Pension Funds and Corporate Governance in Developing Countries: What do We Know and What do We Need to Know? Mario Catalán Johns Hopkins University WORLD BANK (Pension Reform) October 22nd, 2003

Introduction and Motivation ¾ There was an impressive WAVE OF PENSION REFORMS FROM PAY-AS-YOU-GO TO FUNDED SYSTEMS in the period 1980-2000. IN LATIN AMERICA: Chile (1981), Peru (1991), Argentina (1994), Colombia (1994), Uruguay (1996), Bolivia (1997), Mexico (1997), El Salvador (1998) PAY-AS-YOU-GO

FUNDED

PUBLIC MANAGEMENT

PRIVATE MANAGEMENT OF PENSION FUNDS 2

Introduction and Motivation (II) LITERATURE

BENEFITS ASSOCIATED WITH PENSION REFORMS (AMONG OTHER)

MORE SAVINGS

FASTER CAPITAL ACCUMULATION AND GROWTH

CAPITAL MARKETS DEVELOPMENT (BOND AND STOCK MARKETS)

MORE EFFICIENT ALLOCATION OF (GIVEN) SAVINGS TO PRODUCTIVE INVESTMENT GROWTH 3

Purpose of this Paper To Review and Study the STOCK MARKETS DEVELOPMENT EFFECTS of Pension Reforms

FOCUS: THE CORPORATE GOVERNANCE CHANNEL

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The Stock Markets Development Effects of Pension Reforms THE LIQUIDITY CHANNEL STOCK MARKETS DEVELOPMENT EFFECTS OF PENSION REFORMS (CHANNELS)

THE INNOVATION AND TRANSACTION COSTS REDUCTION CHANNEL THE CORPORATE GOVERNANCE CHANNEL

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The Corporate Governance Channel ARGUMENT

¾ Pension Funds (Quickly) Become LARGE SHAREHOLDERS OF PUBLICLY TRADED FIRMS in Thin Stock Markets. ¾ Being Large Owners, PENSION FUNDS HAVE AN INCENTIVE TO MONITOR THE MANAGERS OF PUBLICLY TRADED FIRMS. DEFINITION OF THE CORPORATE GOVERNANCE CHANNEL

¾ All Pension Funds’ Actions Aimed at Discouraging the Expropriative Activities of Managers of Publicly Traded Firms. ¾ Management Activities are “Expropriative” if They are Not Aimed at Maximizing Shareholder Value. 6

DEFINITION OF THE CORPORATE GOVERNANCE CHANNEL

PENSION FUNDS’ ACTIONS AIMED AT IMPROVING CORPORATE GOVERNANCE (Shareholder Value Maximization)

MONITORING OF MANAGEMENT

Detection of Corporate Crime

LOBBYING FOR BETTER LEGISLATION

Legal Definition of Corp. Crime

LOBBYING FOR BETTER ENFORCEMENT

Enforcement of ProInvestor Laws

INITIATE LEGAL ACTION AGAINST MANAGERS

Enforcement in Specific Cases 7

Questions ¾ WHAT DO WE KNOW ABOUT THE CORPORATE GOVERNANCE CHANNEL IN DEVELOPING COUNTRIES? ¾ WHAT DO WE NEED TO KNOW? (What is the Research Agenda)? ¾ GIVEN WHAT WE KNOW, WHAT ARE THE POLICY LESSONS? ¾ PURPOSE OF THIS PAPER: ¾ ORGANIZE THE LITERATURE ON THE SUBJECT ¾ PROPOSE THE RESEARCH AGENDA ¾ IDENTIFY POLICY ISSUES 8

Outline ¾ 1) FACTS: The Macroeconomic and Stock Market Significance of Pension Funds in Different Countries ¾ 2) WHAT DO WE KNOW ABOUT THE STOCK MARKETS DEVELOPMENT EFFECT? Does Pension Reform Spur Stock Markets Development? ¾ 3) WHAT DO WE KNOW AND NEED TO KNOW ABOUT THE CORPORATE GOVERNANCE CHANNEL? ¾ 4) THE POLITICAL ECONOMY OF PENSION AND CORPORATE GOVERNANCE REFORM ¾ 5) WHO WATCHES THE WATCHERS MANAGEMENT COMPANIES)? ¾ 6) Conclusions

