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Forces For Stabilization.

How U.S. pension funds can help avert future financial crises.

Roughly two years have passed since the global financial crisis triggered by the Russian default, the collapse of Long Term Capital Management, the of capital controls by Malaysia, and the large devaluation in Brazil. While economists have debated the causes of the crisis, and the international community has moved to reform the International Monetary Fund and The World Bank, little has been written about the fundamental role pensions--especially in the United States--can play in the prevention of future financial crises.

The causes of the crisis, and the wholesale contraction in bank lending in 1997-98, have been exhaustively analyzed, with several different theories emerging. Many commentators have focused on unsustainable macroeconomic policies in the affected countries: very high current account deficits as a percent of GDP, pegged exchange rates, and excessive growth in money supply and aggregate demand. Others have focused on economic weakness in Europe and Japan in the 1990's, which led commercial banks to seek lending opportunities elsewhere, and the "herd" behavior of investors. Another school holds that the policies of the IMF dramatically worsened the situation in Indonesia, Thailand, and Korea. And many commentators blame "crony" capitalists for extracting subsidies and monopoly rents from governments. Almost all critics agree, however, that a common characteristic among the affected countries was excessive reliance on debt, versus equity, finance, arising in part from the reluctance of owners to sell equity.

Although a key factor in the crisis was the misallocation of capital by lenders and corporate managers, only some of the post-crisis reform efforts have focused on private sector activity in developed markets. And what discussion there has been has focused largely on commercial lenders and bondholders as opposed to equity investors. Yet international equity investors--and fund managers in particular--have a role to play in stabilizing the global economy. U.S. pension funds, which are an increasingly important force in the global economy, can contribute to the avoidance of future emerging market crises by playing an informed and carefully modulated role on corporate governance issues involving major emerging market companies. Dialogue with the managements of these companies may lead to both higher investment returns and better allocation of capital, thereby reducing the severity, if not the occurrence, of future financial crises.

At the end of 1999, U.S. pension funds held assets of $8 trillion. State and local government pension funds control in excess of $3 trillion in assets, with the balance held by private funds. More than eighty-six million Americans own stock via a private pension fund, and perhaps twenty million more participate in public funds. About half of all private fund assets are invested in Defined Benefit Plans.

U.S. pension fund assets represent roughly 60 percent of world pension fund assets of $13.3 trillion. Approximately 11 percent, or $875 billion, of U.S. pension fund assets are invested in foreign equities. Since non-U.S. equities have an estimated market capitalization of $11.7 trillion, U.S. pension funds must be considered a major institutional force in the global allocation of capital. Furthermore, investments in non-U.S. equities by U.S. pension funds are expected to grow substantially. UK pension funds, for example, hold about 26 percent of their assets overseas.

This trend is also seen in the emerging markets, where it is estimated that U.S. pension funds have in excess of $50 billion invested out of a total market capitalization of approximately $1.2 trillion. Moreover, a significant portion of this money is indexed, and index money is, by definition, the very opposite of "hot" money.

As of September 30, 2000, The Morgan Stanley Capital International (MSCI) Emerging Markets Free Index capitalization of $1.1 trillion represents about 5.25 percent of world market capitalization of $21.39 trillion, as measured by the MSCI All Country World Index. There are twenty-six countries in the index. Six countries--Korea, Taiwan, Mexico, Brazil, South Africa, and India--represent 60 percent of index capitalization. Note that three of the top six countries have experienced severe financial crises since 1994.

The largest 100 companies in the index represent roughly 66 percent of its capitalization, and the top ten represent nearly 23 percent. The largest emerging market companies such as Telmex, Samsung, and Taiwan Semiconductor have capitalizations in excess of $38 billion, or roughly the size of the seventy-fifth largest company in the S&P 500.

The case for investing in emerging markets rests on three pillars: diversification, return enhancement, and broader investment opportunity set. An investor in emerging markets is able to create a more efficient portfolio (higher level of return for a given level of risk) and to increase the number of stocks from which to choose. The emerging markets represent a modest portion of the world market portfolio, and some investors believe that, given the volatility of emerging markets, they are not worth the effort. But with the relentless forces of globalization--and especially with the introduction of China onto the global economic scene--it is possible that the percent of the world market portfolio represented by the emerging markets will grow.

Broadly speaking, corporate governance can be viewed as the relationship among various participants in determining the structure and direction of corporations on the most basic level. For example, what are the duties, responsibilities, and powers of the board of directors? For that matter, what are the procedures for selecting the members of the board, and who participates in the selection? Finally, how should the company decide whether to merge with a competitor, divest itself of certain assets, or buy back stock?

In their book, Watching the Watchers: Corporate Governance for the 21st Century (Blackwell Publishing, 1996), Robert Monks and Nell Minow outline key issues in corporate governance and its evolution in the United States. They define the elusive entity known as the corporation and explain the relationship between the shareholders, management, and board of directors. In particular, Monks notes the importance of a well-trained, diligent, and independent board of directors. Corporate governance patterns are an evolving relationship, the authors argue, reflecting fundamental power relationships in society.

