POLICY RESEARCH WORKING PAPER 1243

Are Institutional Investors JorInonIn tofiveiduttral countiets inest:

an Important Source Ws and v''y litde. in- * ' ~~~~~~~~~~~~~~~~~~er,ergin maketseciJuitie's .:".of Portfolio Investment Butonl;in e'rrarel:

requiations on foreign'in Emerging Markets? nesent 'irwestmnernt a sungocont:

constraint.Punom Chuhan

The World BankIntemational Economics DepartmentDebt and International Finance DivisionJanuary 1994

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[iFUCY RESEARCH WCRKING PAPER 1243

Summary findingsChuhan examines five major industrial countries' investors (such as pension funds and insuranceportfolio investment in developing countries to learn if companies) have tended to approach the markets forinstitutional investors are significant investors in emerging developing countries cautiously. They investemerging developing countries. only a tiny fraction of their portfolios in emerging

The data reveal considerable divergence in the pattcrn market securities.of outwar ' portfolio flows for the indust;ial countries Chuhan finds that investor-countrv regulationsstudied. governing outward portfolio investment were a

Evidence on asset composition and discussions with significant constraint only in Germany.market participants suggest that major institutional

This paper - a product of the Debt and International Finance Division, International Economics Department - is partof a larger effort in the departmcnt to study th- sources of private capital flows to developing countries. Copies of the paperare avai.able free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Rose Vo, room S042, excension 31047 ( 37 pages). January 1994.

The Policy Research Working Paper Series disse-inates the findings of work in progress to encourage the exchange of ideas aboutdevelopment issues. An objective of the series is to get she findings out quickly, een ifthe presentations are kss than fully polisbed Tebpapers carry the names of the authors and should be used and cited accordingly. The findings, interpretations, and conclusions are theauthors' own and should not be attributed to the World Bank, its Executive Board of Directors, or any of its member countries.

Produced by the Po cy Research Dissemination Center

ARE INSTITUTIONAL INVESTORS AN IMPORTANT SOURCEOF PORTFOIIO INVESTMENT IN EMERGING MARKETS?

by

Punam Chuhan

The author is in the Debt and International Finance Division of the World Bank. Theopinions expressed do not necessarily represent those of the World Bank or its Board ofDirectors. I would like to thank Sudarshan Gooptu, Ronald Johannes, Kwang Jun, andVikram Nehru for useful comments, and Himmat Kalsi and Sarabjit Sinha for support withthe data.

Summary

Portfolio flows to developing countries have grown rapidly in recent years. This paperexamines recent trends in several major industrial countries' portfolio investment indeveloping countries and assesses the significance of industrial country institutional investorsas a source of finance for the emerging market countries.

Flow of funds data shows that major industrial countries account for a large and risingamount of the portfolio investment flows to developing countries. Net portfolio investmentflows to these ccuntries from the major developed countries of Canada, Germany, Japan, andthe U.S. amounted to over $9 billion in 1992, nearly 30 percent of developing country bondand equity issuance in international capital markets. Although overall portfolio investmentflows from these major industrial countries to developing countries have risen, there isconsiderable divergence in the pattern of these flows. Only for US investors, who haveprovided the bulk of these flows, has outward portfolio investment shown a strong upwardtrend beginning in 1989. By contrast, Canadian, German and Japanese portfolio investmentin these countries has been uneven and fairly small.

Industrial country institutional investors (namely, pension funds and insurancecompanies) have approached emerging market securities cautiously, investing only a tinyshare of their portfolio in emerging market assets. Employing data on investment mandates,asset holdings based on comprehensive surveys, and asset holdings based on financialstatements of the largest investors (selected sample), the study finds that the share invested inemerging market stocks is typically less than 5 percent of foreign equity holdings and usuallyabvut 0.2 percent of total assets. However, the observed upward trend in holdinigs ofemerging market assets indicates that institutional investors could prove to be an importantsource of finance in the future.

An informal survey of market participants reveals that despite restrictions on outwardportfolio investment, institutional investors typically do not view these controls asimpediments to investment in emerging market securities. Institutional investors areapparently more concerned about the relative riskiness of en,L,,Ying markets. The limitedinformation on these markets is also an important obstacle. Moreover, the smal! size of theemerging markets and their relative illiquidity are also serious concerns. Surprisingly,restrictions on portfolio investments in host countries do not appear to be a crucial factorimpeding these flows.

- j -

TABLE OF CONTENTS

I. Introduction 1

II. Recent Trends irn Industrial Country Portfolio Flows to Developing Countries 3

III. Institutional Investors as a Source of Funds 8

Size of Institutional Investors: Pension Funds and Insurance Companies 9

Foreign Investments of Institutional Investors 13

Emerging Market Investments of Institutional Investors 17

IV. Impediments to Institutional Investors' Portfolio Investments inDeveloping Countries 24

Regulations in Investor Countries 24

Host Country Factors 28

Access of Developing Countries to Industrial Country Capital Markets 30

V. Conclusion 33

References 36

Tables

Table 1 Portfolio Flows to Developing Countries, Purchases ofForeign Securities 4

Table 2 Equity Flows to Developing Countries, Purchases ofForeign Equities 6

Table 3 Total Assets of Institutional Investors 10

Table 4 Institutional Investors' Holdings of Foreign Securities 14

Table 5 Share of institutional Investors' Foreign Securities inTotal Assets 15

Table 6 Emerging Market Investment of US Pension Funds 20

Table 7 International Portfolio Investment of Selecteu US PensionFunds 21

Table 8 Composition of Japinese Overseas Equities 22

Table 9 International Portfolio Investment of UK Pension Funds 23

Table 10 Restrictions on Outward Portfolio Investment ofInstitutional Investors in Five Major Industrial Countries 25

I. Introduction

P.ivate capital flows to developing countries, especially portfolio flows, have surgedbeginning in 1989. The increase in these flows is in sharp contrast to the pattern observedthrough most of the 1980s, when private capital flows to these countries had all but dried up.Favorable economic developments in selectec emerging market countries of Latin Americaand South East Asia, along with supply-side factors have boosted private capital flows.Portfolio flows, which have been the fastest growing category of voluntary capital flows,have become an increasingly important source of external finance fo, developing ccintries.

The paper addresses several issucs pertaining to portfolio flows to developingcountries. It examines recent trends in industrial country portfolio flows to developingcountries. It also reviews regulatory and other impediments to outward portfolio investmentin investor countries. In addition, the paper identifies factors that have contributed to a surgein portfolio flows to emerging developing countries.

Sources of portfolio finance for developing countries are reviewed in Section II.Gross portfolio investment flows to developing countries have risen as investors haveincreased their purchases of developing country equities and bonds. In 1992, these flowswere over $35 billion for four major industrial countries (Canada, Germany, Japan and US),a fourfold increase over 1988. U.S. investors alone purchased $28.5 billion of foreignsecurities from developing countries last year (compared to $4.5 billion in 1988). Netportfolio investment flows have also grown, again led by US investors. Net purchases offoreign securities by these four industrial countries climbed to over $9 billion in 1992 from anegligible amount in 1988. Although portfolio flows have increased, there are considerabledifferences in the pattern of these flows across countries. While US investors have steadilyincreased their gross and net purchases of developing country securities, net portfolioinvestment by Canadian, German and Japanese residents in developing countries has beenuneven.

Section III explores the potential for institutional investors as a source of funds.Institutional investors, who are major playtrs in international financial markets, have not ledthe growth in portfolio flows to the emerging market countries. Instead, these investors haveapproached emerging market securities cautiously, and invested only a tiny share of theirportfolio in emerging market assets. The share invested in emerging market stocks istypically less than 5 percent of foreign equity holdings and usually about 0.2 percent of totalassets. At the end of 1992, pension funds and insurance companies had an estimated $17billion to $20 billion invested in emerging market stocks, 3 percent of market capitalizationof the emerging stock markets. Despite the small size of these holdings, the observed trendtowards diversification into emerging market securities suggests that institutional investorsare likely to be an important source of external finance for emerging developing countries inthe future.

Impediments to institutional investors' purchases of emerging market securities arepresented in Section IV. Although industrial countries have liberalized capital movements,institwrional investors in these countries still face some restrictions on their foreign

2

investments. This is especially true of insurance companies, which typically face ceilings onthe size of foreign assets in their portfolio. Pension funds, on the other hand, generally haveless stringent restrictions and controls and more freedom to invest overseas. Among the fivemajor industrial countries in this study, German institutional investors have the most stringentcontrols. Japanese institutional investors are also subject to ceilings on foreign asset size, butthese investors apparently have not found these limits to be binding. In the US, insurancecompanies typically face restrictive ceilings on foreign asset holdings, and many publicpension funds are restriCtcc by statutes from investing overseas.

Despite restrictions on outward portfolio investment, institutional investors typicallydo not view these controls as impediments to investment in emerging market securities.Investors are apparently more concerned about the relative riskiness of emerging markets.The limited information on these markets is also an important obstacle. Moreover, the smallsize of the emerging markets and their relative illiquidity are a serious impediment.Surprisingly, restrictions on investments in host countries do not appear to be a crucial factorimpeding portfolio investment.