(PENSION

FUND

9

1) Facts: The Macroeconomic and Stock Markets Significance of Pension Funds

Macroeconomic Significance

Pension Funds’ Assets as Percentage of GDP

Stock Market Significance

Pension Funds’ Equity Holdings of Publicly Traded Firms as Percentage of Stock Market Capitalization

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Figure 1A: Macroeconomic and Stock Market Significance of Pension Funds - OECD Countries (1999), Latin American Countries (2000) 8.8

Chile Bolivia (*)

28.7

2.5

Argentina

7.2

6.2 5.1

Perú Mexico

47.7

0.0

0.0

Latin America

4.9

Colombia

1.0 4.3

Uruguay

0.0 4.1 8.0

Netherlands

119.3

11.2

Switzerland

110.2 22.3

UK Iceland

25.9

75.4

19.6

Australia

66.1

5.3

Finland

53.4 11.4

Canada

47.4

NA

45.0 5.7

Sweden

39.0

9.4

Spain

`

Pension Funds' Assets as a Percentage of GDP

27.9 25.2 24.7

Denmark NA

Luxembourg

19.7 5.7

Japan NA

Greece Portugal Belgium

5.1

Norway

3.7 7.6 NA

Italy

0.2

Austria

18.7

Pension Funds' Equity as a Percentage of Stock Marker Capitalization

12.7 5.8

France

OECD

85.8

US

Ireland

86.8

15.4

12.0

9.5

5.6 5.2

0.0 3.6

Germany 0.03.4 Korea

0.3 3.2

Hungary

0.7 2.2

Czech Republic

1.0 2.0

0.0

20.0

40.0

60.0 %

80.0

100.0

120.0

Source: Figure / Table 1B and Table 1.

Figure / Table 1B: Pension Funds Macroeconomic and Stock Market Significance in OECD Countries (1999)

Australia Austria Belgium Canada (*) Czech Republic Denmark (*) Finland (**) France (***) Germany (*) Greece (***) Hungary Iceland Ireland (***) Italy Japan (**) (0) Korea (*) (**) Luxembourg (***) Netherlands (1) Norway Portugal (*) Spain (2) Sweden (*) Switzerland (3) (*) UK US (*)

GDP Mill USD 391,656 208,557 249,202 657,856 54,549 171,904 126,870 1,433,142 2,092,549 119,335 47,645 8,353 94,940 1,172,335 4,515,312 406,265 18,439 395,612 157,268 114,251 597,748 250,332 256,436 1,456,473 9,274,300

MC Mill USD 427,683 33,025 184,942 800,914 11,796 105,293 349,409 1,475,457 1,432,190 204,213 16,317 4,807 68,773 728,273 4,546,937 395,667 35,940 695,209 63,696 66,488 431,668 373,278 693,127 2,933,280 16,635,114

E AUM/GDP Mill USD % 83,954 66.1 16 3.6 9,412 9.5 91,309 47.4 118 2.0 26,580 24.7 18,664 53.4 NA 5.6 36 3.4 NA 12.7 110 2.2 742 85.8 NA 45.0 1,635 5.2 260,686 18.7 1,172 3.2 NA 19.7 55,552 119.3 2,357 7.6 3,856 12.0 40,585 27.9 21,162 39.0 77,936 110.2 654,596 86.8 4,312,000 75.4

E/MC MC/GDP % % 19.6 109.2 0.0 15.8 5.1 74.2 11.4 121.7 1.0 21.6 25.2 61.3 5.3 275.4 103.0 NA 0.0 68.4 171.1 NA 0.7 34.2 15.4 57.6 72.4 NA 0.2 62.1 5.7 100.7 0.3 97.4 194.9 NA 8.0 175.7 3.7 40.5 5.8 58.2 9.4 72.2 5.7 149.1 11.2 270.3 22.3 201.4 25.9 179.4

