The China challenge

By Hugo Restall
[Editorial page editor, The Asian Wall Street Journal, November 21, 2001]

Chinese pension reform probably sounds to most people like a pretty boring topic. But consider that if the pension system for one-fifth of humanity is left the way it is now, China's savings rate could fall to about 20% of GDP in 20 years' time from 40% today -- and so cut the country's, and the world's, economic growth rate dramatically. Over the next five years, the Chinese pension system's deficit is projected to total $35.4 billion, compared to $4.3 billion last year.

The good news is that the experts all seem to agree about what needs to be done. Earlier this month at a conference cosponsored by the Cato Institute, an American libertarian think tank, and Peking University's China Center for Economic Research, there was near universal agreement that fully funded individual accounts were the way to go.

Jose Pinera, the pioneer of this model in Chile, was there to give an address. But he also got called into multiple meetings over at China's Ministry of Labor and Social Security, suggesting that the consensus is spreading among the bureaucrats.

However, there's plenty of room for caution as well. Back in the mid-1990s, the World Bank was, incredibly, giving China some good advice. In its "China 2020" series of reports published in 1997, the Bank suggested that the country support its elderly with three "pillars" -- a safety net for those in danger of slipping below the poverty line; large, mandatory individual retirement accounts; and voluntary savings. Not much progress has been made toward that goal since then, so what's to suggest things are about to change now?

So far China has only managed to increase the size of the "pools" of money which companies and workers pay in order to finance the pensions of current retirees. In other words, the thousands of little pay-as-you-go systems administered at the city and county level are being consolidated under the provincial governments. Creating a unified system is part of the final vision, but in the short run this seems to have made things worse. As Zhao Yaohui writes elsewhere on this page, when benefits are doled out by a distant bureaucracy, local authorities and the workers themselves lose all incentive to make sure the contributions are made. Firms are dodging payments without consequence, swelling the deficit.

China has even fallen into a trap that the World Bank warned about, notional accounts. Workers are told that they are accruing a pension in their own account, and even earning a low rate of interest on it. When they retire, their pension will be based on the total found in their account statement. But in fact there is no money backing up the account, since the state continues to pay retirees out of the contributions coming in from workers. Even a pilot scheme this year in Liaoning province which was to experiment with real individual accounts has apparently devolved back into notional accounts because it ran short of money.

The problem China faces is navigating the transition to a fully funded system. If the new system is linked to the old in any way, as in Liaoning, it will surely be dragged down. It's becoming increasingly clear that a clean break is needed. But how to make that break?

In principle, funding the existing obligations to retirees and workers with less than, say, 15 years to retirement shouldn't be too difficult. The best option is using the proceeds of privatization. But the burden can also be shifted onto future, wealthier generations by issuing bonds. The present value
of China's unfunded pension obligations has been estimated at 50% of GDP, which sounds impressive. But considering that China's national debt is not very high, financing it with bonds over the coming decades is reasonable.

The real worry is that the deficit in the pay-as-you-go system might balloon as more companies dodge their obligations. The temptation will then be to "borrow" against the fully funded accounts, as seems to be happening in Liaoning.

The only solution is to allow individuals closer control over their own savings, and allow them to employ the services of private fund managers. Also the accounts shouldn't be limited to those younger workers who have time to accumulate a full pension. A sliding schedule should be devised so that even someone with just a few years left before retirement can opt to have the contributions for that period placed in his own account, rather than in the pension pool, in return for a reduction in his state pension.

Given the justifiable suspicion among workers that they will never be paid their pensions, this option would no doubt be attractive to many. It would motivate the worker and local authorities to make sure employers make their contributions, thus cutting the deficits caused by noncompliance.

There would be problems to overcome. China's capital markets are at an early stage -- the stock markets are volatile, and the first open-end mutual fund has only just been launched. So workers with a short time-horizon would probably be restricted to investing in government bonds with low returns. The transition costs would be moved up, as the money flowing into the pay-as-you-go pools would fall off faster.

The main benefit would be to the reform process, by establishing the benefits of fully funded accounts for all workers and protecting them from the depradations of the pay-as-you-go system. Older workers choosing self-reliance over the iron rice bowl would have a powerful demonstration effect.



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