China’s pay-as-you-go pension system, created in 1995, is on the verge of bankruptcy, largely because of a rapidly aging population (Exhibit 1). At the same time, the country’s one-child-per-household policy is undercutting the traditional family approach to caring for aged parents, leaving the government to care for the elderly. To finance pensions, the government must fill a gap that will come to $15 billion by 2005 and to $110 billion by 2010 (Exhibit 2). Major changes in government policy are needed to meet these obligations and to manage pension assets more professionally. When the reforms come, they will be among the strongest drivers of development in China’s nascent primary and secondary capital markets as well as in fund management, thereby creating sizable opportunities for domestic and foreign securities firms alike.

One way to close the deficit would be to turn state-owned enterprises into publicly traded ones; almost two-thirds of China’s top 500 companies have yet to be listed.¹ On current plans, by 2005 equity issues are expected to reach a total of $200 billion, including more than $80 billion from large-capitalization companies. A further substantial source of funding would be the sale of the currently nontradable state-owned shares through secondary-market offerings. At the end of 2000, such nontradable shares were worth, at market prices, $387 billion—that is, 67 percent of the market capitalization of all listed companies in China (Exhibit 3).

But selling state-owned shares remains a sensitive matter. In October 2001, securities regulators suspended their sale after they were blamed for a market collapse, so the government is now searching for an alternative. Government debt issues may help pay for pensions, though not in the long term. The authorities are exploring ways to modernize the market for domestic government debt by creating regular auctions of large and liquid benchmark issues.² But the management of public pension assets, currently carried out in a decentralized way by government staff with little training, could prove to be a bigger challenge than financing the deficit. Pension funds hold only 1 percent of the personal financial assets of individuals in China, compared with 6 percent in Hong Kong, 28 percent in Singapore, and 37 percent in the United States.

Proposed reforms, following the global trend, will move China away from the current defined-benefit model and toward its defined-contribution counterpart.³ One model China has been considering is the system used in Singapore, where both employers and employees contribute to a designated fund, and benefits depend on these contributions and on the fund’s performance. To ensure long-term returns, the government may gradually allow domestic and foreign institutions to manage the money. If defined-contribution pension plans are introduced, they should promote an increase in the total value of equity holdings in China as well as big changes in the domestic securities business.

Investors, for example, will pay increasing attention to their asset mix and to the risk-return profile of their pension assets, and they will be able to choose from a wider range of higher-quality financial products. Open-end mutual funds, first allowed in China in September 2001, will probably be favored. As demand and competition rise in the mutual-fund business, the cost of these products will fall to the levels prevailing in developed markets.⁴

Meanwhile, the presence of institutional asset managers in China will grow as more retail equity investment flows into pension and mutual funds. Retail investors dominate equity markets in China; in 2000, its institutional investors undertook just 20 percent of all trading, compared with 49 percent in Hong Kong and 58 percent in the United States. By 2005, institutional investors are expected to account for 30 percent of all trading, and total accumulated public pension assets under professional fund management should be worth $23 billion to $37 billion, up from essentially zero today. Annual fund-management revenue might be as high as $230 million to $370 million. Under the terms of China’s agreement to enter the World Trade Organization, foreign fund managers can participate in the domestic market through joint ventures in which they can have stakes of up to 33 percent until year-end 2004, rising to 49 percent thereafter.

Finally, regulators will have to improve their monitoring and enforcement capabilities. As education and experience make investors more sophisticated, it might be possible to shift the responsibility for scrutinizing the market to investors, as the United States has.

A shift to defined-contribution pensions and the closing of the pension-funding gap through the listing of state-owned enterprises and the sale of state-owned shares will make China’s domestic equity market the most important in Asia outside Japan. Precisely how the Chinese equity market will develop is still unclear, but securities and fund-management companies with global aspirations can’t ignore it.