_Transition cost_ arises from the financing gap (a flow concept) created when expenditures to pensioners and future retirees must continue even though part of the contributions have been diverted to funded individual accounts. Thus transition cost stems from the need to pay off, over some years, the debt of the old system. This financing gap stems from the IPD but it is not equal to the IPD, since some of the expenditures are for new obligations that accrue each day, and some of the current obligations are covered by ongoing contributions.

The size of IPD depends on many economic and demographic factors such as the age structure of covered workers and pensioners, pension system coverage, level of pension benefits, retirement age, replacement rates, indexation mechanism, and discount rates. World Bank (1997) estimated China's IPD at between 46 percent and 69 percent of 1994 GDP, based on a hypothesis that the system would be terminated in 1994. A recent estimate puts the IPD at 94 percent of the 1998 GDP ( Dorfman and Sin 2000).

The Chinese government, reluctant to recognize explicitly the pension debt, has been looking at other options to reduce or finance the transition cost (see box 2). In fact, the government has tried to use a combination of three methods to reduce the IPD and finance the transition. First, China has kept a small PAYGO pillar, with a 13 percent of contribution and a 20 percent replacement rate (State Council document 26). About 4-percentage point of the contribution was designed to finance the transition.<sup>8</sup> Second, older workers were kept under the old system, which will reduce the IPD to some extent. Third, the government did not cut pension benefits, but had hoped that expanding pension coverage would provide some extra funding, as workers in the private sector and township and village enterprises are younger.

It is now evident that these methods have not provided sufficient funding to finance the transition cost. The funding problem is acute: In 1998, 22 provincial pension pools had deficits amounting to RMB4.2 billion, and the other 10 provinces had RMB2.7 billion in surplus (Hang, 1999).9 By the end of 1998, total reserves in the basic pension system (pillars 1 and 2) amounted to RMB58.7 billion, which was distributed unevenly. Five coastal regions, Guangdong, Jiangsu, Shanghai and Zhejiang accounted for RMB26.7 billion; 21 provinces had only RMB31.1 billion; and five provinces had no reserves (Hang, 1999). In 1999 the situation worsened and the central government had to step in to provide funding for pension payments in 25 provinces. Obviously, extra funding resources must be found to finance the transition cost.

Based on international experience, several options can be considered by Chinese policymakers:

- Reduce IPD by downsizing the existing system and reducing benefits,

- Use asset-debt swaps during corporatization or privatization of SOEs,

- Use general tax revenue or issue debt.

A recent World Bank study further specified options to finance the transition costs which include (i) financing from general revenues or dedicated Social Security taxes; (ii) financing from central and/or

> s According to World Bank 1997, 9 percent of payroll tax/contribution is sufficient to finance a small PAYGO pillar with a benefit level of 24 percent of provincial average wage (replacement rate). In State Council document 26, the contribution rate of 13 percent is obviously more than enough for a modest 20 percent benefit. The extra 4 percentage points in payroll tax was designed to finance the transition cost.

> 9 However, since there is no national pooling, the central government cannot use the surpluses in several provincial pools. These surplus pools are located in the coastal region.

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