metadata: authors: 0: author: Vittas,Dimitri
count: South Africa
docna: 0: docna: The use of "asset swaps" by
            institutional investors in South Africa
docty: Policy Research Working Paper
subtopic: Pensions & Retirement Systems,Social Funds and Pensions,Financial Crisis Management & Restructuring,Capital Markets and Capital Flows,Non Bank Financial Institutions,Capital Flows,Mutual Funds
teratopic: Finance and Financial Sector Development
abstracts: cdata!: Leading financial economists have
            proposed the use of international asset swaps (Merton 1990,
            Bodie and Merton 2002) as a way of efficiently achieving
            international diversification without eroding the level of
            foreign exchange reserves and weakening local market
            development. International asset swaps entail limited
            foreign currency flows (only net gains or losses need to be
            exchanged). They protect foreign investors from market
            manipulation and expropriation risk and have much lower
            transaction costs than outright investments. But asset swaps
            are constrained by the attractiveness of local markets to
            foreign investors, and by various regulatory issues covering
            counterparty risk and collateral considerations, and
            accounting, valuation, and reporting rules. Institutional
            investors are well developed in South Africa. Their total
            assets corresponded in 2001 to 159 percent of GDP, a level
            that was surpassed by only four high-income countries. But
            because of the imposition of exchange controls, they lacked
            international diversification. In July 1995 South Africa was
            the first developing country that explicitly allowed its
            pension funds and other institutional investors to make use
            of "asset swaps." But the South African
            authorities did not authorize the use of properly specified
            swap contracts as described by Bodie and Merton, but rather
            permitted institutional investors to "obtain foreign
            investments by way of swap arrangements." As the author
            argues in this paper, the asset swap mechanism turned out to
            be cumbersome and inefficient. However, it did allow
            institutional investors to attain some level of
            international diversification. Other developing countries
            should consider authorizing their institutional investors to
            engage in international asset swaps. But they should
            authorize the use of properly designed swap contracts,
            preferably based on baskets of liquid securities, permit
            only global investment banks to act as counterparties,
            require the use of global custodians, properly monitor
            credit risk, maintain adequate collateral, and adopt
            market-to-market valuation rules. Asset swaps are clearly a
            second-best option compared to the lifting of exchange
            controls. However, they may facilitate risk diversification
            in the presence of such controls. And they may even have a
            role to play in their absence.
geo_reg_key: 517195,517191
repnme: repnme: The use of "asset swaps" by
            institutional investors in South Africa
display_title: The use of "asset swaps"
            by institutional investors in South Africa
listing_relative_url: /research/2003/12/2860750/use-asset-swaps-institutional-investors-south-africa
topicv3: Pension Funds m1326066 611,Capital Markets m1326967 332,Mutual Funds m1326970 2180,Retirement m1504007 2896,Credit Risk m1505083 3885
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
no_of_pages: 37
author_keys: 0: author_key: 92949
model_extractions: WPS3175

### **Financial Sector Development World Bank**

# **The Use of “Asset Swaps” by Institutional Investors in South Africa**

## **Dimitri Vittas**

#### World Bank Policy Research Working Paper 3175, December 2003

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Policy Research Working Papers are available online at http://econ.worldbank.org._
# **Abstract**

Leading financial economists have proposed the use of international asset swaps (Merton 1990, Bodie and Merton 2002) as a way of efficiently achieving international diversification without eroding the level of foreign exchange reserves and weakening local market development.

International asset swaps entail limited foreign currency flows (only net gains or losses need to be exchanged). They protect foreign investors from market manipulation and expropriation risk and have much lower transaction costs than outright investments.

But asset swaps are constrained by the attractiveness of local markets to foreign investors, and by various regulatory issues covering counterparty risk and collateral considerations, and accounting, valuation, and reporting rules.

Institutional investors are well developed in South Africa. Their total assets corresponded in 2001 to 159 percent of GDP, a level that was surpassed by only four high-income countries. But because of the imposition of exchange controls, they lacked international diversification. In July 1995 South Africa was the first developing country that explicitly allowed its pension funds and other institutional investors to make use of “asset swap.” But the South African authorities did not authorize use of properly specified swap contracts as described by Bodie and Merton, but rather permitted institutional investors to “obtain foreign investments by way of swap arrangements.” As Vittas argues in this paper, the asset swap mechanism turned out to be cumbersome and inefficient. However, it did allow institutional investors to attain some level of international diversification.

Other developing countries should consider authorizing their institutional investors to engage in international asset swaps. But they should authorize the use of properly designed swap contracts, preferably based on baskets of liquid securities, permit only global investment banks to act as counterparties, require use of global custodians, properly monitor credit risk, maintain adequate collateral, and adopt market-to-market valuation rules.

Asset swaps are clearly a second-best option compared to the lifting of exchange controls. However, they may facilitate risk diversification in the presence of such controls. And they may even have a role to play in their absence.

