.6	8.3
Eastern Europe, Middle East, Africa
Hungary	3.3	3.9	4.2	4.5	3.8
Poland2	3.0	3.6	4.3	5.0	6.0
Turkey	1.1	1.6	1.5	1.5	n.a.
South Africa2	…	…	…	74.4	68.7
Latin America
Argentina	1.8	2.3	2.7	3.2	4.6
Brazil	n.a.	2.1	2.6	2.6	2.8
Chile	14.4	17.1	18.6	19.2	19.9
Colombia	0.8	0.8	0.8	0.9	1.0
Mexico	1.4	1.4	1.3	1.5	1.7
Peru	na	na	na	2.0	2.2

Sources: National regulators; and IMF staff estimates.

¹Both life and general insurers.

²Life insurers only.

View Table

Table 4.5.

Assets Under Management by Insurance Companies¹

(In percent of GDP)

	1998	1999	2000	2001	2002
Asia
Korea	25.8	29.4	30.2	34.0	35.8
Malaysia	13.6	15.1	14.9	20.5	21.0
Philippines	3.5	3.7	3.8	3.7	4.0
Singapore	18.5	23.3	24.4	34.1	37.6
Thailand	5.8	6.5	6.6	7.6	8.3
Eastern Europe, Middle East, Africa
Hungary	3.3	3.9	4.2	4.5	3.8
Poland2	3.0	3.6	4.3	5.0	6.0
Turkey	1.1	1.6	1.5	1.5	n.a.
South Africa2	…	…	…	74.4	68.7
Latin America
Argentina	1.8	2.3	2.7	3.2	4.6
Brazil	n.a.	2.1	2.6	2.6	2.8
Chile	14.4	17.1	18.6	19.2	19.9
Colombia	0.8	0.8	0.8	0.9	1.0
Mexico	1.4	1.4	1.3	1.5	1.7
Peru	na	na	na	2.0	2.2

Sources: National regulators; and IMF staff estimates.

¹Both life and general insurers.

²Life insurers only.

The investment decisions of life insurance companies operating in emerging markets depend on regulatory constraints, the development of local capital markets, and risk management guidelines. In most emerging market economies, insurers are required to maintain local assets to match local liabilities.⁴⁴ Thus most local insurance assets are invested in local capital markets. With the exception of Hong Kong SAR (which follows prudent man rules) and, to some extent, Singapore, most countries have a strong bias toward fixed-income instruments, since many regulations explicitly limit investments in equity and real estate and prohibit investment in foreign instruments.

Increasingly, insurers in emerging markets are beginning to use asset and liability management principles and risk management tools to make their strategic asset allocation decisions. However, the lack of long-term, fixed-income instruments and relative illiquidity in bond and equity markets constitutes the biggest hurdle to the management of duration gaps. In Korea, for example, a typical life insurer’s liability has an average duration of 7 years, while the average duration of its assets is only 3½ years. Similar duration gaps exist in many other emerging markets. Faced with such a gap, insurers have relatively few options to increase asset duration and most strive to invest in the long-end of the local fixed-income market. As a result, insurance companies are the largest investors in the 10-year segment of the local bond market. Also, while insurers provide a stable demand for local long bonds, their buy-and-hold behavior constrains liquidity in the secondary markets. This, in turn, makes portfolio adjustment costly and hinders asset and liability management. The paucity of interest rate derivatives and long-term swaps also constrains such activities.

Many insurers thus choose to manage duration gaps through the liability side by repricing existing products and offering new products of shorter duration. In particular, unit-linked products are gaining popularity in many emerging Asian and European markets.⁴⁵ In Hungary, for example, two-thirds of the new life insurance contracts are unitlinked products, while in Poland, one-third of life insurance products are unit-linked (Dorfman and Ennsfellner, 2002). These products usually carry a low minimum return with a “bonus” component depending on the equity market performance. The existence of the “bonus” effectively lowers the duration of the liability. By some estimates, a 20-year unitlinked life product has an effective duration of only six years. The emergence of unitlinked life products has transferred some market risk to policyholders and thus facilitates asset and liability management; however, such products pose certain competitive pressure to the mutual fund industry where traditional products carry no minimum return at all.