The improved market access and increased secondary market liquidity provided byRule 144a has contributed to an increase in emerging market issues in the U.S. privateplacement market, which is dominated by institutiona! investors. Rule 144a placementsinvolving depositary receipts have been a popular vehicle for raising equity capital for firmsin emerging developing countries. In 1991, emerging market countries successfully used thisroute to raise $2.2 billion in equity capital. Capital raising through Rule 144a ADRs, whichhave lower transaction costs than public offerings, is especially popular among first-time andsmall-sized issuers.'

Section V concludes with an overview of the factors motivating portfolio flows.Global and country-specific factors have boosted portfolio investment in emerging marketportfolio instruments.2 In particular, unfavorable economic developments in major industrialcountries and a trend towards increased diversification into foreign assets combined with highpotential returns in emerging markets have attracted investors to these markets.

'Borrowers seeking a wider investor base are beginning to move away from this market tothe US public market.

2See Calvo, Leiderman and Reinhardt (1993) for an analysis of the impact of global factorsand Chuhan, Claessens and Mamingi (1993) for an analysis of the impact of both global andcountry-specific factors.

3

II Recent Trends in Industrial Country Portfolio Flows to Developing Countries

Total portfolio flows fO developing countries from the major industrial countries havegrown steadily in recent years as investors have diversified into emerging market securities.This increased investor intere t is in sharp contrast to investor behavior through most of the1980s. During this period, canital flows contracted as several major developing countriesexperienced debt-servicing problers, deteriorating economic performance, and inconsisterteconomic policies. In the late 1980s, many developing countries improved their economicmanagement and performance and capital flows to this group of countries surged beginningin 1989.3 This geographical shift int flows has been accompanied by a shift in thecomposition of capital flows. Th. share of portfolio flows in total capital flows has begun torise reflecting the increased importance of portfolio investment relative to both bank lendingand foreign direct investment.4

Major industrial countries account for a large amount of the portfolio investmentflows to developing countries.5 6 Net portfolio investment flows to these countries from thtmajor developed countries of Canada, Germany, Japan, and the U.S. amounted to over $9bil':rl3n in 1992(Table 1), 7 I nearly 30 percent of developing country bond and equityissuance in international capital markets. Although overail por folio investment flows fromthese major industrial countries have risen, there is co.,siderable divergence in the pattern ofthese flows. For US i- vestors, who have provided the bulk of these flows, outward portfolioinvestment has showni a strong upward trena beginning in 1989. By contrast,

3See Gooptu (1993) for a detailed study of portfolio flows to developing countries.

4Bachmann (1992) presents recent trends in foreign direct investment.

'Portfolio investment, which consists entirely of long-term capital, includes long-term publicand private bonds, corporate equities, ADRs, and country-funds.

6These flows comprise industrial country residents' investments and do not capture returringflight capital invested in portfolio securities.

'Net portfolio flows are the difference between purchases and sales of securities

8There are some differences in coverage of portfolio flows among these countries. In theU.S., the acquisition of 10 percent or more of the share of a foreign company is included underdirect investment and not portfolio investment. In the U.K., on the other hand, an investorwould have to purchase at least 20 percent of the share of a companv for a transaction to beincluded under direct investment.

Also refer to Stekler (1991) for problems in the U.S. international travisactions data.

4

Table 1

Portfolio Flows to Developing CountriesPurchases of Foreign Securities

(billions of USS)

1988 1991 1992Net Gross Net Gross Net Gross

CANADA

All Developing 0.0S 0.65 0.13 2.86 0.37 2.66All Foreign 2.11 45.64 5.97 77.68 5.54 97.28

Germany

All Devoloping 0.66 2.58 0.18 2.94 0.72 3.90All Foreign 40.80 165.56 16.85 189.78 45.18 327.02

JAPAN

All Developing 0.29 0. 3 0.38All Foreign 86.71 74.45 36.09

UK

All Foreign 20.22 50.08 57.00

US

All DeveLoping -0.80 4.51 4.20 17.59 7.11 28.50All Foreign 2.80 290.31 46.74 484.23 53.99 680.75

Sources: Statistics Canada, Canada's International Transactions in Securities; DeutscheBundesbank, Statistical Suwtlement to the Monthly Reports of the Deutsche Bundesbank; Bank ofJapan, Balance of Payments; Central StatisticaL Office, Financial Statistics; US Departmentof Treasury, Treasury Bulletin.

Canadian investors' gross portfolio flows to developAng countries actually fell in 1992, andCanadian, German and Japanese investors' net portfolio flows hL.ve exhibited an uneventrend.

U.S.

U.S. portfolio investment flows to developing countries surged beginning in 1989.Gross purchas. s of securities in 1992 -ere nearly five times the 1989 level. In 1992, U.LF.investors purchased $28.5 billion of developing country securities, including $16.6 billion ofstocks and $11.9 billion of bonds (Table 2). The increase in gross porttolio investment flowsto developing countries over 1988-32 more than doubled the share of these flows in totalportfolio investment flows to 4.4 percent. Net flows to fleveloping countries have alsogrown, turning positive in 1990 and reaching $7.1 billion in 1992.

Sever-l factors accounted for this substantial increase in portfolio flows. Amongsource-s,'de factors, th& trend begun by U.S. investors in the late 1980s to diversifyinvestments, aloi g with the telative weakness in major domestic asset markets and declininginterest rates boosted portfolio flows to developing countries. There were several positivedevelopments in recipient countries as well. These included progress towards a NorthAmerican Free Trade Agreement (which enhanced Mexico's growth prospects),comprehensive economic reforms including easing of regulations on foreign investment andadoption of rapid pi,vatization programs, and tlie recovery of Latin America from thesluggish growth of the past decade.

Amoing the developing countries, Mexico is the largest recipient of US portfoiioflo"ws.9 In 1992, nearly 60 percent of US residents' portfolio flows to developing countrieswere to Mexico. The share of US flows in total flows to Mexico was likewise large at 43percent. In recent years, U.S. investors' portfolio investment flows to Mexico have shiftedin favor of stocks (and away from long-term bonds): gross purchases of these stocks totalled$8.4 billion in 1992, and net purchases were $2.8 billion. U.S. investment flows toArgentina and Brazil have also increased with the return of these two countries tointernational financial markets in 1991 (after several years of absence). However, U.S. netportfolio investment flows to these countries were modest at $1.1 billion in 1992. Net flowsto East and South East Asia have increased sharply over 1990-92, climbing from $0.7 billionto $2.6 billion. Among the developing economies of Asia, Korea and Malaysia haveattracted the bulk of U.S. portLvlio flows.

9US FDI to Mexico also rose sharply as US firms attempted to benefit from Mexico'simproved economic prospects.

6

Table 2

Equity Flows to Devtloning CountriesPurchases of Foreign Eouities

(bitlions of USS)

1988 1991 1992Net Gross Net Gross Net Gross

CANADA

All Developing 0.07 0.51 0.49 2.38 0.61 2.31All Forel6n 2.18 18.68 5.02 30.67 5.10 31.41

Germany

ALt Developing 0.02 0.06 0.17 0.31 0.40 0.34ALl Foreign 10.37 31.41 8.21 38.63 3 13 79.04

US

Att Devetoping 0.31 o.73 2.73 9.65 5.03 16.64All Foreign 1.91 76.34 32.01 15D.65 32.27 181.78

Sources: Statistics Canawa, Canada's InternationaL Transactions in Securities; OeutscheBundesbank, jatistical Suplement to the Monthly Reports of the Deutsche Bundesbank; Bank ofJapan, Balance of PaYments; Central Statistical Office, Financial Statistics; US Depar.mentof Treasury, Treasury Bulletin.

7

Japan

Portfolio investment in developing countries has been tiny and has exhibited an erratictrend. Japanese portfolio investrrment flows to developing countries have been uneven,mirroring the trend of total outward portfolio flows in recent years. In the late 1980sJapanese net portfolio investment in developing countries drifted downwards, and in 1990there was disinvestment in these countries. Recently, Japanese investors have begun to showsome cautious interest in emerging market securities, especially equities. But althoughJapanese investors recognize the recent improvement in the creditworthiness of LatinAmerican countries like Mexico, most of the equity investments are directed to Asianmarkets. While country funds were popular with Japanese investors in the 1980s, morerecently, these investors are increasingly targeting individual shares in Asian markets andADRs. 10

The c.urrent weakness in portfolio flows stems from several factors, most importantlythe huge loss in wealth associated with the unprecedented decline of the stock market and thecollapse of real estate prices in the early 1990s. Apart from this, currency movements--thefall of the dollar--have eroded the value of overseas assets, exacerbating the wealth effect.Moreover, retrenchment (cut back on new lending) by Japanese banks and increased issue ofsubordinated debt (raising of new capital) by Japanese banks to meet BIS capital adequacyrequirements have also shrunk Japanese foreign portfolio investment. All these factors haveweakened tle position of Japanese financial institutions, including Japanese institutionalinvestors, as a source of portfolio finance for developing countries.

U.K.

Following a sharp downturn in 1990, UK residents' net portfolio investment flowshave recovered strongly. Although the geographical distribution of portfolio flows is notpublished by the government, market observers believe that flows to developing countrieshave risen briskly. UK institutional investors are particularly active in international markets.Net portfolio purchases of foreign securities by UK pension funds and insura ice companieswere over $24 billion in 1991, accounting for nearly half of all net purchases of foreignsecurities by UK residents.