2
# **Table of Contents***

|**I.**|**Introduction**|**1**|
|---|---|---|
|**II.**|**Barriers to Foreign Investments**|**2**|
|**III.**|**Anatomy of International Asset Swaps**|**4**|
|**IV.**|**Benefits of International Asset Swaps**|**5**|
|**V.**|**The Use of “Asset Swaps” in South Africa**|**8**|
|**VI.**|**Conclusions and Policy Implications**|**19**|
|**Annex**|**I: Growth and Structure of Institutional Investors**|**22**|
|**Annex**|**II: Asset Allocation**|**29**|
|**Refere**|**nces**|**33**|

***** I am indebted to the South Africa Reserve Bank for communicating the full set of exchange control circulars and to various representatives of South African institutional investors for their insights on the structure of the financial and institutional investor landscape and the functioning of the swap arrangements. Several World Bank colleagues, particularly Patrick Honohan, Thordur Jonasson, Leora Klapper, Jeppe Ladekarl, and Sara Zervos, offered useful comments.
# **I. Introduction**

Institutional investors, and especially pension funds and life insurance companies, are becoming major participants in the financial systems of a growing number of developing countries. In some cases, like Egypt, Malaysia or Sri Lanka, the sector is dominated by public agencies, but in several countries, including Argentina, Brazil, Chile, Cyprus, Hungary, Mauritius, and especially South Africa, private institutions play a prominent role in the accumulation of long-term financial resources. But in most developing countries, pension funds and other institutional investors operate under strict limitations on their foreign investments, mainly because of the shortage of foreign exchange reserves and the fear of capital flight as well as concerns about stimulating the development of local capital markets and the local economy in general. As a result, they are not allowed to diversify their country risk and build an adequate level of international diversification.

The use of international asset swaps has been proposed by leading financial economists (Merton 1990, Bodie and Merton 2002) as a way of efficiently achieving international diversification without eroding the level of foreign exchange reserves and weakening capital market development. In July 1995, South Africa was the first developing country that explicitly allowed its pension funds and other institutional investors to make use of asset swaps. However, the South African authorities did not authorize use of properly specified swap contracts as described by Bodie and Merton, but rather permitted institutional investors to “obtain foreign investments by way of swap arrangements” (hence, the presence of inverted commas in the title). This paper examines the use of these facilities. It discusses the operating modalities of the arrangements, the extent to which they met their objectives, the accounting and regulatory issues they raised, and the policy implications for other developing countries.

The structure of the paper is as follows. After this introduction, sections II reviews briefly the barriers to foreign investments. Section III offers a brief anatomy of international asset swaps, while section IV discusses their main benefits. Then, section V offers a detailed examination of the use of swap arrangements in South Africa, with an evaluation of the extent to which these facilities deviated from proper swap contracts.

1
Section VI concludes with an evaluation of policy implications for other developing countries. Sections V and VI pay special attention to accounting, regulatory and supervision issues. Two annexes provide some useful background information. The first covers the growth and structure of institutional investors in South Africa and the second reviews their asset allocation policies and the impact of evolving government policies on them.

# **II. Barriers to Foreign Investments**

The imposition of exchange controls on investment in foreign assets affects the financial performance of pension funds and insurance companies. Such controls have an effect similar to that of prescribed investments in that they force contractual savings institutions to invest all their resources in domestic assets. Their rate of return may suffer if there are fewer investment opportunities in the local market. Exchange controls prevent an international diversification of risk and a reduction in the exposure of contractual savings institutions to domestic currency and market risk.

Pension funds and other institutional investors in most developing countries are not generally allowed to invest overseas. Even OECD countries until the early 1980s used to apply tight quantitative restrictions on overseas investments by local institutions.<sup>1</sup> The most common rationale for such restrictions is to reduce the risk of capital “flight”, especially institutionalized capital flight. Another rationale is that locally mobilized longterm savings, generated from contributions and premiums paid by or on behalf of local workers, should be invested “at home” to stimulate the development of local capital markets and enhance employment opportunities for those same workers rather than workers elsewhere. In some countries, restrictions on foreign assets had been justified on prudential grounds (since less was generally known about foreign assets) but globalization and the strengthening of financial regulation and supervision have weakened substantially the relevance of this factor (except for the expropriation threat).

Even in the absence of legal limitations on foreign investing by local institutional investors, there are other significant barriers. Among the most important are the risk of

> 1 For a list of restrictions imposed by governments in OECD member countries, see OECD (2000).

2
expropriation by foreign governments (including heavier taxes imposed on foreign investors) and transaction costs. These costs can be so large that they may offset any diversification benefits that would otherwise accrue, especially when relatively low volumes of funds are involved.

International diversification improves the risk/return tradeoff of investment portfolios by reducing the exposure to cyclical and long-term structural shifts in local economic performance and by allowing participation in dynamic industries or regions in other parts of the world. International evidence shows that while the average rate of return may not increase as a result of international diversification, the average risk, measured by the volatility of returns, is substantially reduced (Davis 1993). International diversification is more important for smaller countries where the benefits of diversifying away from a small number of liquid securities are greatest.

In the 1970s, pension fund investments in foreign assets were very small, even in those few countries that did not impose exchange controls on overseas investments or strict limits on foreign assets of pension funds. But following the general relaxation of exchange controls in the 1980s and the growing globalization of capital markets, the share of foreign assets in pension fund portfolios increased considerably in a number of countries. In some countries, e.g. Hong Kong, overseas assets account for two-thirds of the total assets of pension funds. In most OECD countries, foreign investments have gradually grown over time and now represent between 25% and 30% of assets. In the US, where the large local economy is highly diversified and where presence of global corporations provide an indirect avenue of international diversification, overseas assets are less than 12% of total assets, although this still represents a significant increase over time. A similar indirect diversification is offered to Swiss pension funds by the large multinational Swiss companies (Queisser and Vittas 2000).