Most investors or their agents, the money managers, will sell a stock rather than involve themselves in corporate governance issues--the famed "Wall Street Walk." For them, it is less expensive to sell than to become educated or active in the corporate governance arena. But this approach may not always be appropriate or feasible--especially considering the high transaction costs associated with emerging markets investing, and the indexed approach many large institutional investors adopt with this asset class.

The benefits of shareholder activism can in the first instance be measured in the increase in stock price. Economists have increasingly focused on the relationship between corporate governance and equity returns. One finding: Companies with poor shareholder protections also have lower equity market valuations.

There are several examples in the United States of shareholders encouraging managers to enhance performance of their companies. Lens Investment Management, a large shareholder in the Pioneer Group, played a central role in forcing the sale of the company to UniCredito Italiano in May by threatening to initiate a proxy battle to install a more compliant board. Moreover, a study by Tim C. Opler and Jonathan Sokobin found that firms appearing on focus lists distributed by the Council of Institutional Investors between 1991 and 1994 saw their share prices outpace the S&P 500 by a substantial margin in the two years after being listed.

Not all corporate governance issues require the expensive proxy fights that occurred in the 1970's and 1980's. Indeed, an important benefit of shareholder activism is the "demonstration effect." Even if it is unlikely that a corporation will be targeted by institutional investors, corporate managers' sensitivities are heightened by the mere possibility of such shareholder interference. This effect might prove especially potent in the emerging markets. By targeting one or two visible firms for suspect board or transparency practices, U.S. pension fund managers might send a signal: Those companies seeking international financing must adhere to international standards.

CalPERS, TIAA-CREF, State of Wisconsin, and State of Florida are among the U.S. institutions most often associated with the shareholder activism movement. Even so, institutional shareholder activism in the United States is not particularly visible. For example, although CalPERS owns shares in over 1,600 U.S. corporations and carefully votes the proxies of each, it only targets ten companies with suspect governance practices and poor performance histories for more active participation in its annual "Focus List."

The emerging markets comprise a very diverse set of countries with profoundly different political, economic, cultural, and regulatory regimes. (Korea, commonly regarded as one of the most advanced emerging markets, is a member of the OECD, while Zimbabwe is a very poor country.) In many countries, the legal and institutional structures that permit corporate governance issues to be adjudicated do not exist, or are arbitrarily enforced. Weaknesses in corporate governance were frequently cited as one source of the Asian crisis. This has led to large technical assistance programs by the Group of Seven, and the emergence of incipient global norms. For example, Korea mandated that "outside" directors comprise at least 25 percent of major Boards.

What are some of the policies and procedures that large U.S. pension funds might follow in pursuing a corporate governance dialogue with emerging companies? They might include:

* Communicating international guidelines to the management of leading emerging market companies.

* Voting directly proxies for emerging market companies. For years, fund managers have had a fiduciary duty under ERISA to vote domestic proxies. These duties have been fulfilled either in-house or are outsourced to consultants like Institutional Shareholder Services (ISS) and Investor Responsibility Research Center (IRRC). As both companies expand their services and competitors enter the market, we can expect the price, as well as the difficulty, of voting emerging market proxies to decrease substantially.

* Entering into dialogues with select corporate managements that stand to benefit from U.S. investment and management expertise.

* Formulating international corporate governance standards. Presumably, these could draw from general guidelines applicable in the United States, while at the same time reflecting the unique aspects of emerging markets investing. In this regard, the International Corporate Governance Network, which was founded in 1995, has put forward a "Statement of Global Corporate Governance Principles."

* Including emerging companies in the international guidelines.

* Possibly funding investment managers, whose mandate would be to take concentrated positions :in poorly performing firms, and agitating for change.

The goal is not a proxy fight or acrimonious dialogue, but the fostering of communication and the better understanding of objectives. Initial discussions need not be confrontational, but exploratory. There can be little doubt that the differences between the Anglo-Saxon legal and institutional traditions, and those of the rest of the world will be evident. But managements of top flight emerging market companies are increasingly realizing that adopting the norms of U.S. corporations can confer tangible benefits. Many have issued American Depository Receipts (ADRs) in order to access U.S. capital markets and increase interest and liquidity in their shares. In so doing, they must adopt U.S. GAAP, or reconcile their financial statements to U.S. GAAP, depending on the type of issue. (About 45 percent of the MSCI EMF can be bought via ADRs.)

Just as countries have recognized that substantial benefits accrue to those countries that reduce tariffs, so leading emerging companies recognize that continued access to foreign capital implies adopting international norms. U.S. pension funds, which are among the most sophisticated investors in the world, can help bring that about. The result may be not only higher investment returns, but also a stronger international financial system.

George R. Hoguet is Head of Active Emerging Markets at State Street Global Advisers.
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Title Annotation:pension funds
Publication:The International Economy
Geographic Code:1USA
Date:Jan 1, 2001
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