Germany

After rising fairly briskly over 1988-90, net portfolio investment flows to developingcountries levelled off in 1991, before falling sharply in 1922. Gross purchases of foreignse-,urities from developing countries were also uneven over this period. Traditionally, thebulk of German portfolio investment to developing countries has been to the Centrally

'°The bulk of Japanese portfolio investment outside of the OECD has traditionally been tothe Asian NICs of Korea, Singapore, Taiwan, and Hong Kong.

8

Planned Economies (up to 90 percent in 1990). This pattern has changed with unification,and the CPE's share was under 30 percent in 1992.

The recent decline in portfolio flows is the direct result of the process of economicand political unification in Germany. Financial transfers to the east from the west followingunification have created a heavy demand on domestic savings.

Canada

Canadian portfolio investment flows to developing countries remain fairly small andthe trend has been uneven. Net purchases of developing country securities were $368 millionin 1992 compared to $87 million in 1988. Although Canadian investors have begun todiversify overseas, this diversification has been largely in favor of EC countries and notdeveloping countries.

III. Institutional Investors as a Source of Funds

Institutional investors are major players in domestic and international finar,cialmarkets." These investors, especially in the U.S., Japan, and U.K., have grown in sizeand importance. Pension funds and insurance companies form the largest segment of theinstitutional market (e.g., about 70 percent in the US and 90 percent in the UK). These twomajor types of investors are particularly significant for emerging developing countriesbecause they provide a potential source of large funds. Moreover, the assets of theseinstitutional investors consist mostly of securities--bonds and equities--the very vehiclesthrough which developing countries have begun to attract voluntary private capital. Inaddition, these inivestors generally provide a more stable source of finance than othernonbank private sources of funds (because their investments are mostly in longer termassets). 12

Institutional investors like pension funds and insurance companies have apparently notspearheaded the surge in portfolio flows to the emerging developing countries, although theyhave increased their investment in emerging market securities. The early money that enteredemerging markets of Latin America was so-called hot money, money chasing high short-termreturns arising from market anomalies. Several characteristics of emerging markets, such assmall size and delays in price adjustment, allowed investors to earn abnormal returns.

"Institutional investors are defined as investors who manage money for individuals andfirms. These investors include insurance companies, pension funds, mutual funds, andinvestment trusts.

'2Pension funds and life insurance companies, which are increasingly used by households asa means for savings rather than as a vehicle for transferring risk, have long-term liabilities.These investors, therefore, tend to hold long-term assets to match these liabilities.

9

Market observers believe that institutional funds have begun to replace some of the hotmoney, including repatriated flight capital, which formed a large share of the initial flows toemerging Latin countries.

Size of Institutional Investors: Pension Funds and Insurance Companies

Institutional investors have clearly played a significant role in mobilizing resources inthe major industrial countries. This is particularly the case of U.S. pension funds andinsurance companies whose $5.6 trillion in assets at end of 1992 accounted for nearly 15percent of all U.S. financial assets and over 30 percent of the assets of U.S. financialinstitutions (Table 3). Pension funds are the second largest source of domestic funds in theU.S. market, next only to commercial banks."3 The growth of U.S. pension assets, bothprivate and public, continued to outpace the growth of total US financial assets between 1980and 1992, and the share of pension funds in total assets rose from 5 percent to nearly 9percent during this period." Traditionally, equities have comprised a high share of pensionfund assets: equity holdings grew rapidly during the 1980s, and the share of equities in totalassets of pension funds rose from 41 percent in 1980 to 48 percent in 1992.'5

U.S. insurers' assets also expanded rapidly during this period, climbing from under$640 million to over $2.3 trillion. Life insurance companies, which had assets of $1.6trillion at the end of 1992, dominate the insurance sector. The share of life insurers' assetsin total financial assets of the U.S. was 4.2 percent at the end of 1992 (that of all insurerswas 5.9 percent). Like pension funds, U.S. insurers are an important source of capital in theUS economy. But unlike these funds, insurance company assets are largely invested inbonds, which comprised nearly 60 percent of these institutions' assets at end-1992. Lifeinsurance companies are important investors in the corporate bond market, and they havebeen the largest institutional holders of corporate bonds issued in US markets

'3Pension plans in the US are placed with banks or trust companies, insured with lifeinsurance companies, or self-administered. Non-life insurance based pension plans are generallytrusteed pension plans under which contributions are paid into a trust administered by a trustcompany or a bank. Large firms with investment staffs might handle investment proceduresthemselves. State and local government retirement systems provide retirement benefits for state,city, and country employees.

'4Refer to Hoffman and Mondejar (1992) for a historical perspective of U.S. pension funds.

'5Refer to Papke (1992) for a survey of the literature on investment policy of pension fundsand for an analysis of US pension fund asset mix using plan-level data contained in Form 5500.Also see Lakonishok et al. (1992) for an explanation of why pension fund managers haveconsistently underperformed with respect to the S&P 500 Index.

10

Toble 3

Total Assets if Institutioral InvestorsCbillions of US)

1980 I98A 1990 1991 12

Persion Funck

Canada 43.262 131.343 171.824 188.364

Germany* 17.173 41.599 55.194 58.633 67.457(Sept92)

Japan 24.344 134.130 158.824 182.323 191.893

UK** 151.292 483.866 583.548 642.898

US 667.700 1919.200 2257.300 3070.900 3334.300

Life Ins. Co.

Canada*** 36.759 85.519 106.106 118.062

Germany 88.363 213.552 299.526 325.680 375.317(Sept92)

Japan 124.592 734.652 946.917 1113.691 1214.855

UK** 145.685 358.898 447.901 516.740

us 464.200 1132.700 1367.400 1505.300 1624.500

Insurance Co.

Canada*** 45.988 108.197 132.949 141.398

Germany 125.121 301.134 425.787 453.067 529.308(sept92)

Japan 159.197 890.675 1137.164 1329.160 1433.330

UK** 177.005 431.104 533.150 606.311

us 646.300 1586.600 1896.600 2096.900 2253.200

Total

Sources: Statistics Canada, Quanrtey Est)matcs of Trusteed Pension Ftnds & Financial Statistics; Bank of Canada Rev)ew;Statistics Canada, Financial Institunons Financial Statisdcs; GeschfUsber(ch: des Bundesaufslchtsemmes; Bank of Japan,Economic Statistics Monthly; Board of Governors of the Federal Reserve System, Flow of Funds Accounts; CentralStatistical Office, Financial Statstics.

* - pension funds and burial funds for 1980 & 1988; * - figures in the first column are for 1981; ** - assets held inCanada.

11

since the 1930s. Life insurers are also major lenders in the private placement market.Stocks, on the other hand, have typically comprised only a small percentage of total assets ofinsurance companies. This practice is the outcome of both the nature of the contractualliabilities of insurers and because of legal restrictions, especially in earlier periods,governing the investments of insurers.16 The share of stocks was under 14 percent for allinsurance companies in 1992, and 11.3 percent for life insurers.

Japanese institutional investors witnessed a dramatic growth of assets, in the 1980s.The deregulation of the Japanese financial sector created strong competition for domesticsavings between the banks, life insurance companies, trust banks--mutual funds andinvestment trusts--securities firms, and the postal saving system."7 Coupled with Japan'shigh savings ratios, total assets of all financial institutions increased more than six-foldbetween 1980 and 1991. The assets of pension funds and insurance companies grew morethan seven-fold in the same period. The recent collapse of the Japanese stock market hasdampened growth, however. At the end of 1990, these investors held 13 percent of theassets of financial institutions in the country.

The growth of Japanese insurance company assets, especially life insurance companyassets, was phenomenal in the 1980s. Japanese insurers' assets increased more than eight-fold between 1980 and 1992. The insurance industry is dominated by life insurancecompanies, which represent over 80 percent of the assets of the industry. With more than$1.2 trillion in assets at the end of 1992, life insurers are the largest source of privateinstitutional funds in the domestic market. In the 1980s, as demand for loans by thecorporate sector weakened life insurance companies diversified into securities. Lifeinsurance companies also aggressively diversified overseas in the 1980s (investing largely inforeign bonds) in response to higher interest rates abroad and to the decline of corporate loandemand at home. Japanese private pension funds also grew rapidly in the 1980s. Assets ofJapanese pension funds at trust banks were $192 billion at the end of 1992.18 At the end of1990, these pension funds held under 2 percent of the assets of financial institutions in Japan.Assets of publicly managed pension funds (managed by public authorities) are very large, buttheir assets are not invested overseas and, therefore, these pension funds are not included inthis study.

'6For many years life insurance companies operating in N.Y. State were not permitted tohold any common stock. This law was eased beginning in 1951.

17Refer to Tatewaki (1991) for a more detailed study of the growth of the Japanese financialsector in the 1980s.

"8Until recently, private pension funds were monopolized by life insurance companies andtrust banks. New regulations also allow "finns with discretionary fund management licenses"to manage up to a third of the new pension money going into certain categories of pensionfunds. Assets of pension funds held by life insurance companies are not reported under pensionfund assets.