Removing exchange controls and fully integrating with international capital markets should be the ultimate objective of policy in all developing countries. However, complete removal of exchange controls is often constrained by the paucity of foreign exchange reserves and the fear of stimulating capital flight, especially if confidence in future stability is low. An alternative to complete and immediate removal of exchange 3
controls would be to authorize asset swaps between domestic and foreign institutional investors, especially pension funds. This would allow risk diversification while averting a capital flight. Another option would be to maintain exchange controls for general purposes, but permit contractual savings institutions to embark on a slow and gradual increase in their holdings of foreign securities. A third option would be to combine these two measures, i.e. allow a small amount of foreign investments as well as limited use of asset swaps.

# **III. Anatomy of International Assets Swaps**

The basic mechanics of international asset swaps are easy to present.<sup>2</sup> Pension funds that already own domestic equities engage in a swap with a global pension intermediary, probably an investment bank with operations in London, New York, Hong Kong, Singapore, or other international financial center. The international swap counterparts must have very high credit ratings, or alternatively the swaps must be guaranteed by third parties with strong credit ratings, otherwise they would result in risk substitution rather than risk diversification.

In an equity swap, the total return per dollar on the domestic stock market is exchanged annually for the total return per dollar on a market-value weighted-average of the world stock markets. Equity swaps effectively transfer the risk of the domestic stock market to foreign investors and provide the local pension funds with the risk-return pattern of a well-diversified world portfolio. Since there are no initial payments between parties, there are no initial capital flows in or out of the country. Subsequent payments, which may be either inflows or outflows, involve only the difference between the returns on the two stock market indices. No principal amounts flow across the exchanges from the swap arrangements.

For example, on a notional or principal amount of $1 billion, if, _ex post_ , the world stock market earns 10 percent and the domestic market earns 12 percent, there is only a flow of (.12 - .10) x $1 billion or $20 million out of the country. Furthermore, the local investors make net payments overseas precisely when they and their country can “best”

> 2  This and the following section draw extensively on Bodie and Merton (2002).

4
afford it: namely, when the domestic market has outperformed the world markets. In those years in which the domestic market underperforms the world stock markets, the swap generates net cash flows into the country to the domestic investors. Hence, in this example, if the domestic market earns 8 percent and the world stock market earns 11 percent, then domestic investors receive (.11 - .08) x $1 billion = $30 million, a net cash inflow when local conditions are poor and foreign currency inflows may be highly desirable.

Equity swaps enable pension funds to achieve broader international diversification. A different type of swap could enable them to hedge equity risk altogether. This would be particularly important for people in countries where there is no local entity, including the government, capable of issuing fixed-income securities that are free of all risk. This second type of swap would call for the pension fund to swap the total return on its equity portfolio for a risk-free interest rate denominated in a “strong” currency or in units of constant purchasing power. This type of swap would work the same way as an equity swap, except that the net cash flows produced by the swap would result in the pension fund receiving a risk-free rate of return. The counterparty must have a very good credit rating, or the swap must be guaranteed by a third party with a strong credit rating. The local pension funds would have to make payments to the swap counterparty only in years when the local market outperforms the risk-free rate.

A third possibility is to swap the income stream from holdings of domestic bonds for the interest income (fixed or floating) of foreign bonds. Again local swap counterparts only make payments when the local bond market outperforms the international bond market.

# **IV. Benefits of International Assets Swaps**

The general case for the use of international asset swaps by pension funds and other institutional investors has been strongly made by Merton (1990) and Bodie and Merton (2002).

The main benefits come from a significant improvement in the efficient frontier of risk versus expected return. The global equity markets can be used to achieve better 5
diversification and the global fixed-income markets can be used to achieve better hedging opportunities.<sup>3</sup> This latter would be particularly important for people in countries where there is no local entity, including the government, capable of issuing fixed-income securities that are free of risk. Swapping the income stream from holdings of domestic bonds for the interest income (fixed or floating) of foreign bonds would be particularly attractive for countries that in addition to prohibiting their own institutional investors from investing overseas do not also allow foreign institutions to invest in the local bond market. The same benefits in terms of risk diversification and ease of transaction would accrue for both domestic and international portfolio investors interested in investments in the originating country.

As already mentioned, asset swaps have a limited effect on capital flows as no principal amounts are exchanged. Furthermore, local pension funds would have to make payments to the swap counterparty only in years when the local market outperforms the international markets and income generation in the local economy is high. Asset swaps of a long tenor could also provide some shield to the financial markets of developing countries from sudden adverse developments in the financial markets of major OECD countries. Asset swaps could offer some protection from sudden outflows of capital that could be triggered by the high volatility of sentiment among international fund managers and their susceptibility to herding behavior. This would be another reason favoring significant use of asset swaps even in a world that is free of foreign investment controls.

Asset swaps (equity as well as bond) may also be attractive to international portfolio investors if cross-border transactions in the underlying securities suffer from technical inefficiencies (e.g., no participation in international clearing arrangements or no possibility of transacting in book entry form<sup>4</sup> .) Moreover, asset swaps can also mitigate the other barriers to investing abroad — expropriation risk and high transaction costs.

> 3  Following the terminology of Bodie and Merton, diversification is used to mean an allocation of the portfolio among many risky assets, while hedging is used to mean eliminating risk by taking an offsetting position in another asset.  In this terminology, substituting a risk-free asset for risky assets in the portfolio is hedging.