Notes: GDP: Gross Domestic Product, MC: Market Capitalization, E: Pension funds' holding of shares issued by domestic residents. AUM: Assets under management of pension funds. (*) E includes the total amount of shares held by pension funds (issued by domestic and foreign residents). The amount of foreign shares in pension fund portfolios is usually small. (**) AUM includes only financial assets. The amount of non-financial assets is usually negligible. (***) The figure for AUM/GDP corresponds to 1996 and is based on OECD (1998). (0) The figure for AUM/GDP in Japan is based on Institutional Investors Statistical Yearbook (2001). There is a substantial gap between the 1 figure that is obtained in this way and the OECD (1998) figure for 1996, which is 41.8%. (1) AUM includes only autonomous pension funds and excludes the non-supervised pension funds, which are a small fraction of the total. (2) The Institutional Investors Yearbook consolidates the assets of pension funds and insurance companies. (3) AUM in 1998 is shown in the table. Sources: IFS, Institutional Investors Statistical Yearbook (2001), OECD (1998), Emerging Stock Markets Factbook (2002)

Table 1: Private Pension Funds and Stock Markets in Latin America Country

GDP

MC

AUM

E

MF

Million USD Million USD Million USD Million USD Million USD

Chile Perú Colombia Argentina Uruguay Bolivia (*) Mexico Country

(1)

(2)

75,200 53,428 82,700 284,204 20,051 8,334 579,910

60,401 10,562 9,560 166,068 161 1,742 125,204

GDP

MC

(3)

(4)

(5)

35,869 2,750 3,580 20,381 816 2,395 28,201

4,412 660 91 2,507 -

1,671 -

AUM

E

MF

Country

66,300 54,050 82,300 268,697 18,540 7,947 625,640

56,310 11,134 13,217 192,499 153 1,555 126,258

GDP

MC

3,615 741 247 1,767 -

3,638 -

AUM

E

MF

Chile Perú Colombia Argentina Uruguay Bolivia (*) Mexico

NA NA NA NA NA NA NA

47,584 13,363 9,664 103,434 NA NA 103,137

35,832 4,083 5,327 11,923 804 2,749 47,688

3,225 1,143 283 906 -

%

%

%

%

(7)

(8)

(9)

(10)

80.3 19.8 11.6 58.4 0.8 20.9 21.6

47.7 5.1 4.3 7.2 4.1 28.7 4.9

2001 MC/GDP

AUM/GDP

%

%

851

788

53.5 6.1 5.8 7.7 5.6 31.6 6.9

2002 MC/GDP

AUM/GDP

%

%

167 -

NA NA NA NA NA NA NA

59.4 26.0 37.4 12.3 506.8 137.5 22.5

14.8 24.0 2.5 20.5 -

8.8 6.2 1.0 2.5 -

AUM/MC (E+MF)/AUM (E+MF)/MC %

84.9 20.6 16.1 71.6 0.8 19.6 20.2

-

Million USD Million USD Million USD Million USD Million USD

AUM/MC (E+MF)/AUM (E+MF)/MC

%

897

35,441 3,307 4,786 20,786 1,045 2,508 42,867

AUM/GDP

(6)

