Standards, Codes and Pension Flows

by Helmut Reisen

​The case for mutual benefits arising from the global diversification of portfolios holds well for funded retirement savings. While in the developed world unfunded (pay-as-you-go) pension schemes are locked into the ageing economy, fully funded pension schemes would not escape demographic pressures if their assets were to remain invested in ageing countries alone. Indeed, when only ten years from now the baby boom generation will start to draw on the funded pensions, the impact of that decumulation on local asset prices and thus on pension benefits might be negative.

The superior growth performance of the developing countries and the low correlation of returns generated by the emerging stock markets with those of the developed stock markets promise higher pension benefits. Differences with respect to the exposure to country-specific shocks, the stage of economic and demographic maturity and the (lack of) harmonization of economic policies suggest that the diversification gains will not disappear quickly.

Portfolio Equity Flows and their Benefits

Portfolio equity flows have played an important role for external firm finance in emerging countries. Increases in equity flows have been associated with significantly lower cost of capital and higher per capita economic growth. Deep and liquid stock markets facilitate capital re-allocation from low-return to high-return activities and the incubation of new start-ups. Recent empirical research for a panel of developing countries has found that portfolio equity flows exert a higher independent growth effect than even foreign direct investment flows (while the benefit of other forms of flows is contingent on the health of local banking systems).

Banks in Argentina halted operations during the crisis. © LEHTIKUVA / REUTERS/Alejandro Kaminetzky
Banks in Argentina halted operations during the crisis. © LEHTIKUVA / REUTERS/Alejandro Kaminetzky

Until the mid 1990s, emergingmarket assets have delivered superior returns to investors but subsequently have suffered from a series of financial crises. The recent poor performance of emerging markets has often been attributed to weak local banking systems, lack of transparency and poor corporate governance practices. This has prompted the current international effort to codify best practices and to disseminate them widely. The Financial Stability Forum (FSF), itself established in April 1999 as part of the effort to strengthen financial systems and improve coordination among the agencies responsible for them, posts on its Web site the Compendium of Standards (, citing 69 (!) standards. Of these, twelve have been highlighted as key for sound financial systems.

Standards and codes so far seem to have found little investor attention; since the process started private capital flows to developing countries have been declining steadily; Argentina, which has been the emerging-market champion for its adherence to financial standards, is now effectively excluded from global capital markets. But there are signs now that institutional investors are starting to pay attention to standards and codes.

At the end of February the California Public Employees’ Retirement System (CalPERS), the biggest public pension plan in the US with an investment portfolio of US$ 151 bn, decided to withdraw from Indonesia, Malaysia, the Philippines and Thailand, while taking new equity positions in Hungary and Poland. CalPERS’ move followed a review of its ‘permissible country’ criteria, increasing the weight of elements that qualify for ‘socially responsible investment’. While CalPERS’ investment in Asia has been modest, its eminent position will provide an important signal to other institutional investors.

In the new model adopted by CalPERS for investing in emerging markets, market liquidity and volatility, market regulation and investor protection, capital market openness, settlement proficiency and transaction costs account for 50 percent of the scores. Political stability, financial transparency and labour standards account for the remaining 50 percent. Only 13 emerging markets have been defined as ‘permissible’. Of these, curiously, Argentina (currently rated by Moody’s and other agencies in ‘selective default’) scores best according to the investment criteria. The choice of emerging markets in which the model allows CalPERS to invest will be reviewed annually.


The table above indicates that bluechip Asian companies now seem to keep more transparent accounts than their US counterparts, while investors have been paying a premium (in terms of higher price/ earning ratios) for US stocks partly because of the perceived superiority in the quality of their earnings reporting. Last year, however, the gap between pro forma earnings, which exclude many expenses (such as stock options), and actual earnings, reported according to generally accepted accounting principles, was considerable in blue-chip US firms while even mildly negative in the top Asian firms.

CalPERS’ country blacklist can be compared to the long-practised country ceiling policy, that the major rating agencies have just started to give up for good reason. Recently, both Standard & Poor’s and Moody’s announced that they will allow certain borrowers to ‘pierce’ the country ceiling, i.e. to obtain better ratings than foreign-currency bonds of the government in their respective domiciles. In a globalized economy, national jurisdictions have lost importance in determining a company’s ability and willingness to honour liabilities.

Pension Funds and Emerging Markets

By pronouncing young developing nations, rather than single companies, unfit for their investment, an ageing country’s pension fund will hurt its pension beneficiaries and developing-country workers alike. It severely limits its global portfolio diversification benefits and withholds capital from the poor in developing countries, possibly making labour conditions even worse. Some of the investment criteria emphasised by CalPERS are endogenous to their own investment attitude: to develop deep and liquid stock markets in poor countries with a small local investor base requires the help of inflows. Pension funds, based on their long-term liability structure, are investors cherished by emerging markets, as pension flows do not belong to the hot-money variety and can help improve market infrastructure and corporate governance in the recipient countries.

Moreover, the ban will not prevent capital to flow; it just deteriorates the terms (by raising capital cost in the excluded country) and alters the form of the flow (by discouraging portfolio equity but implicitly encouraging foreign direct investment). To the extent that the withdrawal of pension funds from emerging stock markets depresses stock market valuations, capital cost will rise in the affected countries. This makes emerging-market companies cheaper acquisition targets. Pension funds will stay invested in countries even if these are deemed not to be ‘permissible’: through their investment in, for example, US companies with significant manufacturing presence and affiliates in those same places that become a cheaper host to foreign direct investment.

At the margin, however, country-specific investment criteria may provide a catalyst for changes in governance, openness and transparency practices. The authorities of those countries on the radar screen of institutional investors that are close to making it onto the list of investible countries may be enticed to carry out final steps, for example in bank regulation or market openness, to push them into the investible-market league.

Helmut Reisen is head of research at the OECD Development Centre in Paris ( He writes here in a personal capacity. He is a member of the WIDER project on Capital Flows to Developing Countries since the Asian Crisis: How to Manage their Volatility, and is the author of Pensions, Savings and Capital Flows: From Ageing to Emerging Countries, published in 2000 by Edward Elgar in association with the OECD.