> 4   The use of interest rate swaps by foreign investors has recently grown in Iceland in connection with demand for housing bonds that pay inflation linked interest rates. Because Icelandic housing bonds are not registered with international clearing agencies (Asgeirsson 2002,),  foreign investors prefer to enter into interest rate swaps with Icelandic institutions. The latter invest in indexed housing bonds which they then

6
With swap contracts, trading and ownership of actual shares remain with domestic investors<sup>5</sup> . By implication, the accounting and regulatory treatment remains a domestic issue. Foreign investors also benefit from the swap contract by avoiding the costs of trading in individual assets in the local markets and – for equity swaps – by not having the problems of corporate control issues that arise when foreigners acquire large ownership positions in domestic companies. Unlike standard cash investments in equities or debt, the default or expropriation exposure of foreign investors is limited to the difference in returns instead of the total gross return plus principal (in the above example, $20 million versus $1.02 billion).

The potential exposure of foreign investors to manipulation by local investors is also probably less for the swap contract than for direct transactions in individual stocks. It is more difficult to manipulate a broad market index than the price of a single stock. Even if settlement intervals for swaps are standardized at six months or one year, the calendar settlement dates may differ for each swap, depending upon the date of its initiation. Hence, with some swaps being settled every day, manipulators would have to keep the prices of shares permanently low to succeed.

Furthermore, with the settlement terms of swaps based on the per-period rate of return, an artificially low price (and low rate of return) for settlement this year will induce an artificially high rate of return for settlement next year. Thus, gains from manipulation in the first period are given back in the second, unless the price can be kept low over the entire life of the swap. Since typical swap contract maturities range from two to ten years (with semi-annual or annual settlements), this would be difficult to achieve.

Bodie and Merton show that international asset swaps can be used effectively and at reasonable cost to achieve the goal of improved international risk-sharing without violating restrictions on capital outflows to other countries. However, the practical availability of international asset swaps to institutional investors in developing countries

> pledge as collateral security for repo loans from the central bank. Foreign investors pay the interest on the repo and earn the yield on the indexed bonds (Central Bank of Iceland 2003).

> 5   It is assumed in this discussion that pension funds and other institutional investors are only allowed to “swap” securities that they already hold. However, the swap market does not necessarily require that institutional investors hold the underlying securities. Trading “notional” values would achieve the same result.

7
heavily depends on the attractiveness, or investability, of the local markets for foreign investors. A forthcoming study by Ladekarl and Zervos (2003) draws attention to the investability criteria used by international investors. The study finds that good housekeeping and plumbing, implying sound macroeconomic policies, adequate data availability and transparency, and effective basic regulation and supervision, are prominent among the investability criteria used by global investment institutions. Aggarwal, Klapper and Wysocki (2003) also find that foreign institutional investors consider such country criteria as total market capitalization and returns as well as investor protection and legal enforcement. These findings imply that in developing countries that do not meet basic criteria of investability, domestic institutional investors may have to pay a significant premium to foreign investors in order to be able to conclude effective swap contracts. A very high premium would discourage local pension funds from engaging in this type of activity.

The use of international asset swaps also raises important questions that relate to accounting and regulatory issues, counterparty risk, and custodial and settlement arrangements. These aspects are discussed in sections V and VI after the presentation of the South African experience.

# **V. The Use of “Asset Swaps” in South Africa**

Institutional investors, and especially the contractual savings sector, are very well developed in South Africa. The net assets of retirement funds and long-term insurers, after eliminating double counting, amounted in 2001 to ZAR 1.39 trillion or 142% of GDP (See Annex I). This was up from 119% of GDP in 1995. Adding the assets of unit trusts brings the total for institutional investors to ZAR 1.56 trillion in 2001, equivalent to 159% of GDP.<sup>6</sup> Only four other countries in the world (the Netherlands, Switzerland, the United Kingdom, and the United States) have institutional investors that have more assets in relation to GDP than South Africa. The net flow into contractual savings (pension funds and long-term insurers), taking into account contributions and premiums as well as

> 6   Short-term insurers are not classified as institutional investors in South Africa. Their assets amounted to 4.6% of GDP in 2001.

8
investment income and after allowing for benefit outlays, administrative expenses and tax payments, amounted to an impressive 18% of GDP in 2001.

The asset allocation policies of institutional investors have been shaped by the use of prescribed asset ratios that favored public sector securities (before 1989) and by the imposition of exchange controls that prevented investments in overseas assets (Annex II). Insurance companies and pension funds were required until 1989 to place 53% of their untaxed liabilities and 33% of their taxed liabilities into fixed-interest-bearing public sector securities. The real return on those securities was substantially lower than that on listed equities. Although it was positive in real terms in the 1960s, it turned negative in the 1970s and 1980s when inflation accelerated to double digits. The foregone income loss on prescribed securities reached 6.1% in the 1960s, 16% in the 1970s and 5.8% in the 1980s. Taking into account their asset allocations, the investment return of long-term insurers was lower by 4.5 percentage points in the 1970s and 1.7 percentage points in the 1980s. The corresponding figures for pension funds were 7.8 and 2.6 percentage points, respectively (Annex II).

Prescribed ratios were abolished in 1989 and institutional investors proceeded to adjust their portfolios. By 1995, public sector claims represented 28% of total assets and equities 46%. Long-term insurers invested more in equities (56%) than self-administered private and official pension funds (30% and 12% respectively). However, foreign investments were still prohibited.

The South African authorities have long been aware of the lack of international diversification of the assets of local institutional investors and their exposure to the domestic equity market. The latter had increased considerably during the period of sanctions and divestment of foreign companies from South Africa (see Annex I). In March 1995, at the time of the abolition of the financial rand<sup>7</sup> , the budget statement alluded to the demand for foreign assets by various types of institutional investors to enable them to achieve a wider spread of their risks.