-

Million USD Million USD Million USD Million USD Million USD

Chile Perú Colombia Argentina Uruguay Bolivia (*) Mexico

2000 MC/GDP

%

62.9 29.7 36.2 10.8 683.0 161.3 34.0

%

12.6 22.4 5.2 26.0 -

7.9 6.7 1.9 2.8 -

AUM/MC (E+MF)/AUM (E+MF)/MC %

NA NA NA NA NA NA NA

%

75.3 30.6 55.1 11.5 NA NA 46.2

%

11.2 28.0 5.3 9.0 -

8.4 8.6 2.9 1.0 -

Notes: The symbol (-) indicates the number "0", and NA indicates that the information is "not available". GDP: Gross Domestic Product; MC: Market Capitalization (Year End); AUM: Assets Under Management of Private Pension Funds (Year End); E: Equity in Private Pension Funds' Portfolios (Year End); MF: Mutual Funds in Private Pension Funds" Portfolios (Year End). Average annual exchange rates were used to convert the GDP figures in domestic currency to USD. Argentina: The E and MF figures for the years 2001 and 2002 were obtained from the September shares of those assets in the total amount of AUM, and then applying those percentages to the AUM of December 2001 and 2002. Bolivia: The entire capitalization funds are invested in fixed income instruments. See Salomon Smith Barney (2002). Chile: The E and MF figures for all years were obtained from the September shares of those assets in the total amount of AUM, and then applying those percentages to the AUM of the December AUM figures. Mexico: By regulation, Pension Funds are not allowed to invest in equity. Peru: The E and MF figures for the years 2001 and 2002 were obtained from the September shares of those assets in the total amount of AUM, and then applying those percentages to the AUM of December 2001 and 2002. Sources: MC: Standard and Poors-IFC Emerging Stock Markets Factbook; AUM, E, MF: Salomon Smith Barney (2002); GDP and Exchange Rates: IFS. (*) The figures for E and MF exclude the assets in the capitalization fund.

Remarks ¾ Substantial Cross - Country Variation in Macroeconomic and Stock Market Significance ¾ Pension Funds can be Large in Terms of Assets over GDP, while Being Small as Equity-Holders ¾ Pension Funds are not Large Equity-Holders in Latin America, in Spite of the Thinness of the Latin American Stock Markets ¾ The Stock Market Significance of Pension Funds in Latin America is Always Below 10%, and is Less Than 3% in Five out of Seven Countries. ¾ This is Due to the Portfolio Allocations as well as the Immaturity of the New Pension Systems ¾ Substantial Effects Associated with The Corporate Governance Channel Unlikely (As of Year 2000)

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2) Does Pension Reform Spur Stock Markets Development?

¾ Relevant Question for Developing Countries with Mandatory and Private Funded Systems as well as Developed Countries with Publicly Managed Retirement Funds. ¾ The Answer is Not Obvious

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Quotation - Alan Greenspan Remarks Regarding the Possibility That US Social Security Trust Funds Might Be Partially Shifted From US Treasuries to Equity Investments “If social security trust funds are shifted in part, or in whole, from US Treasury securities to private debt and equity instruments, holders of those securities in the private sector must be induced to exchange them, net, for US Treasuries. If, for example, social security funds were invested wholly in equities, presumably they would have to be purchased from the major holders of such equities. Private pension and insurance funds, among other holders of equities, presumably would have to swap equities for Treasuries. But, if the social security trust funds achieved a higher return investing in equities than in lower yielding US Treasuries, private sector incomes generated by their asset portfolios, including retirement funds, would fall by the same amount, potentially jeopardizing their financial condition. This zero-sum result occurs because of the assumption that no new productive saving and investment has been induced by this portfolio reallocation process…”.

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“Irrelevance” Argument • Pension Reforms Are Irrelevant for Stock Market Development: One Should Expect No Stock Market Development Effect from Pension Reforms Even if Pension Funds Invest in Domestic Stock • Empirical Implication: One Should Observe No Correlation (Including Control Variables) Between Pension Fund and Stock Market Development Across Countries 14

Catalán, Impavido, Musalem (2000) • Pension Fund and Stock Market Development are Positively Correlated Across a Large Number Countries • Causality Analysis: The Development of Pension Funds Leads to Stock Market Development Also Walker and Lefort (2001)

Possibility of a Significant Corporate Governance Channel Still “Alive” 15

Figure 2: Pension Funds and Stock Market Development: Competing Hypotheses

Stock Market Development D(MC/GDP) or D(VT/GDP)

Pension Fund Relevance (CIM)

Greenspan’s “Irrelevance” Proposition

Note: D: Change in the Variable in a given period, PF: Pension Fund Assets, CS: Contractual Savings, MC: Stock Market Capitalization, VT: Stock Value Traded, GDP: Gross Domestic Product, (CIM): Catalán, Impavido and Musalem (2000).