12

The assets of UK institutional investors have grown at a brisk pace. Pension fund andinsurance company assets increased by over 300 percent during 1982-91. Assets of pensionfunds climbed from $151 billion to $643 billion during this period. Most of the growthoccurred in the first half of the 1980s, continuing a rapid growth trend that began in the mid-1970s. Over the past several years, however, net cash inflows into pension funds havedeclined and have also turned negative. In the 1980s, UK pension funds' asset mix shifted infavor of equities and away from UK bonds and UK property. The share of equities in totalassets expanded from about 56 percent in 1981 to about 77 percent in 1991. Since cash flowdeclined over this period, the change in asset mix has been accomplished by a switchingbetween categories rather than through new money allocations. Part of this shift into equitiesrepresented a diversification of the portfolio into overseas equities. The growth of U.K.insurarnce comrpany assets slowed in the 1980s, but remained moderate. The slowdown ingrowth reflects the low growth of life insurance company assets, which comprise over 8:

percent of total insurance industry assets. Life insurers' assets totalled $517 billion at theend of 1991, and composition of these assets was 46 percent in stocks and 16 percent inbonds.

Although German institutional investors have grown at a moderate pace, they aresmall relative to other financial institutions in the country. The assets of pension funds andinsurance companies wer, $512 billion at the end of 1991 compared to $142 billion at theend of 1980. In contrast to the U.S. and U.K., German pension funds are fairly small andwere under 2 percent of total assets of all financial institutions at the end of 1991. The smallsize of private pension funds arises from the common practice in Germany of includingpension liabilities in firms' balance sheets. Thus figures in Table 3 only include fully fundedand independent pension schemes. The small size of pension funds is also the result of agenerous state pension system. German insurance company assets, by contrast, are large.These assets grew at a fairly modest pace in the 1980s, and represented 12.4 percent ofassets of all financial institutions at end-1991.

The assets of Canadian institutional investors have also demonstrated fairly stronggrowth. Assets of pension funds and insurance companies totalled $330 billion at the end of1991, rising by nearly 300 percent since 1980. The size of assets as a percent of total assetsof all financial institutions was about 24 percent at the end of 1991. Pension funds, bothpublic and private, comprise the second largest source of investible funds in the domesticeconomy, next only to the Chartered banks. The share of fixed-income securities (i.e.,bonds) was fairly constant at about 45 percent in the 1980s, although there appears to be aportfolio shift towards equities and away from mortgages and short-term investments inrecent periods. Canadian insurance companies, which accounted for 10.5 percent of totalassets of financial institutions at the end of 1991, have grown at a somewhat slower pacethan pension funds.

13

Foreign Investments of Institutional Investors

The presence of institutional investors increased in foreign capital markets in the1980s. Foreign investments of pension funds and insurance companies were fairly smallprior to 1980, and only totalled about $50 billion (Table 4). By the end of 1990, thisnumber had grown to about $500 billion, and rose further to an estimated $610 billion at theend of 1991. The rapid growth in foreign assets was primarily fueled by Japanese and U.K.institutional investors who aggressively and rapidly diversified their portfolios during thisperiod. U.S. institutional investors, by contrast, displayed much slower growth (Table 5).19

U.S. investors have traditionally been slow to invest overseas displaying a strong biasfor investing in domestic assets.20 Thus through most of the 1980s, foreign investments ofU.S. institutional investors grew at a slow pace, despite the rapid globalization of financialmarkets. In 1992, the share of international assets in total assets of U.S. life insurancecompanies and pension funds was estimated to be 4.3 percent, much lower than thecomparable level for institutional investors in both Japan and U.K. U.S. pension funds hadan estimated $152 billion (4.6 percent of total assets) invested in foreign assets, mostlystocks, at the end of 1992. Private or corporate pension funds exhibit a greater degree ofdiversification, and these funds had invested 5.8 percent of their assets in inm. rational stocks(at end-1991). Public pension funds, on the other hand, had less than 3 percent of theirportfolio in foreign stocks (at end-1991). Insurance companies had a slightly smaller shareof their assets invested overseas."2 In 1992, life insurance companies had invested 3.7percent of their assets in foreign bonds, mostly Canadian bonds. Foreign stock holdings oflife insurers are believed to be very small.

Although both pension funds and life insurance companies have fairly small shares offoreign securities in total portfolio, there is considerable difference in the pattern of theseshares in the 1980s. While life insurance companies registered very little if any change inthe share of assets in foreign securities during this period, pension funds experienced asizable increase in the percentage of foreign securities in total assets. Thus pension fundsincreased their holdings of foreign securities from an estimated 0.7 percent in 1980 to 4.6percent in 1992. This trend towards diversification was particularly strong beginning in 1987for large private funds.22 Public pension funds began to diversify in favor of foreign assets

19Also refer to Davis (191988 and 199).

20French and Poterba (1991) and Tesar and Werner (1992) find that despite the potentialbenefit from international diversification, investors favor domestic assets over foreign ones.Among the major industrial countries, U.S. investors display especially strong evidence of homecountry bias.

2'lnsurance companies' asset mix is similar to that of life insurance companies.

22Also see Greenwich Reports (1991 and 1992).

14

Table 4

Irntitutional investors' Holdino of Foreign Securities(billiar of USS)

1980 1988 1990 1991 1992

Persian Func

Canada 1.759 6.902 9.880 15.000e

Germany* 0.069 0.200 0.349 0.370

Japan e 0.112 8.477 11.372 15.406 16.215

UK** 15.285 79.611 104.955 133.489

US 4.674 52.800e 95.000 125.000 152.000.

Life Ins. Co.

Canada*** 1.204 1.650 1.682 2.212

Germany 0.530 1.200 2.991 3.260 e

Japan 3.359 103.979 128.116 139.200 137.922

UK** 7.956 34.191 48.204 63.821

us 19.236 40.299 49.234 54.517 59.980

Insurance Co. ""

Canada*** 1.510 2.090 2.110 2.644

Germany 0.850 2.060 4.260 4.530

Japan 4.311 120.231 151.341 164.704 167.032

UK** 10.890 43.756 59.666 77.496

us 26.800 56.500 68.300 75.900 83.000

Sources: Statistics Canada, Quarterly Esdimates of Trusteed Pension Funds & Financial Stadsdcs; Bank of Canada Rcview;Statistics Canada, Financial Institudons 'Financial Stadsdes; Geschqjtsbcrichs des Bundesaufsichtsemces and Davis (1991);Bank of Japan, Economic Stadsdcs Monthly; Board of Governors of the Federal Reserve System, Flow of Funds Accounts;Central Statistical Office, Financial Stadsdcs and Greenwich Associates.

e - estinute; * - pension funds and burial funds for 1980 & 1988; '. - figures in the first column are for 1981; "' - assetsheld in Canada; **** - estimates for Canada, Germany, and the U.S.

15

Table 5

Share of Institutional Investors' Foreign Securities in TotaL Assets(in percentage)

1980 1988 1990 1991 1992

Pension Furds

'anada 4.07 5.25 5.75 8.00 e

Germany* 0.40 0.40 0.C3 0.63 e

Japan 0.46 6.32 7.16 8.45 8.45

UK** 1U.10 16.45 17.99 20.76 22.03

UR 0.70 2.70 4.21 4.07 4.56

Life Ins. Co.

Canada*** 3.28 1.93 1.59 1.87

Germany 0.60 0.60 1.00 1.00 e

Japan 2.70 14.15 13.53 12.50 11.35

UK** 5.46 9.53 10.76 12.35

US 4.14 3.56 3.60 3.62 3.69

Insurance Co.****

Canada*** 3.28 1.93 1.59 1.87

Germany 0.60 0.60 1.00 1.00

Japan 2.71 13.50 13.31 12.39 11.65

UK** 6.15 10.15 11.19 12.78

Us 4.14 3.56 3.60 3.62 3.69

Sources: Statistics Canada, Quarterly Fstima:es of Trusteed Pension Funds & Financial Statistics; Bank of

Canada Review; Statistics Canada, Financial Insitutions' Financial Statstics; Geschafisbericht des

Bundesaufsichtsemtes and Davis (1991); Bank of Japan, Economic Statistics Monthly; Board of Guvernors of

the Federal Reserve System, Flow of Funds Accounts; Central Statistical Office, Financial Statistics and

Greenwich Associates.

* - pension funds and burial funds for 1980 & 1988, * - figures in column one are for

1981, *+* - assets held in Canada, **** - estimates for Canada, Germany, and U.S.

16

more recently, however.

In contrast to U.S. investors, Japanese investors rapidly diversified their portfolio inthe 1980s, investing large sums overseas. Japanese overseas investment was propelled by thederegulation of the financial system, high interest rates abroad through most of the 1980s,and accounting restrictions that allow insurance companies to pay policy holders dividendsout of income but not capital gains, and thereby increase the attractiveness of high-interestsecurities. Japanese institutional investors have dominated foreign security investments ofJapanese financial institutions. Pension funds and insurance companies raised the share offoreign securities in total portfolio to 11.3 percent at the end of 1992 compared to 2.4percent at the end of 1980.

Among the Japanese institutional investors, life insurance companies have the largestinvestment in foreign securities: $167 billion at the end of 1992. The share of foreignsecurities in total assets is likewise large. This share rose from 2.7 percent in 1980 to over14 percent in 1988, before falling to 11.4 percent in 1992. Japanese pension funds alsoincreased the share of foreign assets in their portfolio, although by not as much, to anestimated 8.5 percent from an estimated 0.5 percent over this period.