**Chronology.** In July 1995, in order to assist long-term insurance companies, pension funds and unit trusts in achieving this goal, the authorities decided to allow such

> 7   A specialized market in which holdings of foreign securities by SA residents were traded.

9
institutions to invest a portion of their assets abroad. However, taking into account the low level of foreign exchange reserves at the time, the authorities decided against permitting outright purchases of foreign currency for foreign investment purposes. Instead, they decided to allow institutional investors to “obtain foreign investments by way of swap arrangements”. These arrangements were required to provide for the actual exchange with foreign investors of part of their existing asset portfolios for foreign assets rather than for the traditional swap contracts described above. Special emphasis was placed on measures to safeguard the foreign exchange reserves against the subsequent withdrawal from South Africa of the reciprocal non-resident investments. The facility was seen as a further step in the process of gradually easing exchange controls (see Table 1 for a chronological summary of exchange control circulars).

A limit of 5% of total assets was initially applied. This was increased to 10% in June 1996. At that time, a limit for outright investments overseas was also introduced. This was equal to 3% of the net inflow during calendar 1995, but subject to an overall limit of 10% of total assets. In March 1997, an additional limit of 2% of the preceding calendar year’s net inflow was introduced for investments in securities listed on registered stock exchanges in SADC member countries, bringing the total limit for outright foreign investments to 5% of the net inflow. However, the total overall limit was kept unchanged at 10% of total assets. A clear definition of the net inflow of each type of institution was also provided (Table 2). For unit trusts, the relevant entity was changed to the unit trust management company and its total assets under management in South Africa. In July 1997, registered fund managers were authorized to use the asset swap mechanism but were not granted the cash flow dispensation.

In March 1998, the overall limit of foreign assets by way of swaps was raised to 15% of total assets, while the limit of outright foreign investments was increased to 5% of the preceding calendar year net inflow and that for investments in SADC countries to an additional 10% of the net inflow. In February 2000, the limit of 15% of the total assets of long-term insurers, pension funds and fund managers was unchanged but that for unit trusts was raised to 20%. In addition, the limit of outright foreign investments was raised to 10% of the preceding calendar year net inflow, with no separate limit for investments in SADC countries.

10
||**Table 1: Summary of Exchange Control Circulars**|
|---|---|
|1995 07 14|New facility was introduced permitting institutional investors to obtain foreign<br>investments by way of swap arrangements. Decision noted negligible country risk<br>diversification of institutional investor assets of R500 billion as well as low level of<br>foreign exchange reserves of R12.5 billion, hence the attractiveness of the asset swap<br>mechanism. Authorization of individual transactions was required, based on<br>application and approval, up to 5% of total assets. Mention was made of possible<br>future allocation for outright foreign investments and reference to gradual easing of<br>exchange control.|
|1996 06 21|Limit on investment in foreign assets by way of asset swaps was raised from 5 to 10%<br>of total assets. Limit for outright foreign investments was introduced. This was set at 3<br>percent of net inflow during calendar 1995, but subject to overall limit of 10% of total<br>assets.|
|1997 03 13|Limits of 10% of total assets for asset swaps and 3% of the net inflow during calendar<br>1996 for outright investments were renewed. Additional limit of 2% of net 1996<br>inflow was introduced for outright investments on registered stock exchanges in<br>SADC member countries. The total overall limit was kept unchanged at 10% of total<br>assets. Clear definition of net inflow was provided for each type of institutional<br>investor. Also, for unit trusts, the relevant entity was changed to the unit trust<br>managementcompany anditstotalassets under management inSouth Africa.|
|1997 07 01|Definition of qualifying institutions for the asset swaps mechanism was broadened to<br>include all registeredfundmanagers offering private clientasset managementservices.|
|1997 07 22|It was clarified that only asset swap transactions that did not involve a flow of funds<br>would be permitted. Future transactions should be structured on the basis of an<br>exchange ofcashand/ora portfolio ofassets.|
|1998 03 11|The overall limit of foreign assets by way of swaps was raised to 15% of total assets.<br>The limit of outright foreign investments for long-term insurers, pension funds and<br>unit trust management companies was raised to 5% of the net inflow during calendar<br>1997 while the limit of outright investments on registered stock exchanges in SADC<br>countries was raised to 10% of net calendar 1997 inflow. Both flow limits were subject<br>tothe overall 15% asset limit.|
|1999 02 23|Dispensation and limits were renewed without change. Reference was made to<br>applications for foreign asset swaps of R130 billion approved and R60 billion<br>transacted uptothe end of 1998.|
|2000 02 23|Limit of 15% of total assets was renewed for long-term insurance companies, pension<br>funds and fund managers. It was raised to 20% for unit trust management companies.<br>The definition of assets was broadened from total assets employed in South Africa to<br>total assets. The limit of outright investments for long-term insurers, pension funds and<br>unit trust management companies was raised to 10% of net calendar 1999 inflow, with<br>no separate limit for investments in SADC countries, but subject to the respective asset<br>limits.|
|2001 02 21|Reference was made to total foreign assets acquired under the asset swap mechanism<br>amounting to R100 billion. However, the asset swap mechanism for new transactions<br>was terminated. Total foreign assets were retained at 15% of total assets for long-term<br>insurers, pension funds and fund managers and 20% for unit trust management<br>companies. New foreign investments by log-term insurers, pension funds and unit<br>trust management companies were, however, limited to 10% of the net calendar 2000<br>inflow, subject tothe overallasset limits.|
|2001 11 13|The cash flow dispensation was extended to registered fund managers, who were<br>authorized to make new foreign investments up to 10% of their net calendar 2000<br>inflow, subject tothe15% asset limit.|

11
# **Table 2: Definition of Net Flow of Funds to Institutional Investors**

Differences in the nature of the business of the various categories of institutional investors prevent the formulation of a unique definition of the net flow of funds to these institutions. Separate definitions for each of the three broad categories are therefore required.