In a number of Latin American countries, a significant share of life insurance contracts are specified in foreign currency. This “dollarization” of liabilities is a consequence of the region’s history of high inflation and exchange rate volatility. As a result, Mexican regulators, for instance, require that dollarlinked liabilities be matched with dollar-linked assets, making insurance companies one of the largest holders of sovereign dollar-denominated external debts (see Oswald and Sekiguchi, 2002). Although this offers significant support for these instruments, external diversification for the Mexican insurance industry is limited to portfolio investments in foreign-currency-denominated securities issued by Mexican entities.⁴⁶ In contrast, Colombia’s regulatory framework does not have formal guidelines on asset-liability management. Nevertheless, even local insurance companies hold more than 20 percent of their assets in foreign-currency-denominated assets. Unlike the case of Mexico, Colombian insurance companies can invest in foreign currency debt instruments of any sovereign or corporate that is investment grade.

Most emerging markets have adopted solvency requirements for insurance companies that are based on or similar to those of the European Union directives (see OECD, 2001). A few economies, including Singapore, Indonesia, Malaysia, and Taiwan Province of China, have adopted risk-based capital (RBC) regimes that are similar to the U.S. and Japanese systems.⁴⁷ Under the European system, only underwriting risk is included in the calculation of the solvency requirement, while the U.S. and Japanese system explicitly accounts for investment and asset and liability mismatching risks in addition to the underwriting risk.⁴⁸ Given the growing importance of investment risks, analysts have argued that the European system does not adequately address the risks in insurance operation.⁴⁹ Under the European system, investment risks are controlled by means of investment regulations on a particular investment, asset class, or region. Consequently, regulators in many emerging market economies prescribe specific investments as well as the percentage of their assets that insurers are permitted to invest in each.

Moreover, many emerging market regulations do not provide specific guidance on asset and liability management, and this could lead to excessive risk taking. While subsidiaries of global insurance companies in emerging markets normally have to adhere to internal risk control guidelines on asset and liability management, local insurers usually lack such expertise and guidance. Therefore, some local insurers seek yield enhancement at the expense of asset and liability management. For example, in Hungary, market participants noted that during the recent turmoil in the local bond market that sent the short-term interest rates soaring, most local subsidiaries of global insurers continued to invest in the long end of the yield curve to minimize the duration gap. However, local insurers reportedly shifted their allocations to the short end of the curve to pick up yield at the expense of increasing their duration gap. When solvency requirements only account for underwriting risk, asset-liability mismatches do not cost the insurer in terms of statutory capital; market participants refer to this as “free risk.” In the past, U.S. and Canadian life insurers faced similar situations, when competitive pressure drove insurance companies to incur asset and liability mismatches (and associated market and credit risks) while seeking higher returns (Briys and de Varenne, 1996). A large number of insurance companies failed in the United States in the late 1980s and early 1990s, while a few also went bankrupt in Canada in the early 1990s. These failures eventually led to changes in the U.S. and Canadian insurance regulations in the mid1990s. (For the experience of insurance companies during recent emerging market crises, see Box 4.4.)

As in the mature markets, regulations in several emerging markets dictate minimum guaranteed returns on insurance products. However, only a few countries (including Thailand, Croatia, and Korea) reportedly have guaranteed returns that are higher than market rates. Moreover, in Thailand, policyholders are not only given guaranteed returns at maturity but they also enjoy guaranteed surrender values. During a rising interest rate environment, customers with products that are locked at guaranteed returns below the current market rate could simply cash out with the guaranteed surrender value and shop for better rates. This could force the insurers selling their bond portfolio at a loss. In a declining rate environment, many insurers have to re-calculate their liabilities on the historical products that were offered at a high guaranteed return with a lower discount rate. This re-calculation has reportedly caused many insurers to raise reserves to meet solvency requirements, which again could lead to undesirable portfolio adjustment.