U.K. pension funds and insurance companies are also very active overseas. Theseinvestors' holdings of foreign securities increased eight-fold to $211 billion as their share offoreign securities in total assets increased from 8 percent to 16.9 percent between 1981 and1991. Pension funds have diversified overseas to a greater extent than life insurancecompanies. At the end of 1991, pension funds had 20.8 percent of their portfolio in foreignsecurities compared to 10.1 percent at the end of 1981. This share grew to 22 percent in1992. Pe-sion funds have rebalanced the geographic composition of their foreign equitiesmix in favor of Continental Europe.23 At the same time, the share of U.S. in foreignequities has declined sharply from 57 percent in 1982 to 27 percent in 1991, well below theU.S. weight in world markets. The share of Continental Europe has increasea appreciably inthe total and was the largest foreign category at 37 percent of total foreign equities by theend of 1991--much larger than the percentage of this group in world markets. The share ofJapanese equities in total overseas equities has fluctuated. UK pension funds have continuedto invest new money in other foreign markets, but these are mostly in the equity markets ofAustralia and South East Asia.

U.K insurance companies have more than doubled the share of foreign investment intotal assets in the last 10 years. At the end of 1991, U.K. insurance companies had 12.8percent of assets in foreign securities and life insurance companies 12.4 percent.

By contrast, German institutional investors are almost entirely invested in thedomestic market. The share of foreign securities in total assets are a tiny fraction of the

23World Markets Company (1991).

17

assets of German pension funds and insurance companies. For pension funds this share isunder 1 percent, and for life insurers it is 1 percent. The near total lack of diversificationinto overseas assets is clearly the result of tight restrictions on investment.

Canadian pension funds have diversified overseas to a moderate degree, but insurancecompanies have actually reduced the share of foreign exposure. At the end of 1991,Canadian pension funds were holding an estimated 8 percent of their assetb in foreignsecurities. Pension funds have increased their investment in foreign assets following aproposal in 1990 to ease the ceiling on overseas investment. The proposal was passed inDecember 1991, and there are signs that the growth of foreign assets has picked up. Thereis considerable variation in the percentage of assets invested overseas among the trusteedpension funds, with larger funds investing a higher share of assets abroad.24 Pension funds'investments have traditionally been in foreign stocks, especially U.S. stocks.

Emerging Market Investments of Institutional Investors

Institutional investors' foreign investmnents have typically been in industrial countrystock and bond markets, but emerging developing country stocks and, to a lesser extent,bonds have also recently attracted these investors. These countries have fairly well-developed and active stock markets, they have recently eased rules governing foreigninvestment, and their economies have improved growth prospects.25 U.S. investors havetypically tended to favor Latin American securities, but investment in developing Asianmarkets has increased. Japanese investors, by contrast, while recognizing the improvedcreditworthiness of several Latin countries, have directed their investments to South EastAsian markets because of the relative proximity of these markets. U.K. investors are alsomore heavily invested in the emerging markets of the Far East, although interest in emergingLatin American economies has increased in recent years. Industrial country investors have inthe past used country funds and, more recently, ADRs to invest in emerging market equities.Direct investment in equity markets has been a less important means for investing in thesecountries."

Institutional investors have invested in bonds to a much lesser extent. The reasonbeing that many institutions are constrained by the credit quality of issues (see section IV onregulatory impediments on institutional investors' asset portfolios). Thus US insurancecompanies have restrictions on the quality of their investments, i.e. in terms of the share of

24Dufour (1992) contains an excellent overview of the Canadian pension industry.

25Since emerging markets are weakly correlated with industrialized markets, the potentialdiversification benefits to global investors are sizable.

26Some evidence of this is also available in the recent opening up of the Koreain stock marketwhich has attracted a relatively small amount of foreign investment.

18

sub-investm.ent grade securities in total assets. Since most emerging market bonds, especiallythe Latin American ones, are below investment grade they are of limited interest to theseinstitutional investors. Investment-grade rating on some recent Latin offerings are believedto have boosted the attractiveness of these issues to institutional investors: a BBB-investment-grade rating by Duff and Phelps (a US rating agency) for a $1 billion offering byCemex in May and a $750 million issue by Bancomer in June helped to attract institutionalinvestors to these securities.

Nevertheless, pension funds and insurance companies are approaching emergingmarket securities cautiously. The market perception is that these investors may have setrelatively high targets for investing in emerging market portfolio instruments, but that thesetargets may not have been fulfilled. Our review of financial statements of the largest USpension funds revealed that even though investment committees at a few pension funds hadset a limit of 5 percent for emerging market assets, this limit far exceeded the actual share ofemerging market securities held. Asset allocators usually view emerging market assets in thecategory of "alternative" investment. This category includes non-traditional assets, i.e. assetswith low liquidity and high risk--junk bonds.

Methodology

The recent trends in portfolio investment in emerging market countries by institutionalinvestors can be observed both from these investors annual flows into these countries'securities and from their holdings of emerging market securities. Regional breakdown ofportfolio flows by institutional investors is typically not available in any reliable form. Stockdata is also not readily available. This study employs data on investment mandates, assetholdings based on comprehensive surveys, and asset holdings based on financial statements ofthe largest investors (selected sample). The data is not exhaustive, but it helps us to derivereasonable estimates of investments by institutional investors in these markets.

We were typically able to obtain data on the geographic composition of the portfolioof pension funds but not of insurance companies. In cases where data on insurancecompanies is not available, we assume that these companies have invested the same share inemerging market assets as pension funds. This appears to be a reasonable assumption giventhat life insurance companies (and all insurance companies) have invest.i even less of theirportfolio in assets abroad than pension funds. Thus the assumption would overestimaterather than underestimate the holdings of developing country assets. The exception is Japan,where life insurance companies have invested large sums in foreign securities. For Japaneseinstitutional investors we use data on the composition of stocks registered and traded throughthe Japanese Securities Dealers Association. Despite the limitations of this data, particularlyin that it does not cover all foreign security trading, it is indicative of the underlying trend.

19

Data on investment mandates of US pension funds and asset mix reveals that the shareof assets invested in emerging market securities is indeed very small, though increasing(Table 6). Moreover, the data shows that pension funds have predominantly invested inemerging market equities and to a much lesser extent in bonds. The mandated investment i.small capitalization and emerging markets was about $5.2 billion, or 3.4 percent of the totalforeign investments of US pension funds in 1992. Although this represented more than adoubling of the amount invested in 1989, it was only 0.2 percent of the total investments ofUS pension funds. Despite the sn.all share of assets allocated to emerging market securities,the size relative to emerging stcck market capitalization was considerably higher at 0.7percent. While emerging market investments are a very small share of total investments, theincrease in this share represents an encouraging trend.

Our survey of the largest US pension funds tends to support the small size ofemerging market share in total assets. The geographical composition of the investments ofthe 23 largest private and oublic pension funds, with total asset size of over $550 billion in1991, shows that the emerging market portfolio is less than 0.2 percent of total assets of thisgroup (Table 7) An informal survey of market observers and participants revealed that theamounts invested by pension funds and insurance companies in emerging market stocks isvery small. Furthermore, a good deal of the investment is in Mexican securities, especiallyADRs.27

Japanese institutional investors have also invested very little in emerging markets,typically lagging U.S. and U.K. institutional investors in some regions. Data on thegeographic composition of foreign stocks registered on the Japanese Securities DealersAssociation shows that the category "Other", which includes several OECD countries andemerging developing countries, accounted for 6.1 percent of foreign stocks at the end of1992 (Table 8). Based on this data and discussions with market observers, it is reasonable toassume that emerging market equities comprise less than 2 percent of foreign equities ofJapanese investors and about 0.2 percent of total assets. In addition, discussions with marketobservers indicate that this figure is also fairly representative of Japanese insurancecompanies and pension funds.

The share of emerging market assets in total assets of UK pension funds andinsurance companies is also very modest. Table 9 presents the geographical distribution ofpension fund assets. The data reveals that the amount invested in emerging markets is notmore than 1 percent, and in all likelihood much smaller than 1 percent of pension funds'total portfolio.28 Discussions with investment houses managing UK pension funds suggeststhat this share is tiny and closer to 0.2 to 0.3 percent.

27The Telmex ADR was particularly popular with institutional investors.

28The category "Other Countries" in Table 9 includes Australia, a market in which UKinvestors are fairly active.

20

Table 6Emerging Market Investment of US Pension Funds*

(In billions of US $)1989 1990 1991 1992

Invetrment in Emerging Markets 2 3 4 5.2

Totr.l Foreign Investments. 86 95 125 152

Investmont in Emerging Markets asa percent o, Foreign Investment. 2.3 3.2 3.2 3.4

Sources: Intersec and Girenwich Associates.Based on mandated inv estment of US Pension Funds.

21

Table 7

International Portfolio Investment of Selected US Penslon Funde*(1991)

Size No. of Foreign Assets# Emerg. Mkts. Assets#(billions Funds (range in mill- (range in millionsof USS) ions of US$) of USS)

Under 10 2 523 - 575 0.8 - 0.8(2) (1)

10 - 19.9 8 0.9 - 2,962 5.7 - 44.1

(7) (3)

20 - 29.9 8 0.3 - 4,822 22.2 - 217

(7) (3)

30 - 49.9 3 374 - 1,400 81.4 - 81.4

(2) (1)

50 and up 2 5,684 - 6,045 44.2 - 409.9

(2) (2)

All Funds 23 0.3 - 6,045 0.8 - 409.9

(20) (10)

Sources: Annual Reports and data directly provided by the funds.

