Better risk mgmt of long-term capital urged

While China's central regulators have clearly expressed their support for capital inflows from long-term funds, the performance of late is less satisfactory.

For example, China's pension and insurance capital funds only direct 10 to 20 percent of their capital to equity investment. This level is much lower than the international average of 50 percent. It is also far from the 40 percent and 45 percent ceilings respectively set for social security funds and insurance funds in terms of equity investment.

Meanwhile, their asset allocations are too "conservative".

The proportion of trading financial assets as included in the balance sheets of the social security fund was 48.32 percent, 55.1 percent and 51.81 percent, respectively, in the three years between 2020 and 2022. This shows that the social security fund significantly increases its participation when the stock market enjoys upward momentum over the short run, but rapidly reduces its exposure when the market weakens. The ratio of trading financial assets has not increased accordingly when the Ministry of Finance lifted the upper limit equity of investment for the social security fund beginning in 2021.

According to the National Financial Regulatory Administration, about 23.23 trillion yuan ($3.26 trillion) of insurance capital was used in 2021, of which 12.7 percent was directed toward share purchases and fund products. The comprehensive rate of return for the insurance sector was around 5.5 percent in 2021.

In 2023, the balance of used insurance funds stood at 27.67 trillion yuan, of which 12.02 percent was invested in stocks and funds, with an average return rate of about 4.02 percent.

Both social security and insurance funds have shown an extremely cautious attitude amid market volatility. The proportion of equity investment has remained at a low level, even showing a downward trend. Their preference over low-risk, high-dividend or fixed income investment products is comprehensible, as they are closely related to people's lives.

But these figures also suggest that China's long-term capital practices insufficient participation in the equity market. Long-term capital has not given full play to its role as market stabilizer or fulfilled its mission as serving the real economy and facilitating China's economic restructuring. This is not conducive to preventing risks in the financial market, attracting global resources or addressing people's needs in an increasingly aging society.

There are some deeper structural problems in the Chinese stock market that have been inhibiting the entry of long-term capital.

For one thing, the stock market has relatively higher volatility. Listed company quality needs to be further improved. The idea of value investment has not been deeply taken to heart, resulting in the lack of confidence in long-term capital.

In addition, the institutional construction of the bond market has lagged behind. Credit risk events thus occur from time to time, stymying investment demand of insurance and pension capital. The less developed derivatives and alternative investment markets cannot fully meet the risk management and asset allocation needs of long-term capital.

Therefore, top financial regulators introduced a set of guidelines in late September to advance the entry of more medium- to long-term capital. Equity-focused mutual funds should seek substantial development. An institutional environment facilitating more long-term capital inflows and advocating long-term investment should be completed. The overall capital market ecosystem should also be further optimized, according to the guidelines.

The guidelines — together with the Securities, Funds and Insurance Companies Swap Facility officially launched on Oct 10 — will complement each other. They will safeguard market stability and prevent systematic risks amid market downturns and liquidity dry spells.

But it should be noted there is no such thing as an omnipotent financial tool. Actually, every tool is a double-edged sword. Tools will aggravate market performance in both bull and bear markets. The various policies and tools introduced have somehow reflected the incompleteness of the internal mechanism of the Chinese capital market.

To address existing structural problems, the development of a multilevel capital market is crucial — especially for professional and market-savvy institutional investors. The expansion of medium- to long-term capital, best represented by pension and insurance capital, is thus of great importance.

In fact, pension and insurance funds have served as pillars in mature markets.

Assets under the management of public pension funds in the United States are now around $4.5 trillion. The size of private pensions in the US is some $35.4 trillion, which is about 1.3 times the country's GDP. Pension assets account for 63 percent and 92 percent of GDP, respectively, in Japan and Canada.

The huge amount of long-term funds are not only important participants for stock and bond investment in multilevel markets, but also help stabilize the market with their investment philosophy and professional research capabilities.

Overseas fund experience concerning investment tools, risk management and asset allocation can be referenced in a useful way.

By the end of 2022, more than half of the 200 largest pension funds in the US used derivatives including stock index futures, interest rate swaps and credit default swaps to hedge inflation, interest rates, credit and other risks, according to news portal Pensions & Investments. Their average allocation in alternative sectors such as private equity, real estate and infrastructure also reached 26 percent, up nearly 10 percentage points from 10 years ago.

Japan's Government Pension Investment Fund allows the use of derivatives such as stock index futures and treasury bond futures for hedging. The Canada Pension Plan Investment Board has widely used derivatives such as swaps and forwards to manage risks.

Therefore, the investable scope of China's long-term capital should be expanded by considering risk appetite. The yield of bond investments can be amplified when the equity market is weak, and the hedging tool portfolio can be enriched.

For example, restrictions on the use of stock index futures and treasury bond futures can be relaxed. Long-term funds can be allowed to invest in structured products linked to stock indexes. Most of China's social security fund and companies' annuities are entrusted to domestic asset managers. Their investment styles are similar while excess returns are limited. Therefore, opportunities can be given to domestic and overseas private equity firms who are more experienced in managing pension funds, multi-asset allocation and the use of hedging tools.

In addition, the limits on long-term capital's overseas investment should be further relaxed. The ratio of foreign direct investment should be increased, and the risk management system for cross-border investment should be enhanced.

Long-term funds should step up strategic cooperation with world-leading asset management firms to grasp more advanced investment philosophy practices and risk management skills.

In addition, the A-share market stabilization fund should be set up as soon as possible, which is the most powerful support for the entry of patient capital and long-term funds.

The Ministry of Finance can take the lead by paying a certain amount of "guarantee money" to provide an insurance mechanism for institutions that invest in A shares for longer periods.

Meanwhile, the social security fund, insurers, companies and annuities should withdraw a certain percentage of investment income to pay the "security funds". Only qualified institutions should be included in this policy.

In this way, market structure can be improved. There will be less short-term speculation in the A-share market and more long-term capital can be ushered in.

The writer is chief economist at Zhongtai Securities.

The views do not necessarily reflect those of China Daily.