Insurance regulations do not require the marking-to-market of assets on a daily basis and usually liabilities are not marked-to-market at all, thereby differentiating insurers from other institutional investors in emerging markets as well. While in most countries regulatory valuation principles prescribe for marking assets to market, the reporting for insurers is usually on quarterly basis (Dickinson, 2002). Thus, insurers can at times “sit through” short-term market turbulence, thus providing stability to the market, as long as their solvency is not threatened.⁵⁰ This perhaps makes them a more diversified and stable investor. Furthermore, most insurers are not benchmarked against any particular index, so the risk of “herding” with other investors during drastic market swings is mitigated. But most regulations only require using market value for assets but not for liabilities. The asymmetric mark-to-market requirement on the two sides of the balance sheet could have undesirable consequences. For example, in Singapore, reports indicated that during the recent equity market downturn, many insurers suffered losses on their equity holdings. While their liabilities linked to equity market performance would have been correspondingly lower, the regulation does not provide for re-calculating the liability based on the market value. Consequently, some insurers appeared to have insufficient capital due to the decline in their assets and, to meet the solvency requirements, had to sell equities in a falling market.⁵¹,⁵²

Box 4.4.

The Impact of Emerging Market Crises on Insurance Companies

Financial crises worsen the operating results and balance sheets of all financial intermediaries, but the effects are particularly severe for insurance companies. A financial crisis is usually accompanied by a sharp decline in output, a massive devaluation, increasing inflation and interest rates, and a collapse in asset values. The consequences of these drastic economic changes for the insurance industry are manifold: demand for insurance products drops, resulting in lower premiums and a rise in early terminations of existing contracts; claims increase due to higher inflation and an adverse environment; insurers’ assets decline in value; and rising inflation requires higher reserve on the liability side. Thus, a financial crisis poses a major threat to the solvency and liquidity of the insurance industry.

This has become rather clear after recent emerging market crises, as noted in a recent study by Swiss Re (2003). Life insurers suffered not only from a decline in new business, but also from an increase in lapses—nonpayment of premiums on existing life products. As the Table shows, new business collapsed during the year of the crisis and lapse ratios increased by almost three-fold in the year after the crisis. In Argentina, probably due to the expectation of a future crisis, the lapse ratio steadily increased beginning two years before the crisis. Savings-type policies were the most sensitive to changes in income and wealth and thus experienced the most pronounced decline in premiums. The increase in lapses was more significant in Indonesia and Argentina, where a majority of life products were denominated in U.S. dollars. In Argentina, contracts with a savings component were mostly cancelled once the parity was broke and the majority of new products sold after the crisis were one-year local-currencydenominated pure insurance products—a major setback to a once sophisticated insurance market.

Financial Crises and Emerging Market Insurers

Source: Swiss Re (2003). T refers to the year of the financial crisis. It is 1998 for Indonesia and Thailand, and 2002 for Argentina.

Financial Crises and Emerging Market Insurers

		T-2	T-1	T	T + 1	T + 2
New business, percent change (year on year)
	Indonesia	25.4	21.6	−12.6	0.9	34.4
	Thailand	10.1	−16.3	−29.1	37.9	40.5
Lapse ratios, in percent
	Indonesia	3.7	2.6	5.5	12.8	7.9
	Thailand	3.2	3.4	5.4	9.2	8.3
	Argentina	9.6	15.4	31.3

Source: Swiss Re (2003). T refers to the year of the financial crisis. It is 1998 for Indonesia and Thailand, and 2002 for Argentina.

View Table

Financial Crises and Emerging Market Insurers

		T-2	T-1	T	T + 1	T + 2
New business, percent change (year on year)
	Indonesia	25.4	21.6	−12.6	0.9	34.4
	Thailand	10.1	−16.3	−29.1	37.9	40.5
Lapse ratios, in percent
	Indonesia	3.7	2.6	5.5	12.8	7.9
	Thailand	3.2	3.4	5.4	9.2	8.3
	Argentina	9.6	15.4	31.3

Source: Swiss Re (2003). T refers to the year of the financial crisis. It is 1998 for Indonesia and Thailand, and 2002 for Argentina.

Balance sheet pressure threatened the solvency of many insurers and sometimes lead to a costly restructuring process. Virtually all local assets lost in value, and claims were higher, which required higher reserves relative to premiums. Equity relative to capital declined. Thus, solvency, measured as the capital-to-reserve and the capital-to-premium ratio, was in question. Furthermore, insufficient asset and liability management that led to large asset-liability mismatches for the life insurers and poor risk management practices have aggravated the adverse impact and resulted in a few bankruptcies, as in Korea.