* - based on survey of the 25 largest US public and private

Pension Funds. # - figures in parentheses are number of Funds.Valuation dates are not consistent since the fiscal years are

differe~nt for different funds.

22

Table 8Composition of Japanese Overseas Equities*

(In percentage)1988 1990 1991 1992

US 36.7 26.6 32.1 27.5

UK 33.6 18.8 15.5 22.0

Selected OECD Countries** 17.7 36.3 31.8 29.5

Hong Kong 1.9 7.4 8.4 9.8

Singapore 4.4 6.1 4.8 5.1

Others 5.7 4.8 7.2 6.1

Source: Japanese Securities Dealers' Association.* Based on overseas trading by Japanese residents through securities companies.

" Australia, Belgium, Canada, France, Germany, Italy, Luxembourg, Netherlands,New Zealand and Switzerland.

23

Table 9International Portfolio Investment of UK Pension Funds*

(percent of assets overseas)

1988 1990 1991 1992

United States 5 5 6 6

Continental Europe 4 7 8 8

Japan 5 3 5 4

Far East na 2 1 3(excl. Japan)

Other International na 1 1 1

Total Foreign Assets 16 18 21 22

* Based on survey of UK pension funds.

na - not available

Source: World Markets Company

24

Canadian pension funds' foreign portfolio investment is concentrated in U.S.securities. Since stocks account for an estimated 93 percent of foreign assets, about 70percent of foreign holdings are in US equities. Although pension funds have begun todiversify overseas, most of the diversification has been in favor of European equities. Thusthe amounts invested in emerging markets are indeed very small. For lack of better data weassume that Canadian institutional investors have the same share of their assets in emergingmarkets securities as U.S. institutional investors. An assumption that again overestimatesrather than underestimates the size of emerging market holdings.

Tight restrictions on foreign assets of German pension funds and insurance companieshave curtailed investment in developing country assets. In this study, we assume the level tobe negligible.

Based on the above, major industrial country pension funds and insurance companies'holdings of foreign securities were about $17 billion to $20 billion at end-1992. These assetsrepresent 2 percent to 3 percent of emerging market capitalization. The observed upwardtrend in holdings of emerging market assets indicates, however, that institutional investorscould prove to be an important source of finance in the future.

IV Impediments to Institutional Investors' Portfolio Investments in DevelopingCountries

Regulations in Investor Countries

Although industrial countries have liberalized capital movements, institutionalinvestors in these cou.itries still face restrictions on their foreign investments (Table 10).Even though the degree of regulation is quite varied across the major countries, insurancecompanies are generally more tightly regulated than pension funds. Insurance companiestypically face ceilings on the amount of foreign assets in their portfolios. In addition, theyfrequently are subject to restrictions on the share of equities in total assets, the quality ofinvestments, and the use of financial techniques. Pension funds, on the other hand, generallyhave less stringent restrictions and controls and have more freedom to invest overseas. Theyare usually subject to prudent investment and diversification rules, and only occasionally tolimits on the size of external assets. Because ef their fiduciary responsibilities, however,pension fund trustees tend to be rather conservative.

25

f-11.ftTH67Ii4 R ii l aliliti-i rd Portfolio Investmentof Institutional Investors In Five Major Industrial Countries

Restrictions on Foreign Investments ofCountry Insurance Companies I Pension Funds

Canada Ceiling: none. A June 1992 regulation Ceiling: A December 1991 lawremoved ceilings on foreign investments, progressively raises the ceiling on foreignbut limits may be imposed based on investment from 10% to 20% in 1994.prudential considerations.

Germany Ceiling: prohibitive at 5% of Ceiling: prohibitive at 5% of assets.coverage fund. An EC directive would Other: 100%/. matching of liabilities byraise the ceiling on foreign investment in assets in the same currency; restrictions on1994,but regulators are still expected to credit quality of investment.require assured returns on investments.Other: I 00. matching of liabilities byassets in the same currency; restrictions oncredit quality of investment

Japan Ceiling: nonbinding at 30% of assets in Ceiling: nonbinding at 30% of assetsthe general account.a in the general account.Other: companies place tight restrictions on Other: pension funds place tightcredit quality of investments; accounting restrictions on credit quality of investment.incentives which bias investment in favor ofhigh-income securities against thoseyielding potential capital gains.

United Kingdom Ceiling: none. Ceiling: noneOther: at least 800/O matching of liabilities Other: prudenceby assets in the same currency for liabilitiesin any currency that aecount for more than5% of the total.

United States Ceiling: varies by state and is Eiublictypically prohibitive. New York State, Ceiling: typical and often binding.which is the most influential state on Other: Charters of some pension fundsinsurance issues, raised the ceiling on impose restrictions on credit quality offoreign investments of insurance companies investments.to 6% from 3% in 199 0.b PrivateOther: restrictions on credit quality Ceiling: none.of investment; c restrictions on composition Other: "prudent man" rule andof assets. diversification ,d charters of some pension

funds impose restrictions on credit quality ofinvestments.

aRestrictions on Postal Life Insurance are more prohibitive.bDoes not include investments in Canada.clnvestments are rated by the National Association of Insurance Commissioners (NAIC).dThe Employee Retirement Income Security Act (ERISA) of 1974, which govems U.S. private pension funds, requires plan fiduciariesto exercise prudence in investment decisions. ERISA also requires plan trustees to diversify investments in order to minimize risk.

Source: Industry sources and regulatory agencies.

26

Insurane Cmp

Insurance companies, particularly life insurance companies, in the U.S. have variouscontrols on their portfolios.29 Insurers are subject to insurance laws of the state in whichthey are domiciled and even in the state in which they sell their products. Although stateinvestment laws are not harmonized, the thrust of these laws is to impose quantitativeceilings on the percentage of assets that can be held in various forms. Thus, there areceilings on the asset mix between bonds ane equities, on the percentage of assets invested incorporate and public securities, and on the domestic and foreign composition of assets.These quantitative rules are designed to ensure appropriate diversification of the portfolio ofinsurers. State regulators have imposed severe limits on external investment of insurancecompanies. New York State, which is the most influential state on investment issues, onlyrecently raised the ceiling on foreign investments of life insurance companies to 6 percentfrom 3 percent of admitted assets.30

In addition, state investment laws require insurers to maintain miniimum creditstandards on their assets. States typically place ceilings on the share of insurance companyassets that can be held in below-investment-grade securities. The credit rating systememployed by the insurance industry has been developed by the National Association ofInsurance Commissiorners (NAIC). The NAIC rates the credit quality of securities anddetermines the amount of mandatory reserving required against assets of insurancecompanies. The NAIC's rating system is different from that of other rating agencies likeStandard and Poor's and Moody's, however. For example, under NAIC's rating system, aforeign company can get a higher rating than the sovereign rating of the country in which thecompany is domiciled. In 1990, following balance sheet problems at several insurancecompanies stemming from real estate losses and loan quality problems, the regulators rewrotethe credit rules for the insurance industry. The NAIC reformed its credit rating system anddowngraded some securities which had previously been rated investment grade. The NAICis currently working on reconciling state laws.

Other major industrialized countries like U.K. and Germany also impose restrictionson the portfolios of life insurers. In the U.K., life insurers have to match the currencycomposition of their assets to the currency composition of their liabilities. Thus for liabilitiesin any currency that account for more than 5 percent of the total, there has to be a matchingof assets of at least 80 percent in the same currency. Since the liabilities of U.K. lifeinsurers are mostly in domestic currency--sterling--the restriction on matching of assets doeslimit the external assets of these companies.

29Refer to Bedore (1991) for an analysis of the world insurance industry and Wright (1992)for a study of the U.S. life insurance industry.

30Canadian investments are not included in this ceiling.

27

In Germany, the Law on Insurance Supervision is even more prohibitive. Theinvestments of German insurance companies and pension funds are tightly regulated by thefederal government. The assets of German insurance enterprises are to be invested so as toobtain maximum security and returns while ensuring liquidity of the enterprise. Coinmittedassets, consisting of a coverage fund and other committed assets31 (the coverage fund is forlife insurance reserves and the other committed assets cover technical reserves anddividends), are restricted to investments in only 14 predetermined categories. Furthennore,committed assets are to be invested in the same currency in which insurance payments are tobe made, i.e. according to the matching rule. Insurance companies are allowed to invest upto 5 percent of the assets of a coverage fund and 20 percent of the amount of the othercommitted assets overseas. However, foreign stocks may not exceed 20 percent of the totalamount of stocks that can be held by the coverage fund and the other committed assets. AnEC directive requiring a more liberal ceiling percent on foreign investments is expected toboost German institutional investors foreign asset holdings, although the German regulatorsrequirements of assured returns will continue to be a constraint.

Japanese insurance companies have comparatively less prohibitive restrictions on theirexternal investments, although overall investment practices are strictly regulated. In the1980s, Japan continued to raise the ceiling on the percentage of foreign assets allowed in theportfolio of life insurers. Most recently, in 1986, this ceiling was raised to 30 percent from23 percent. Ceilings on holdings of foreign securities have reportedly not been binding sincethe late 1980s, however. The investments of LICs and non-LICs are subject to the sametypes of regulation.