For **long-term insurers** , the most accurate indication of their net inflow of funds is given by the concept “domestic current income surplus". The definition is as follows: Domestic current income surplus = Local current receipts, consisting of Investment income Premiums received (net of reinsurance locally and abroad) Pension and group life business Retirement annuities Other insurance business <u>less</u> Current expenditure, consisting of Claims paid Lump sum at retirement Lump sum at death or other payments Annuities Surrenders (pension funds and other life business) Administrative expenses (including commissions) Taxation Dividend payments For **pension and provident funds** , the most accurate indication of their net inflow of funds is given by the concept “ domestic current income surplus ". The definition is as follows: Domestic current income surplus = Local current receipts, consisting of Investment income Interest and dividends Rent Contributions by Members and Employers, including actuarial deficit reduction contributions <u>less</u> Current expenditure, consisting of Benefits Lump sum at retirement or death Other lump sum payments Annuities Administrative expenses For **unit trusts** , the most accurate indication of their net inflow of funds is given by the concept “ value of net sales of units” The definition is as follows.

Value of net sales of units = Gross sales valued at repurchase prices <u>less</u> Repurchases at actual transaction value.

12
Finally, in February 2001, the asset swap mechanism was terminated but the limit on total foreign assets was retained at 15% of total assets for long-term insurers, pension funds and fund managers and 20% for unit trusts. New foreign investments were, however, still limited to 10% of the preceding calendar year net inflow. In November 2001, the cash flow dispensation was extended to registered fund managers, who were also authorized to make new foreign investments up to 10% of their net calendar 2000 inflow, subject to the 15% asset limit.

Institutional investors utilized the swap facilities to achieve some international diversification of their assets. The SARB indicated that ZAR 60 billion of asset swaps had been effected by February 1999 and the total reached ZAR 100 billion in February 2001. However, the foreign assets acquired through swap arrangements or outright have not been separately identified in the statistics published by SARB. For insurance companies, foreign assets are shown with other assets, while for pension funds, they are included with domestic equities or bonds, as the case may be. Data for long-term insurers show that between 1995 and 2001, other assets grew from 3.7% to 17.1% of assets.<sup>8</sup> In general, market practitioners claim that institutional investors made full use of the permitted 15% limit by 2001.

The South African experience underscores the benefits of a gradual approach. In fact, both of the intermediate solutions mentioned in section II above were used. The authorities allowed limited use of asset swaps and permitted small but gradually increasing amounts of outright foreign investments as special limits for institutional investors. In this way, significant risk diversification was achieved, while averting a capital flight.

However, several questions arise with regard to the South African experience. How did the asset swap mechanism work? Who were the counterparties? What were the costs? How was settlement effected? What was the treatment of local equities that were also listed in overseas markets? Were there any collateral requirements and how was

> 8   As already noted, short-term insurers are not classified as institutional investors in South Africa and did not qualify for use of the asset swap mechanism. Their other assets also grew from 9.4% to 15.4% of their total assets between 1995 and 2001 but this must have been caused by other developments and not by acquisition of foreign assets.

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collateral arranged? And, last but by no means least, what were the regulatory, accounting and reporting requirements?

**Asset Swap Mechanism.** Prior to entering into an asset swap transaction, approval had to be obtained from the South African Reserve Bank (“SARB”).  Once approval was granted, the South African investor was able to source a foreign counterparty that was willing to purchase South African securities from the South African investor.  The SARB did not impose any direct restrictions on foreign investors, but required from local institutions to ensure that either their original counterparties or some new counterparties remained invested in South African securities for a period of 2 years after concluding an asset swap transaction.  This requirement was referred to as **“maintaining the inward leg”** .  The South African investor, as part of its quarterly reporting to the SARB, had to confirm that the inward leg was still in place (during the 2- year period).

**Counterparties.** These were investment banks acting as either principals or agents, especially for mutual funds and pension funds with a global or emerging market mandate and who therefore had an appetite for South African assets. The counterparties would agree to buy a basket of securities from the South African investor, usually against a fee (although it was anticipated by SARB that the counterparty would also prefer to “swap” a basket of foreign securities and from there the term “asset swap”).

**Costs.** Due to the inward leg requirement that aimed to ensure that counterparties remained invested in South African securities for a period of 2 years, asset swaps were usually done at a discount or for the payment of an arrangement fee payable to the counterparty. Initially the discount or some sort of “arrangement fee” was fairly high at around 2% – 2.5% of the market value of the basket of South African securities and may even have reached 5%. But as more counterparties entered the market and based on the size of the basket and the specific securities included in the basket, the discount or fee was negotiated down and more or less stabilized at 1%.  Some European investment banks even arranged swaps without requiring any fee. This was probably because these investment bankers were able to charge their pension fund and mutual fund customers double brokerage fees for acquiring South African assets: once for the underlying bond or

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share purchase, once for the "asset swap". One reason for the low fees was that these were big block transactions which large local institutions were able to put through from their own portfolios without affecting market price. Thus, the foreigners obtained the assets much cheaper than if they had to use the open market. However, obtaining their assets through swap arrangements rather than directly on the market would imply a smaller “additional net” benefit for the South African economy and markets from the swap arrangements.