The crises hit local and foreign insurers alike, but the latter were generally better equipped to withstand episodes of financial crisis. First, foreign insurers’ better diversified investment portfolio and more sophisticated asset and liability management helped them to weather the financial storm. Second, they could always rely on additional capital from the parent company to shore up the balance sheet. As a result, in a few countries, such as Mexico, Indonesia, and Thailand, foreign insurers picked up market share after the crisis.

To remain liquid and solvent through a financial crisis, insurers need to protect their balance sheets and design products that can cope with a volatile environment. Proper asset and liability management is the key to maintaining a strong balance sheet, while creating a well-diversified portfolio and buying reinsurance to transfer away part of the risk are also beneficial. As the insurer’s ability to conduct asset and liability management is constrained by the development of local capital markets as well as regulatory limits, a few countries recently have relaxed the investment regulations. From the liability side, insurers could move away from guaranteed benefits to unit linked products to reduce the investment risk.

Local Mutual Funds

As in the mature markets, mutual funds in emerging markets have been among the fastest-growing institutional investors (Table 4.6). Indeed, mutual fund assets under management in emerging markets grew by 96 percent between the end of 1997 and June 2003 and, as a result, rose from 8 percent of GDP to 15 percent. One key difference between mutual funds in mature and emerging markets has been the relative importance of bond and equity funds. In the mature markets, the assets under management of equity funds are often much larger than those of bond funds (particularly in Japan, the United Kingdom, and the United States). In contrast, emerging market bond funds in a number of countries have larger assets under management than do equity funds, particularly in Brazil, Mexico, Korea, and Taiwan Province of China. In part, this reflects the difference in the relative development of the local markets in mature and emerging markets. In many emerging markets, the degree of liquidity of local government bond markets is markedly better than in local equity markets.⁵³ In addition, this difference reflects a search for higher yields on the part of retail investors. As nominal interest rates have declined in many emerging markets since the late 1990s, retail investors have seen extended declines in the interest earned on traditional savings instruments, such as bank time deposits. To obtain higher yields, retail investors subscribed to bond funds that invested in longer-term government and corporate bonds.

Table 4.6.

Emerging Market Mutual Funds: Total Net Assets¹

Sources: Bloomberg; Federation of Malaysian Unit Trust Managers; Investment Company Institute; Monetary Authority of Singapore; Stock Exchange of Thailand; Superintendencia Bancaria; and Superintendencia Valores Colombia.

¹Funds of funds are not included; home-domiciled funds except for Hong Kong SAR, Korea, New Zealand, and Singapore, which include home- and foreign-domiciled funds.

²As of the end of June 2003.

Table 4.6.