Until recently, Canada had fairly tight restrictions on the share of foreign assets ininsurers portfolio. The Cana.dian and British Insurance Companies Act, under whichCanadian companies were regulated before June 1, 1992, required Canadian companies tomatch their Canadian currency liabilities by Canadian currency assets. The InsuranceCompanies Act, which came into force last year, imposes ceilings on equity and real estateholdings but no specific limits on foreign investment. Other limits may be imposed based onprudential considerations, however. The easing of restrictions is expected to boost demandfor foreign securities, including emerging market securities.

Pension Funds

Pension funds enjoy considerable freedom in investing, including overseas investing.Private pension funds in the U.S. are governed by the Employee Retirement Income SecurityAct (ERISA) of 1974.32 33 ERISA imposes no regulatory impediments to investment. Thus

31Assets required to cover liabilities are terned committed assets.

32In 1974, the U.S. Congress passed sweeping legislation reforming the laws governingprivate pension funds. The ERISA legislation established new standards for plan fiduciaries.

28

there are no quantitative restrictions on private pension funds, but plan fiduciaries arerequired to exercise prudence in investment decisions. Plan trustees are also required todiversify investmerits in order to minimize risk. Public pension funds in the United Statesare constrained by state investment laws and statutes, however, and the restrictions onforeign investments are often severe. As in the case of life insurance companies, theserestrictions vary across states. Pension funds in the U.K. also operate under the prudent manrule. In Japan, on the other hand, the ceil?ng on the share of foreign assets of 30 percent issimilar to that on life insurers and is reportedly nonbinding.

Several countries do maintain regulatory constraints on foreign assets of pensionfunds, however. Thus pension funds in Germany are subject to tight restrictions on foreigninvestment similar to those on insurance companies, and assets are governed by the matchingrule. Canada continues to maintain a ceiling on the share of foreign assets, although it easedthe ceiling from 10 percent to 20 percent in 1990. The Income Tax Act of 1971 permittedCanadian pension funds to invest no more than 10 percent of the book value of pension planassets in non-Canadian investment. Pension funds that exceeded this ceiling were subject toa penalty of 1 percent per month of the value exceeding this limit. In 1990, the governmeitintroduced a proposal to increase this limit to 20 percent in 1994, through yearly incrementsof 2 percent. The proposal was officially adopted by law makers in December 1991.

Host Country Factors

Whereas regulations in investor countries have been a factor in determining theoverseas investments of institutional factors, other factors have often been more crucial. Inour informal survey of market experts and participants, the most frequently citedimpediments to investing in emerging markets were the perceived riskiness of these markets,limited in?ormation on these markets, and illiquidity problems arising from smallness ofmarkets. Surprisingly, restrictions in host countries did not appear to be a crucial factor.

Institutional investors in the U.S. have approached emerging markets securitiescautiously because of the high relative riskiness and the relative illiquidity of these markets.Debt issues of emerging markets, specially those in Latin America, are usually belowinvestment grade and therefore often do not meet credit quality requirements. In addition,only a few stocks listed in emerging stock markets meet the investment criteria that USinvestors are used to. US institutional investors are also inhibited by the smallness of the

Under the new rules plan fiduciaries are required to be strongly loyal to plan beneficiaries.Actions which conflict with loyalty are clearly stated. Failure to meet these fiduciaryresponsibilities may result in loss of tax-exempt status of a pension plan. The new legislationalso set up minimum funding requirements for pension plans. In addition, the new legislationcreated an insurance scheme for pension benefits through the Pension Guaranty Corporation.

"Also refer to Brown (1991).

29

market. The small size of markets and their domination by a handful of companies adds toexcessive volatility. Moreover, investors believe that the small size of these marketscontributes to privileged information as being a big factor in moving share prices. Lack ofinformation is not a major concern with respect to Latin markets, because of proximity ofthese markets, but may be a problem with markets in other regions. Only in the case of lifeinsurance companies were investment ceilings (in source country) considered to be a seriousconstraint. U.S. institutional investors do not view host country restrictions as beingparticularly strong impediments to investing in emerging country securities.

Japanese investors are particularly concerned about the perceived riskiness ofemerging markets and the lack of information on most of these markets. Japaneseinstitutional investors do not have enough staff to cover these countries, thus directparticipation by Japanese investors in these markets has been very limited.34 The relativeilliquidity of these markets is also viewed as a serious problem. Japanese investors typicallyinvest large sums abroad, and their investment decisions are likely to move small markets.This could explain why U.S. treasuries, which are very liquid, have been so popular withJapanese investors in the past Host country restrictions, on the other hand, are not viewedby Japanese investors as being overly prohibitive.

More constraining, especially for insurance companies, are common practices withinthe industry and Japanese regulations governing dividends. Insurance companies aretypically conservative in their investments, and as a practice tend to purchase mostly highinvestment-grade securities. As pointed out earlier, most emerging market issuers do notmeet this investment criteria. Turning to regulations on dividends, insurance companies areprohibited from using capital gains to pay dividends to policyholders. These institutions thusprefer high-yield securities over equities with a large potential for capital gains. This policypotentially xestricts the participation by insurance companies in emerging stock markets.

UK institutional investors view the relative illiquidity and relative riskiness ofemerging markets as major impediments to investing in these markets. Limited informationon these markets was also perceived as a problem. Host country regulations, however, werenot a crucial impediment to investment in emerging country securities. Moreover,investment restrictions were also not viewed as an obstacle.

Among the five major industrialized countries, Germany presents the only clear casewherein investor country restrictions have been the main obstacle to investing. The tightrestrictions on institutional investors have strongly curtailed their overseas investments. Thisis riot to say that the perceived riskiness of emerging markets, limited information, and poorliquidity are not viewed as serious impediments.

34Japanese institutional investors prefer ADRs and Euromarket securities issued by emergingmarket entities.

30

Limited information about the emerging markets and risk perceptions are cited as theimportant constraints for Canadian institutional investors. The cost of obtaining informationis very high and is viewed as a limiting factor. These could explain Canadian investors'strong preference for US securities. The attractiveness of the U.S. market partly stems fromknowledge of this market based on its proximity and a familiarity with the legal andaccounting practices in the U.S.. The ceiling on overseas investment is not generallybelieved to be a key factor, although large pension funds, which tend to invest a higherpercent of assets overseas, might find it to be not unimportant. Host country restrictions oninvestment are not perceived as a significant deterrent.

Access of Developing Countries to Industrial Country Capital Markets

Rules and regulations governing issuance of securities in industrial markets canimpede developing country borrowers from accessing these markets and the associatedinvestor base. A case in point is the "onerous" public disclosure requirements required bythe US Securities and Exchange Commission for listing in the US public market. The USSEC's Rule 144a, on the other hand, is an example of how foreign issuers' access to USinvestors can be improved. Then again, some countries, such as Japan, require issuers--foreign and domestic--to obtain a minimum rating to be eligible to issue bonds in thedomestic public market. Recently, the Japanese authorities have eased restrictions on foreignissuers in the Shibosai (private placement) market in a move paralleling that of the US SEC'sRule 144a.

The US Capital Market and Rule 144a

For non-US issuers the US capital market is attractive because of its size, but untilrecently, this market has had a complex regulatory system. The U.S. Federal Securities Actof 1933 imposes "onerous reporting requirements" on issuers in the US market. Rigorousdisclosure and reporting requirements under the US securities laws have inhibited non-USissuers. On April 19, 1990 the US Securities and Exchange Commission introduced Rule144a.35

Rule 144a is designed to enhance foreign issuers' access to the US market by easingrestrictions on resale of privately placed securities. This rule allows unrestricted trading ofcertain classes of securities, which are initially issued without compliance with the SEC'srigorous registration requirements for public offerings. The safe harbor exemption isprovided to ADRs, preferred stock, common stock, equity linked securities, and debt. Thesecurities exempted must be non-fungible, which means that they must not belong to thesame class as securities listed on US securities exchange or quoted on NASDAQ. The non-fungibilitv requirement is designed to prevent the growth of two markets--a public retail

35The SEC also introduced Regulation S, which permits offerings of securities to be madeoutside the United States without registration under the Securities Act.

31

market and a private institutional market--for the same security. The nonfungibility of anunregistered security and (therefore) its eligibility for resale under Rule 144a are determinedat the time that the security is originally issued. The purchasers of the securities, in turn,must be 'qualified institutional buyers'. QIBs can purchase these securities for their ownaccount or for the account of other QIBs. A qualified institutional buyer is typically aninstitution that owns and invests at least $100 million in securities of issuers who are notQIBs.36 Rule 144a also contains a notice requirement, which states that the seller must takereasonable measures to make the buyer aware of the registration exemption contained underthe rule. Furthermore, some issuers have to disclose certain information to holders andprospective purchasers of securities if requested. This information requirement is notonerous, however.

The improved access and increased secondary market liquidity provided by Rule 144ahas undoubtedly contributed to the increase in emerging market issues in the U.S. privateplacement market.3" Total cross-border private placements under Rule 144a rosedramatically to $20.9 billion in 1991 from $3.7 billion in the previous year. Issues from theemerging markets group were over $3 billion in 1991. This represents a sizable share of thetotal amount issued in foreign markets by these countries.