**Settlement Procedures.** Settlement initially took place by the South African investor’s custodian transferring the assets to the counterparty’s South African custodian upon payment of the consideration to the South African investor’s custodian – normal DVP rules applied.  Once the consideration was received, the South African investor applied to the SARB again for approval to transfer the consideration abroad.  Once this was received, usually within a few days, the consideration was transferred abroad.  A portfolio of securities had to be acquired within a reasonable period.  Later on the requirement that settlement of the consideration had to take place in South Africa was removed, as it was evident that the resultant currency transfers affected the exchange rate, which was usually to the detriment of the South African investor.  Settlement was then effected through the South African investor’s foreign bank account. In fact, the rules were tightened in July 1997 and only permitted asset swap transactions that did not involve a flow of funds and were structured on the basis of an exchange of cash and/or a portfolio of assets.

**Treatment of Foreign Listed Local Equities.** Shares that were dually listed on the Johannesburg Stock Exchange (JSE) and a foreign exchange were treated as South African securities if purchased in the local market and as foreign securities if purchased overseas. However, local institutional investors were seeking to diversify their exposure away from the JSE and were interested to include in their foreign baskets companies that were not heavily exposed to the local economy.

**Collateral Requirements.** No specific collateral requirements were applied. Global custodians were appointed to facilitate the settlement process but since the “asset swaps” were not genuine swap contracts, there were no special collateral rules. The

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binding jurisdiction when entering into the asset swap was always specified as South Africa.

**Regulatory, Accounting and Reporting Requirements.** Institutional investors had to provide the SARB with a quarterly report detailing their total assets, total foreign investments (limited to 15% of total assets) and the asset swaps entered into during the previous quarter (later on as things developed, the SARB was willing to approve a generic asset swap application in terms of which the South African investor was able to pre-apply for block approval in anticipation of future asset swaps).  Apart from the requirement to report to the SARB on a quarterly basis and the regular reports that must be submitted to leading regulators, there were no other special reporting or accounting requirements. No special rules were provided regarding the accounting treatment. The foreign assets acquired directly or through the swaps had to be valued according to market value or acquisition value, following the same rules that were applied on domestic assets for the particular type of institution. The discount or arrangement fee had to be expensed in the income statement. In its statistical reports, the SARB did not identify separately the holdings of foreign assets of different types of institutional investors.

**Evaluation.** The swap arrangements that were used in South Africa were a long way from the swap contracts envisaged by Bodie and Merton. They were cumbersome and proved difficult to monitor. They were designed to protect the foreign exchange reserves but faced serious problems of enforcement. Unlike in the case of swap contracts, principal amounts did initially cross the exchanges, giving rise to large foreign exchange transactions, although later on asset swap transactions were not allowed to involve a flow of principals across the exchanges. Protection of principal from expropriation risk was not ensured and the swap business could not itself be available for subsequent trading on the market. These swap arrangements did not lend themselves to a development of swap market liquidity.

The foreign investors were supposed to inform the South African institution whenever they were selling the assets they had acquired as part of the "asset swap". But foreign institutions were not in practice bound by the SARB rules in this regard and were unlikely to have complied with this requirement. When the rand came under pressure, it 16
is likely that most, if not all, of the asset swap counterparties proceeded to sell their South African assets. Since nobody was officially informed of this, the South African institutions were not asked to repatriate their leg of the deal nor were they obliged to find new counterparties. SARB inspectors undertook ad hoc spot checks on some of the larger local investors, but did not verify on a systematic basis that the foreign counterparties continued to be invested in South African securities. Some commentators have argued that it would have been better to allow the South African institutions to diversify internationally gradually and directly and without the artificial business of bringing in foreign counterparties which de facto became hot money that rushed for the exit when conditions deteriorated.

Despite these misgivings and cumbersome operational characteristics, the swap arrangements allowed institutional investors to achieve a 15% level of international diversification. Institutional investors continued to be allowed to invest overseas up to 10% of future net inflow but the potential impact of this rule was constrained by the overall limit of 15% of total assets, which most institutions had already reached.

The authorities failed to authorize a continuation of swap arrangements for a total of, say, 10% of assets, allowing a combined total diversification of 25% of assets (15% outright and 10% through swaps). Given the cumbersome nature of the arrangements then in use, they could have encouraged use of proper swap contracts in extending the facility. The decision not to extend the facility and not to use proper swaps is puzzling because there are at least 40 South African companies that are included in the MSCI Emerging Markets Free Index, while 68 out of 74 US emerging market mutual funds invest in South African firms (Aggarwal et al 2003). There is also a large number of European mutual funds that invest in South African securities. Thus, demand for properly designed swap contracts would most likely have been forthcoming.

The South African experience also underscores the importance of an effective regulatory framework, especially with regard to reporting and accounting requirements. Given the cumbersome nature of the swap arrangements, the reporting requirements were difficult to monitor. However, the system was adapted over time and block approval 17
arrangements were introduced. Use of proper swap contracts would have made both reporting requirements and verification of compliance much easier.