Emerging Market Mutual Funds: Total Net Assets¹

	1997	1998	1999	2000	2001	2002	20032
	(In billions of U. S. dollars)
Emerging markets	349.25	514.07	700.17	673.05	687.40	693.45	685.49
Africa	12.69	12.16	18.24	16.92	14.56	20.98	25.70
South Africa	12.69	12.16	18.24	16.92	14.56	20.98	25.70
Asia	216.50	370.82	518.63	463.11	466.82	501.33	428.01
Hong Kong SAR	58.46	98.77	182.27	195.92	170.07	164.32	201.15
India	9.35	8.69	13.07	13.83	13.49	n.a.	n.a.
Korea	53.11	165.03	167.18	110.61	119.44	149.54	133.76
Malaysia	8.66	10.19	11.39	11.39	12.46	14.13	18.63
Philippines	n.a.	n.a.	0.12	0.11	0.21	0.47	0.63
Singapore	74.55	67.84	109.85	95.94	97.91	105.74	n.a.
Taiwan Province of China	12.37	20.31	31.15	32.07	49.74	62.15	66.83
Thailand	n.a.	n.a.	3.61	3.23	3.49	4.97	7.00
East Europe	1.66	2.57	4.14	5.67	4.35	18.55	25.88
Czech Republic	0.36	0.56	1.47	1.99	1.78	3.30	4.12
Hungary	0.71	1.48	1.73	1.95	2.26	3.38	4.55
Poland	0.54	0.51	0.76	1.55	n.a.	5.47	7.50
Romania	n.a.	n.a.	n.a.	0.01	0.01	0.03	0.03
Russia	0.04	0.03	0.18	0.18	0.30	0.37	0.61
Turkey	n.a.	n.a.	n.a.	n.a.	n.a.	6.00	9.07
Latin America	118.40	128.53	159.17	187.34	201.68	152.58	205.90
Argentina	5.25	6.93	6.99	7.43	3.75	1.02	1.32
Brazil	108.61	118.69	117.76	148.54	148.19	96.73	143.79
Chile	4.55	2.91	4.09	n.a.	5.09	6.71	6.14
Colombia	n.a.	n.a.	10.87	11.97	12.92	15.63	16.89
Costa Rica	n.a.	n.a.	n.a.	0.92	n.a.	1.74	2.17
Mexico	n.a.	n.a.	19.47	18.49	31.72	30.76	35.59
	(In percent of GDP)
Emerging markets	7.74	12.51	17.81	15.66	16.45	16.80	14.96
Africa	8.52	9.10	13.92	13.21	12.74	20.08	16.27
South Africa	8.52	9.10	13.92	13.21	12.74	20.08	16.27
Asia	12.18	24.86	31.42	26.07	27.34	27.84	22.26
Hong Kong SAR	33.66	59.77	113.46	118.48	104.44	101.74	126.36
India	2.30	2.12	2.99	3.00	2.83	n.a.	n.a.
Korea	11.15	52.05	41.17	23.97	27.96	31.37	25.96
Malaysia	8.65	14.12	14.38	12.64	14.16	14.90	18.41
Philippines	n.a.	n.a.	0.15	0.14	0.29	0.61	0.77
Singapore	78.16	82.82	134.98	104.87	115.37	121.58	n.a.
Taiwan Province of China	4.25	7.60	10.82	10.36	17.69	22.07	23.14
Thailand	n.a.	n.a.	2.95	2.64	3.03	3.93	5.35
East Europe	0.19	0.33	0.60	0.75	0.55	2.07	2.37
Czech Republic	0.68	0.98	2.68	3.87	3.11	4.74	4.88
Hungary	1.56	3.13	3.59	4.18	4.36	5.14	5.51
Poland	0.36	0.31	0.47	0.94	n.a.	2.89	3.63
Romania	n.a.	n.a.	n.a.	0.02	0.02	0.06	0.06
Russia	0.01	0.01	0.09	0.07	0.10	0.11	0.14
Turkey	n.a.	n.a.	n.a.	n.a.	n.a.	3.37	3.83
Latin America	6.95	7.57	10.91	11.46	12.85	11.49	14.61
Argentina	1.79	2.32	2.47	2.61	1.40	1.10	1.03
Brazil	13.44	15.11	22.47	24.76	29.09	21.81	28.36
Chile	5.51	3.67	5.61	n.a.	7.46	10.09	8.81
Colombia	n.a.	n.a.	13.43	15.25	15.75	22.14	23.26
Costa Rica	n.a.	n.a.	n.a.	5.76	n.a.	10.27	12.19
Mexico	n.a.	n.a.	4.05	3.18	5.08	4.83	5.79

Sources: Bloomberg; Federation of Malaysian Unit Trust Managers; Investment Company Institute; Monetary Authority of Singapore; Stock Exchange of Thailand; Superintendencia Bancaria; and Superintendencia Valores Colombia.

¹Funds of funds are not included; home-domiciled funds except for Hong Kong SAR, Korea, New Zealand, and Singapore, which include home- and foreign-domiciled funds.

²As of the end of June 2003.

View Table

Table 4.6.