Rule 144a placements involving depositary receipts have been a popular vehicle forraising equity capital for emerging country companies. In 1990, non-US companies raised$889 million (7 issues) in equity capital through Rule 144a placements involving depositaryreceipts.38 The emerging market group of countries raised only $40 million in equitycapital through one Korean issue. In 1991, non-US companies raised over $2.7 billion inequity capital through 22 issues. The emerging market countries successfully used thisvehicle for raising $2.2 billion in equity capital. Mexico accounted for the bulk of the equitycapital raised by emerging markets through 11 issues. The upward trend in equity capitalraisings through Rule 144a placements involving depositary receipts by emerging marketcountries has continued as more countries have accessed this market.

Capital raising through Rule 144a ADRs are especially popular among first-timeissuers in the US equity market. During 1991 and the first quarter of 192, ADR offeringsunder rule 144a were usually small, with 7 of them under $100 million. The largest ADRoffering in this category was a $636 million offering by Telefonica de Argentina, the

36Banks and thrifts must have $100 million in securities investments and also have $25million in net worth. Broker-dealers need only have securities investmtnts of $10 million.

"Some observers believe that the major gain from Rule 144A is expected to be on the equityside because the private placement market for foreign equity issues was more restricted than theprivate placement market for foreign debt issues.

38Also called RADRs, which are ADRs issued in the U.S. Rule 144A Market, and GDRs,which are simultaneously issued in the US Rule 144A Market and the non-US public markets

32

Argentine telephone company. Public offerings, by contrast, have been used mostly bycompanies that are already publicly traded in the US or that have large issues. ThusTelefonos de Mexico, the Mexican telephone compaiiy, used a public ADR offering for its$1.9 billion equity issue in 1991 and Yacimientos Petroliferos Fiscales (YPF), theArgentinean national oil company, offered $3.04 billion of depositary receipts in itsprivatization.

Despite a narrow investor base, the attractiveness of raising capital through Rule 144aADRs market is in terms of lower cost and less preparation time.39 Rule 144a capitalraisings through ADRs are cheaper and quicker than public offerings. It is costly and timeconsuming to get foreign companies to comply with SEC rules, especially US accountingstandards.'" The average time to get a rule 144a ADR issue to the market is about 6weeks, considerably less than the 6 to 8 months that it takes to get a public ADR listing. Ofcourse, liquidity in the public market is much greater than in the Rule 144a private market,which has a narrow investor base limited to qualified institutional investors. However,liquidity in the U.S. private placement market is not likely to be a problem for small issuers,especially first-time issuers.

Emerging market countries also used the Rule 144a private placement market to issuebonds. These countries issued over $1 billion in bonds through Rule 144a private placementsbetween 1990 and the first quarter of 1992 (this includes issues that had a Rule 144a trancheor a Eurobond facility).

Of..er factors have also contributed to the rise in cross-border private placements.The easing by New York State of the foreign investment ceilings on insurance companies,which are an important source of funding in this market, has provided a boost to cross-border issues. Another important development was NAIC's reform of the credit ratingsystem. The reform resulted in a shortfall of domestic issuers of acceptable quality andimproved the attractiveness of some foreign accompanies. Insurance companies haveincreased their investment in foreign private placements. The 10 largest US insurancecompanies invested between 7 to 25 percent of their private placement investments inforeign-domiciled credits in 1991.4' In addition, more insurance companies, particularly thesmaller companies, are also entering this market. According to market sources, over 50insurance companies invested in cross-border private placements in 1991.

Economic conditions in the United States and in other industrialized countries havespurred the growth of cross-border issuance by emerging market countries. Furthermore,

39Also refer to "Wall Street's Latin Bonanza," Euromoney, April 1992, pp. 65-68.

40A rule 144A ADR will usually cost a company less than $500,000 in accounting and legalfees, whereas a publicly-listed ADR can cost up to several million dollars.

41IDD, May 11, 1992.

33

low interest rates in the US have also prompted many countries to seek credit here. ThusMexican borrowers, faced with record low US interest rates and high capital costs at home,have aggressively issued debt securities on overseas markets. US markets have an addedattraction in that they offer a wider range of maturities, which allows companies to match thelives of their liabilities to those of their assets.

Japanese Public (Samurai) and Private Placement (Shibosai) Markets

Credit guidelines for Samurai bond issues were relaxed in August 1992, improvingforeign borrowers' access to Japan's capital market. Sovereign and public entities now needa 'BBB' investment grade or higher rating to issue in this market, compared with theprevious minimum 'A' rating. Since the more liberaiized rule was introduced, a number ofdeveloping countries hae-c launched offerings in this market. However, the continuingdifferentiation on the basis of credit means that lower rated (non-investment grade) borrowersare not afforded access to this market.

This April, The Japanese Securities and Exchange amended rules for non-Japaneseissuers in the private placement--Shibosai--market (which resembles the US 144a privateplacement market), increasing the attractiveness of this market both for issuers and forinvestors. The new rules have widened the number of 'Qualified Institutional Investor'categories from 11 to 15. Two types of issue are now allowed instead of only one type: a'Q bond' which can be sold to an unlimited number of qualified institutional investors and a'49er which can be sold to 49 or fewer domestic investors. Ceilings on issue size have alsobeen raised, including a doubling for issuers rated 'A' or lower to Yen 20 billion. Likewise,the maturity terms have been eased and are in a range of 2 to 20 years. The new rules havealso eased restrictions on the resale of these bonds improving secondary market tradability.These moves have enhanced the Shibosai as a source of funding for foreign issuers, and theyhave also imnproved the attractiveness of this market for investors.

v Conclusion

The recent rapid increase in capital flows to many developing countries has raisedquestions regarding the sustainability of these flows and the importance of "push" and "pull"factors. On the one hand, global factors such as the sharp decline in US and global interestrates and the slowdown in US and other major industrial county economic activity arebelieved to have played an important role in pushing portfolio investment in developingcountries. On the other hand, improved economic prospects in many developing countriesare viewed as being instrumental in attracting (pulling) capital to these countries.

The surge in private source capital flows to developing countries coincided with aweakening of economic and financial conditions in major industrial countries. After nearly adecade of strong growth in industrial countries and rapid growth of capital markets,economic conditions in the major industrial countries reversed beginning in 1989. In theU.S., the economic outlook soured. Moreover, strains emerged in the U.S. financial

34

markets as result of the collapse of the junk bond market, weakness in the real estate sector,deterioration in the credit quality of several issuers, and high indebtedness of households.Investors were increasingly concerned about the soundness and profitability of the bankingsystem and of other financial intermediaries. In Japan, the bubble of inflated stock and realestate prices burst causing serious problems for financial institutions. Investors becameincreasingly worried about the solvency of major financial institutions in the country. InGermany, the cost of economic and political unification added to uncertainty regardinginterest rates and exchange rates in European countries. All these factors heightened investoruncertainty and weakened investor confidence in industrial country markets.

The increasing uncertainty in mnajor markets prompted investors to exit these markets,especially the U.S. and Japanese markets, and find new markets. Investors were seekingmarkets where they could increase returns while lowering risk. A rebalancing of investorportfolios occurred in favor of the emerging markets of Latin America and South East Asia.These markets presented the potential for both high returns and diversification benefits toinvestors.42

A recent study by Calvo, Leiderman and Reinhardt (1993) argues the importance ofglobal factors in explaining the surge in capital flows to developing countries. The authorsfinds that the decline in US interest rates (e.g, the three-month US Treasury bill rate fellfrom 5.9 percent at the beginning of 1988 to 3.3 percent at the end of 1992) and theslowdown in US industrial production over the period 1989-1992 can explain a substantialamount of the capital inflows to Latin America. They conclude that a reversal of theseglobal factors could induce a capital outflow from these countries.

Another study, by Chuhan, Claessens, and Mamingi (1993), finds evidence of bothglobal and country-specific factors in boosting portfolio investment in emerging countrysecurities. In fact, this study shows that country-specific factors (indicative of the risk andreturns of investing in the country) are at least as important in explaining capital flows asglobal factors. Over the past few years, several country-specific factors, including stockmarket returns, credit ratings, and secondary market prices of sovereign debt, postedsubstantial gains on the back of credible economic management, far-reaching economicreforms, and reduced debt-service burden (through implementation of Brady-style debtreduction programs) in many developing countries. For example, the rates of returns onemerging stock markets rose sharply: the IFC's dollar-based composite index for LatinAmerica rose 294.2 percent over 1988-92 and that for Asia 49.5 percent, while the S&P 500index rose 108.4 percent. Credit ratings (e.g., as measured by Institutional Investor) alsoimproved during this period. At the end of 1992, the secondary market price of sovereigndebt (for a selected group of countries) was higher by two-thirds from the level at end-1989.The significance of country-specific factors sug,gests that industrial country private capitalflows to developing countries might well be sustainable in the medium-term if developing

42Also see Howell and Cozzini (1991) for an explanation of global equity flows.

35

countries pursue appropriate policies.

Another factor that lends support to the notion of sustainability is the observed recenttrend towards increased diversification into foreign assets by industrial country investors. Inthe late 1980s, US investors began to diversify their portfolio in favor of foreign assets. Acontinuation of this trend is expected to boost portfolio flows to developing countries.

36

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