Pension Funds Development D(PF/GDP) or D(CS/GDP)

3) Identifying the Corporate Governance Channel EFFECTS ON PRO-INVESTOR LEGISLATION FACT: PRO-INVESTOR LEGISLATION DOES FOLLOW PENSION REFORMS

• • • • • •

The Pro-Investor Laws in Argentina and Chile Require, Among Other Things: The Public Disclosure of Transactions That Involve Majority Shareholders The Independence of Auditors The Risk Rating of Publicly Traded Securities Regulate the Use of Privileged Information and the Transactions Between Insiders and Related Parties Gives More Rights To Minority Shareholders to Participate in Shareholders Meetings and Sue the Boards’ Decisions Mandate the Insiders’ Fiduciary Duty to Minority Shareholders Practices Typical in Countries Civil Law Traditions of Common Law Origin 16

EFFECTS ON ENFORCEMENT OF PRO-INVESTOR LAWS Non-Existent or Scanty Evidence of Enforcement of the New Legislation

Agosin and Pasten (2001) CHILE Restrictions on Pension Fund Activism

Two Cases of Legal Action Initiated by Pension Funds in Defense of Minority Shareholders - “Name and Shame” Strategies (Used by Calpers in USA) Prohibited in Chile - “Public Stands on Issues such as Executive Pay Prohibited in Chile 17

EFFECTS ON PERFORMANCE No Evidence More Monitoring by Pension Funds and Less “Expropriation” of Minority Shareholders’ Wealth

Empirical Analysis: Study Whether Stock Prices of Firms in Which Pension Funds Invested Increased

Improvements in Publicly Traded Firms’ Profitability Stock Prices Should Surge in Anticipation of Future Profits 18

4) The Corporate Governance Channel: Political Economy Issues Rajan and Zingales 2003 “Saving Capitalism from the Capitalists” Politically Powerful Financial Incumbents can Prevent Competition from Potential Entrants by Restricting their Access to Sources of Finance, i.e. By Blocking the Development of Domestic Financial Markets

Financial Incumbents (Banks and Insiders of Publicly Traded Firms)

...can block the Corporate Governance Reform and the Development of Financial Markets 19

¾ Mario Catalán (2003) ¾ Reforms can be interpreted as the outcome of a mutually beneficial agreement between two interest groups Labor Unions

...can block the Pension Reform

¾ Rationalizes Two Facts that Characterize the Latin American Pension Reforms: ¾Followed by PRO-INVESTOR LEGAL REFORMS aimed at improving investor protections in capital markets. ¾Governments restricted pension funds to hold domestic securities, i.e. imposed CAPITAL CONTROLS ON PENSION FUNDS 20

¾ The Capital Controls Create a Captive Source of Low Cost Funds for Domestic Publicly Traded Companies. ¾ This Explains why the Financial Incumbents are Willing to Accept the Pro-Investor Legal Reforms. This Arrangement Restricts the Capacity of Pension Funds to Act in the Pensioners’ Best Interests Pensioners: Ultimate Shareholders At Best There Can Be Good CONDITIONAL Corporate Governance RESTRICTED SHAREHOLDER VALUE AND PENSIONERS’ WELFARE MAXIMIZATION

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Ex-Ante, At the Pre-Pension Reform Stage Trade-off: Pensioners’ Welfare vs Corporate Governance and Capital Markets Development Effect No Capital Controls Tightest Capital Controls (No Foreign Investment)

Maximum Welfare Gains for Pensioners No Corporate Governance Reform and No Capital Markets Development Effect Minimum Welfare Gains for Pensioners Maximum Capital Markets Development Effect 22

International Diversification? Arguments Against Diversification ¾ Retirement Investments are for the Long Term (Dynamic Diversification of Domestic Risk) ¾ Externalities in Capital Accumulation that Justify the Capital Controls