The swap arrangements did not have any implications for accounting records since local institutional investors exchanged their domestic assets for foreign ones and had to value the latter according to prevailing valuation rules. The inward leg requirement did not appear on their balance sheet. If proper swap contracts were to be used, there would be a need for a more specified accounting treatment. The local institutions would continue to own the “swapped” domestic assets. In accounting terms, these could be reported with other domestic assets, with a footnote noting the fact that they have been swapped and their value on the basis of foreign market values. Alternatively, swapped assets could be shown separately at their foreign market value. The income statement would have to indicate the net gain or loss arising from the swap.

For statistical purposes, the volume of swapped assets should be reported separately as should any holdings of foreign assets. In this sense, the SARB practice of including foreign assets with other assets in the case of insurance companies and with domestic equities or bonds in the case of pension funds has failed to reveal valuable information.

Proper swaps are over-the-counter (OTC) instruments that are traded outside organized exchanges. This presents advantages as well as disadvantages. On the one hand, they are subject to less regulation with regard to capital requirements, conduct rules, and loss sharing arrangements in case of default and enjoy considerable flexibility in customization. But, on the other hand, they suffer from greater exposure to counterparty risk and require marked-to-market valuation with effective monitoring and adequate collateralization. These disadvantages can be greatly reduced by use of counterparties with top level credentials and reliance on standardized contracts subject to well established enforcement procedures (Ladekarl and Svennesen 1999, Draghi, Giavazzi and Merton 2003).

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# **VI. Conclusions and Policy Implications**

Pension funds and other institutional investors in developing countries are constrained in achieving broad international diversification by strict controls on foreign investments. These controls are motivated by the desire to prevent capital flight and preserve scarce foreign exchange reserves. It is also sometimes argued that requiring pension funds and other institutional investors to invest locally would stimulate the development of the local capital markets.

International asset swaps can be used to achieve international diversification while averting capital flight and stimulating local capital market development. As argued by Bodie and Merton (2002), the main benefits of asset swaps would come from a significant improvement in the efficient portfolio frontier facing domestic institutional investors. The global equity markets can be used to achieve better diversification and the global fixed-income markets can be used to achieve better hedging opportunities.

Faced with the challenge of allowing their institutional investors to attain greater international diversification when foreign exchange reserves are at a particularly low level, the South African authorities permitted local institutions to “obtain foreign investments by way of swap arrangements”. These turned out to be rather cumbersome and difficult to enforce, but even so they achieved their basic objective of greater diversification without capital flight.

However, the asset swap mechanism used in South Africa deviated considerably from the optimal features of swap contracts that have been underscored by Bodie and Merton. The main benefits of properly designed swap contracts are the ease of transactions, the avoidance of large foreign exchange transactions, the minimization of brokerage and other transaction costs, and the protection from expropriation and market manipulation risks.

Given the presence of 40 South African firms in the MSCI Emerging Markets Free Index (MSCI EMFI) and the existence of a large number of pension and mutual funds from Europe and North America with a strong interest to invest in South African 19
securities, the failure to use properly designed swap contracts is puzzling. Demand for such contracts would most likely have been forthcoming<sup>9</sup> .

There is some concern about regulatory, accounting and reporting issues. However, the experience of South Africa has shown that even with the more cumbersome arrangements used there, these issues have not presented a major problem. Ideally, asset swaps should be valued at market prices, they should be clearly indicated in the balance sheets of institutional investors, and reported separately in official statistics. Asset swaps are a second best compared to a complete lifting of exchange restrictions but they have a role to play even in the absence of exchange controls.

Policy makers in developing countries that would like to encourage their institutional investors to undertake (or expand) international diversification of their assets would need to take the following steps:

- First, the authorities should formally allow pension funds and other institutional investors to engage in international asset swaps. The authorization should specify an upper limit in relation to total assets and to net inflow over the preceding calendar year (15% of assets and 10% of net inflow would seem reasonable targets).

- Second, the authorities would need to specify the criteria of eligible counterparties, in terms of financial standing and experience, or even make up a list of such counterparties, drawn from the ranks of global investment banks with a good record of specialization and performance in this area. Requests for Proposals could be issued to elicit interest by such global investment banks and identify institutions that were willing to compete in the market.

- Third, the types of permitted asset swaps should be specified.  Ideally, swaps involving market indices of liquid instruments would be recommended, including a global index plus a few regional ones. The maturity of asset swaps should be specified, starting with a minimum 2-year term and extending over time to up to 10 years.

> 9   Several other countries around the world meet criteria similar to South Africa.  As of February 2002, Mexico had 22 firms in the MSCI EMFI, while 89 US emerging market mutual funds invested in Mexican firms. Brazil had 34 firms and also 89 mutual funds; Chile 22 firms and 69 mutual funds; Argentina 13 firms and 41 mutual funds; China 41 firms and 83 mutual funds; India 58 firms and 87 mutual funds; and Korea 76 firms and 98 mutual funds (Aggarwal et al 2003).

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- Fourth, accounting and valuation rules should be specified. Ideally, swap contracts should be marked-to-market on a daily basis, even if settlement of net gains and losses is effected on a quarterly or half-yearly basis. Settlement should be effected at least half-yearly. Local institutions should be required to monitor the credit risk of their counterparties. Provisions could be included requiring settlement on a more frequent basis if the total amount of credit risk exceeds a specified threshold.

- Fifth, special collateral and custodian provisions should be established. The use of global custodians of high standing and the maintenance of adequate and appropriate collateral should be required.  In special cases, the central bank could be authorized to act as the custodian, calculating market values and credit risk, holding collateral and even acting as a center point for all transactions until local institutions develop the required expertise to handle such transactions on their own.

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