A Fix for China's Pensions

By James A. Dorn
[The Asian Wall Street Journal. February 9, 2004]

Prior to leaving office last year, Chinese Premier Zhu Rongji argued that pension reform is "the lifeline of our workers." He thus recommended that retirement funds be professionally managed and workers be given a wider range of investment options. He was right. Moving from a pay-as-you-go system to a fully funded system, in which workers have property rights in their retirement accounts, is what China needs. It is also surely consistent with the socialist goal of empowering workers -- a point Jose Pinera, the architect of Chile's successful privatization program, made when he visited China in 1997.

Today China has a highly fragmented social security system confined primarily to workers in urban state-owned enterprises (SOEs). The high payroll tax rates and precarious nature of the system have led to noncompliance and evasion, and workers in the growing nonstate sector have little incentive to join.

China's aging population will sharply increase the number of retirees who have to be supported by each worker over the next few decades. That demographic problem combined with the inability of SOEs to cover even the pensions of current retirees makes reform of the system a top priority.

Some steps have already been taken. In 2001, China's ruling State Council sanctioned an experiment in the northeastern province of Liaoning, intended to increase the use of "social pooling" and to create a firewall between the pay-as-you-go pillar and individual accounts. A National Social Security Fund was also established.

But little progress has been made. Assets allocated to the individual accounts were used to pay current retirees, and the plan to finance the fund through the sale of SOE shares never materialized.

If the present system is not changed, payroll taxes will move steadily upward. Yan Wang, an economist at the World Bank, and several other economists have calculated that tax rates would have to rise from 24% today to 27% in 2005, 45% in 2030 and nearly 60% in 2050 to bring the pension system into balance. Such increases would cripple economic growth in China.

Another indicator of the unsustainable condition of China's pension system is implicit pension debt (IPD) -- the present value of all future benefits promised to current retirees and those still in the work force, in the event the pay-as-you-go system ended today. The World Bank estimates today's IPD amounts to about 50% of China's gross domestic product.

To solve China's pension crisis, the priority is to address the loss-ridden SOEs and the weak condition of the four large state-owned banks. Pension reform cannot be successful without a broad-based change in China's ownership structure. The lack of well-defined property rights to pensions, enterprise assets, and bank capital means that China's financial sector needs radical reform.

The best way for China to put its pension system on a sound footing is by large-scale privatization. Implicit pension debt must be made explicit and the current hybrid system fully privatized, along with SOEs and state-owned banks. Trying to revitalize SOEs and recapitalize state banks will not do the job as long as majority ownership remains in the hands of government officials. Investment decisions will be politicized and capital will not be put to the best possible use. Corruption will continue and wealth will be squandered as special interests vie for political favors.

In a recent article in the Cato Journal, Yaohui Zhao of Peking University and Jianguo Xu of Duke University show that, under reasonable assumptions, China could pay off its pension debt and fund a private system with a total contribution rate of only 15.8% of payroll.

However that can only happen if workers' contributions to their individual accounts remain invested and earn competitive rates of return. To be successful, pension reform must be accompanied by freedom of capital -- workers must be free to choose from an array of investment options, including investing in the private sector and in foreign markets. Moreover, private-pension fund management is essential if the retirement accounts are to be free of political interference.

If all the above assumptions hold, then workers in the nonstate sector who have no incentive to enter the pay-as-you-go system will find the new approach attractive. Their broad participation would make the lower tax rates possible. Moreover, if SOEs and state-owned banks were privatized, workers would have new investment opportunities and the proceeds from those sales could be used to fund the transition. The sale of state assets would also allow authorities to lower the payroll tax needed to finance the new system and pay off the pension debt. If a broad-based tax were substituted for the payroll tax, rates could be even lower with further gains in efficiency.

The longer China waits to move toward a fully funded system, the more costly that transition will be. Workers will not become empowered until they have full rights to their pension funds. Privatizing the pension system would create new wealth that stays with the workers and could be left to family members or others. Workers would no longer be tied to their firms or be wards of the state upon retirement. The private sector would grow as SOE holdings were reduced and new savings and investment poured into the most productive sector of the economy. To achieve those results, China will have to honor its commitment to the World Trade Organization to allow foreign banks to compete fully with state-owned banks by 2007, liberalize interest rates, open capital markets, respect private-property rights, and depoliticize banking and commerce.

Several years ago Ms. Zhao argued, "The best alternative in solving the financial crisis is to give individuals incentives to participate. The best way to give incentives to individuals is to put all pension contributions (from both employer and employee) into individual accounts and make sure that the investment earns competitive returns. This gives individuals the property rights to these accounts." Once workers' rights to their pensions are secure, they will have greater freedom and a brighter future than under the present politicized pension system. Mr. Pinera is correct when he says, "The world would be a better place if every worker were also an owner of capital."

Privatizing China's pension system would be a giant step in the right direction. But that must be accompanied by a larger privatization program if China is to realize its full potential.

Mr. Dorn is a China specialist at the Cato Institute and co-editor of "China's Future: Constructive Partner or Emerging Threat?" (Cato Institute, 2000).