Forces For Stabilization - pension funds

International Economy, The, Jan, 2001 by George R. Hoguet

How U.S. pension funds can help avert future financial crises.

Roughly two years have passed since the global financial crisis triggered by the Russian default, the collapse of Long Term Capital Management, the of capital controls by Malaysia, and the large devaluation in Brazil. While economists have debated the causes of the crisis, and the international community has moved to reform the International Monetary Fund and The World Bank, little has been written about the fundamental role pensions--especially in the United States--can play in the prevention of future financial crises.

The causes of the crisis, and the wholesale contraction in bank lending in 1997-98, have been exhaustively analyzed, with several different theories emerging. Many commentators have focused on unsustainable macroeconomic policies in the affected countries: very high current account deficits as a percent of GDP, pegged exchange rates, and excessive growth in money supply and aggregate demand. Others have focused on economic weakness in Europe and Japan in the 1990's, which led commercial banks to seek lending opportunities elsewhere, and the "herd" behavior of investors. Another school holds that the policies of the IMF dramatically worsened the situation in Indonesia, Thailand, and Korea. And many commentators blame "crony" capitalists for extracting subsidies and monopoly rents from governments. Almost all critics agree, however, that a common characteristic among the affected countries was excessive reliance on debt, versus equity, finance, arising in part from the reluctance of owners to sell equity.

Although a key factor in the crisis was the misallocation of capital by lenders and corporate managers, only some of the post-crisis reform efforts have focused on private sector activity in developed markets. And what discussion there has been has focused largely on commercial lenders and bondholders as opposed to equity investors. Yet international equity investors--and fund managers in particular--have a role to play in stabilizing the global economy. U.S. pension funds, which are an increasingly important force in the global economy, can contribute to the avoidance of future emerging market crises by playing an informed and carefully modulated role on corporate governance issues involving major emerging market companies. Dialogue with the managements of these companies may lead to both higher investment returns and better allocation of capital, thereby reducing the severity, if not the occurrence, of future financial crises.

At the end of 1999, U.S. pension funds held assets of $8 trillion. State and local government pension funds control in excess of $3 trillion in assets, with the balance held by private funds. More than eighty-six million Americans own stock via a private pension fund, and perhaps twenty million more participate in public funds. About half of all private fund assets are invested in Defined Benefit Plans.

U.S. pension fund assets represent roughly 60 percent of world pension fund assets of $13.3 trillion. Approximately 11 percent, or $875 billion, of U.S. pension fund assets are invested in foreign equities. Since non-U.S. equities have an estimated market capitalization of $11.7 trillion, U.S. pension funds must be considered a major institutional force in the global allocation of capital. Furthermore, investments in non-U.S. equities by U.S. pension funds are expected to grow substantially. UK pension funds, for example, hold about 26 percent of their assets overseas.

This trend is also seen in the emerging markets, where it is estimated that U.S. pension funds have in excess of $50 billion invested out of a total market capitalization of approximately $1.2 trillion. Moreover, a significant portion of this money is indexed, and index money is, by definition, the very opposite of "hot" money.

As of September 30, 2000, The Morgan Stanley Capital International (MSCI) Emerging Markets Free Index capitalization of $1.1 trillion represents about 5.25 percent of world market capitalization of $21.39 trillion, as measured by the MSCI All Country World Index. There are twenty-six countries in the index. Six countries--Korea, Taiwan, Mexico, Brazil, South Africa, and India--represent 60 percent of index capitalization. Note that three of the top six countries have experienced severe financial crises since 1994.

The largest 100 companies in the index represent roughly 66 percent of its capitalization, and the top ten represent nearly 23 percent. The largest emerging market companies such as Telmex, Samsung, and Taiwan Semiconductor have capitalizations in excess of $38 billion, or roughly the size of the seventy-fifth largest company in the S&P 500.

The case for investing in emerging markets rests on three pillars: diversification, return enhancement, and broader investment opportunity set. An investor in emerging markets is able to create a more efficient portfolio (higher level of return for a given level of risk) and to increase the number of stocks from which to choose. The emerging markets represent a modest portion of the world market portfolio, and some investors believe that, given the volatility of emerging markets, they are not worth the effort. But with the relentless forces of globalization--and especially with the introduction of China onto the global economic scene--it is possible that the percent of the world market portfolio represented by the emerging markets will grow.