Emerging Market Mutual Funds: Total Net Assets¹

	1997	1998	1999	2000	2001	2002	20032
	(In billions of U. S. dollars)
Emerging markets	349.25	514.07	700.17	673.05	687.40	693.45	685.49
Africa	12.69	12.16	18.24	16.92	14.56	20.98	25.70
South Africa	12.69	12.16	18.24	16.92	14.56	20.98	25.70
Asia	216.50	370.82	518.63	463.11	466.82	501.33	428.01
Hong Kong SAR	58.46	98.77	182.27	195.92	170.07	164.32	201.15
India	9.35	8.69	13.07	13.83	13.49	n.a.	n.a.
Korea	53.11	165.03	167.18	110.61	119.44	149.54	133.76
Malaysia	8.66	10.19	11.39	11.39	12.46	14.13	18.63
Philippines	n.a.	n.a.	0.12	0.11	0.21	0.47	0.63
Singapore	74.55	67.84	109.85	95.94	97.91	105.74	n.a.
Taiwan Province of China	12.37	20.31	31.15	32.07	49.74	62.15	66.83
Thailand	n.a.	n.a.	3.61	3.23	3.49	4.97	7.00
East Europe	1.66	2.57	4.14	5.67	4.35	18.55	25.88
Czech Republic	0.36	0.56	1.47	1.99	1.78	3.30	4.12
Hungary	0.71	1.48	1.73	1.95	2.26	3.38	4.55
Poland	0.54	0.51	0.76	1.55	n.a.	5.47	7.50
Romania	n.a.	n.a.	n.a.	0.01	0.01	0.03	0.03
Russia	0.04	0.03	0.18	0.18	0.30	0.37	0.61
Turkey	n.a.	n.a.	n.a.	n.a.	n.a.	6.00	9.07
Latin America	118.40	128.53	159.17	187.34	201.68	152.58	205.90
Argentina	5.25	6.93	6.99	7.43	3.75	1.02	1.32
Brazil	108.61	118.69	117.76	148.54	148.19	96.73	143.79
Chile	4.55	2.91	4.09	n.a.	5.09	6.71	6.14
Colombia	n.a.	n.a.	10.87	11.97	12.92	15.63	16.89
Costa Rica	n.a.	n.a.	n.a.	0.92	n.a.	1.74	2.17
Mexico	n.a.	n.a.	19.47	18.49	31.72	30.76	35.59
	(In percent of GDP)
Emerging markets	7.74	12.51	17.81	15.66	16.45	16.80	14.96
Africa	8.52	9.10	13.92	13.21	12.74	20.08	16.27
South Africa	8.52	9.10	13.92	13.21	12.74	20.08	16.27
Asia	12.18	24.86	31.42	26.07	27.34	27.84	22.26
Hong Kong SAR	33.66	59.77	113.46	118.48	104.44	101.74	126.36
India	2.30	2.12	2.99	3.00	2.83	n.a.	n.a.
Korea	11.15	52.05	41.17	23.97	27.96	31.37	25.96
Malaysia	8.65	14.12	14.38	12.64	14.16	14.90	18.41
Philippines	n.a.	n.a.	0.15	0.14	0.29	0.61	0.77
Singapore	78.16	82.82	134.98	104.87	115.37	121.58	n.a.
Taiwan Province of China	4.25	7.60	10.82	10.36	17.69	22.07	23.14
Thailand	n.a.	n.a.	2.95	2.64	3.03	3.93	5.35
East Europe	0.19	0.33	0.60	0.75	0.55	2.07	2.37
Czech Republic	0.68	0.98	2.68	3.87	3.11	4.74	4.88
Hungary	1.56	3.13	3.59	4.18	4.36	5.14	5.51
Poland	0.36	0.31	0.47	0.94	n.a.	2.89	3.63
Romania	n.a.	n.a.	n.a.	0.02	0.02	0.06	0.06
Russia	0.01	0.01	0.09	0.07	0.10	0.11	0.14
Turkey	n.a.	n.a.	n.a.	n.a.	n.a.	3.37	3.83
Latin America	6.95	7.57	10.91	11.46	12.85	11.49	14.61
Argentina	1.79	2.32	2.47	2.61	1.40	1.10	1.03
Brazil	13.44	15.11	22.47	24.76	29.09	21.81	28.36
Chile	5.51	3.67	5.61	n.a.	7.46	10.09	8.81
Colombia	n.a.	n.a.	13.43	15.25	15.75	22.14	23.26
Costa Rica	n.a.	n.a.	n.a.	5.76	n.a.	10.27	12.19
Mexico	n.a.	n.a.	4.05	3.18	5.08	4.83	5.79

Sources: Bloomberg; Federation of Malaysian Unit Trust Managers; Investment Company Institute; Monetary Authority of Singapore; Stock Exchange of Thailand; Superintendencia Bancaria; and Superintendencia Valores Colombia.

¹Funds of funds are not included; home-domiciled funds except for Hong Kong SAR, Korea, New Zealand, and Singapore, which include home- and foreign-domiciled funds.

²As of the end of June 2003.