Problems with These Arguments ¾ Burtless (1998) and Vittas and Alier (1998): Substantial Risk Remains Even After Long Investment Periods (40 Yrs) ¾ Optimal Investment Strategy is to Shift Towards Bonds as the Worker Approaches the Retirement Age ¾ Externalities: - No Evidence ¾ Externalities: - Would Have to Be Internalized by the Workers 23

• Corporate Governance Principles: The Pension System must Be Accountable Only to Workers/Affiliates • Objective of Pension Reform: Maximization of Workers/Pensioners Welfare

Design of Pension Reforms Latin American Countries (Ex-Post)

Pension Fund Specific Capital Controls Should Not Be Accepted Because They Can Only Be Interpreted as Part of a “Deal” Aimed at Developing Domestic Capital Markets Pension Fund Specific Capital Controls Should Be Lifted 24

5) Who Watches the Watchers? • FACT 1: Latin American Pension Fund Management Companies Are Owned by Banks (Main Owners BBVA, Santander and Citigroup) • FACT 2: Large Portfolio Allocations to Bank Deposits Potential Conflicts of Interest 25

Two Examples: ¾ Banking Panic: Pension Fund Managers Could Be Reluctant to Run Against the Banking System ¾ Banks-cum-Pension Fund Managers Could Use Deposits to Satisfy Banking Regulations

26

6) Conclusions What Do We Know? ¾ Pension Funds are NOT Large Stock Holders in Latin America. ¾ Pension Funds Can be Large in Terms of GDP and Small as Stock Holders. Pension Funds Development Does Not Guarantee Positive Stock Market or Corporate Governance Effects. ¾ Pension Reforms DO Lead to Pro-Investor Legal Reforms. ¾ No Convincing Evidence that Pension Funds Lobby for the Enactment of the Pro-Investor Laws. ¾ No Convincing Evidence that the New Pro-Investor Laws are Being Enforced Systematically and that Pension Funds Exert Pressure to Guarantee Enforcement. ¾ There is Some Evidence that Pension Funds Lead to Stock Market Development. 27

What Do We Know (Contn’d)? ¾ The Corporate Governance Channel has Not Been Filtered from Alternative Channels Through Which Pension Funds Could Develop Stock Markets. ¾ The Effective “Name and Shame” Tactics used by Pension Funds (such as Calpers) in Developed Countries do not Seem to Be Commonly Used in Latin American Countries. Regulators Often Restrict The Use of Such Tactics. ¾ Political Economy Issues and Conflicts of Interest are Highly Relevant in Latin America Due to the Concentration of Ownership and Power in Domestic Financial Systems. 28

What Do We Need to Know? ¾ We Need to Formulate More Precise Hypothesis and Find More Conclusive Evidence on the Link Between Pension Fund and Stock Market Development ¾ We Need to Filter the Corporate Governance Channel from the Liquidity and Transaction Cost Reduction Channels ¾ We Need to Know Whether Pension Funds Actually Play an Active and Direct Role in the Enactment of Pro-Investor Laws, or Such Laws are Natural Follow-Ups on Pension Reforms that are Enacted Under the Pressure of Labor Unions. ¾ Study the Link Pension Funds, the Ownership and the Performance of Public Firms ¾ Ask Whether the Pension Fund Management Companies Acts in the Best Interest of Pensioners? ¾ Look for Biases in the Investment Decisions of Pension Fund Managers such as Excessive Allocation of Pension Funds’ Assets to Bank Time Deposits and Excessive Acquisition of Equity of Companies that Have Relations with the Banks that Manage the Pension Funds. 29

Pension Reform Design Relevant Issues ¾ Interaction Between the Corporate Governance Channel and The Pension Fund Specific Capital Controls. ¾ The Objective of Pension Reforms Must Be the Maximization of Pensioners Welfare. ¾ All Other Objectives (including Corporate Governance Improvements and Capital Markets Development) must be Subordinated to the Objective of Pensioners Welfare Maximization. 30