What can China learn from the experience of Latin America?

In document Pension Reform in China: Challenges and Answers (Page 74-77)

6. Pension reform in Latin America: lessons for China

6.4. What can China learn from the experience of Latin America?

Security privatization on Argentina's deficits and debt in the years from 1994 to 2001, Dean Baker and Mark Weisbrot (2002) address that the deficits created by the lost Social Security tax revenue and resulting interest payments grew rapidly, so that by 2001 they were nearly equal to 3.0 percent of GDP.

And in fact, the deficit created by Social Security privatization is almost exactly equal to the government budget deficits that Argentina ran in these years. Argentina's government had to borrow to make up for this lost revenue. Argentina was forced to pay a very high interest rate on its new debt, as a result of a series of external events beginning with the US Federal Reserve's interest rate hikes in February of 1994, and the series of emerging market financial crises (Mexico, East Asia, Russia, Brazil) that followed. Therefore, the borrowing that was needed to finance social security privatization came at a very high cost. This cost quickly grew, as higher debt led to higher interest payments. If it had not been for the tax revenues that were lost as a result of Social Security privatization, the country would have had little difficulty covering its bills, and there is no reason to believe that it would be facing the same sort of crisis.

The economic collapse that resulted from Argentina's inability to continue to finance its deficits ultimately affected Argentina's Social Security program. As part of a loan agreement with the IMF, Argentina cut the benefits in its traditional Social Security program by 13 percent in September of 2001 (IMF 2001). As Baker (2002) highlighted, “the irony of this action is that Argentina's decision to privatize Social Security in 1994 helped to touch off a financial crisis, which ultimately forced much more draconian cuts in Social Security than ever would have been contemplated in 1994… The fact that the government and international financial institutions apparently did not take these risks into account in promoting social security privatization was a serious and costly error.”

The recent ongoing global financial crisis 2008-2009, triggered by the sub-prime mortgage crisis, with the failure and merging of a number of American financial institutions, has put a number of economies into a recession and the stock indexes into a downward spiral. When taking into account the world widely increasing role of fully-funded schemes in old-age security system and the growing amount of pension funds invested in the capital market, the immediate negative impact of the current global financial crisis on social security is obvious. Moreover, the financial crisis is now spilling over into the real economy, and this will impact negatively on wage and employment levels. Lower income from contributions and also from tax revenues will occur. And because of higher levels of unemployment, higher expenditure for unemployment benefits will be needed and the financial pressure on the pension provision will be increased. The global financial crisis evidently proved that massive debt and excessive credit is not sustainable, because for a long period of time much of the American economy is built on credit with firms borrowing money from other firms and the general consumer borrowing money for consumption. In the process of social security privatization, which would inevitably cause the decrease in tax revenue and increase in government debt, its financial risks must be taken into account seriously.

6.4.3. Privatized pension system aggravates inequity

Latin America is the most unequal region in the world in terms of income distribution. It is argued that the privatization of pension system in Latin America has aggravate the inequity and made the poor even poorer. Huber (2000) highlighted, that administrative costs, associated with private, fully funded

individual accounts have a potentially highly regressive effect. One estimate suggested that in 1987 total fees and commissions caused an 18 percent reduction in the deposit of an insured individual of 10,000 pesos-per-month income, but only an 0.9 per cent reduction in the deposit of an individual with 10 times that income (Mesa-Lago, 1994:123-124).

One obvious way to reduce the regressive effects of administrative costs is to regulate the structure of fees that private pension fund administrators can levy. Regulation is less effective, however, in stimulating competition. In most countries, the pension fund industry has become highly concentrated, with the proportion of the insured population belonging to the three largest pension fund companies ranging from a low of 40 per cent in Argentina and 60 per cent in Colombia, to 70 per cent in Chile, Peru and Uruguay (Cruz-Saco and Mesa-Lago, 1998:417).

Generally, workers with relatively high earnings will even be better off because the pension reforms have introduced a voluntary pillar that benefits from tax incentives. For workers with less or no contributory capacity, they would have benefited more from the old pension systems because the social security instrument is a non-contributory scheme with an progressive effect and anti-poverty objective, so that low wage workers would get a much higher share of their wages in benefits than do high wage workers. As case of social security benefits in USA, a worker who earned $10,000 a year during their working lifetime can expect to see a benefit that is equal to approximately 70 percent of their average wage. A worker who earned $36,000 a year will get a benefit that is equal to approximately 40 percent of their wage, while a worker who earned $50,000 on average will get a benefit that is equal to 35 percent of their wage. While poorer workers do not live as long as higher paid workers, the progressive benefit structure largely offsets differences in life expectancy.

6.4.4. Government regulations are needed to control risks

Social Security privatization was supposed to isolate the systems from political interference and the effects of economic cycles that usually affect the financing of public schemes, but they are still subject to great risks. On one hand, private individual accounts cause larger administrative and management costs and this should be compensated with high rates of return. This has been the case for some Latin American countries over the last years. But it is improbable that this can be maintained in the long run.

On the other hand, experience form Latin America shows, it is impossible to isolate a private pension scheme from governmental policies’ control, economic circle or external shocks.

Proponents of privatization present a dichotomy between the option of having government control over pension fund assets, with the risk that these assets will then be funneled toward specific political ends.

They insist in allowing the market to determine the allocation of assets in individual accounts.

However, the government’s involvement to ensure that the accounts are invested in relatively safe classes of assets, and also to ensure that the financial institutions that manage the funds are engaged in sound financial practices, is indispensable.

Since any system of individual accounts will require government regulation, there is not a sharp difference between the nature of the government involvement in a public pre-funded system and in a private system of government regulated accounts. Alternatively, if there is a political consensus on

minimizing government control over the allocation of these funds, it is likely to prove equally effective in the two situations. The major difference is that the individual account system will incur far higher administrative fees.

6.4.5. Conclusion

Through the above discussion, what can China learn from the experience of Latin America? Firstly, to give more incentives to the pension system and to extend the pension coverage, China should strengthen the public component of the basic pension scheme. Secondly, in the process of pension reform involving a switch to individual accounts, China should avoid that the lost social security tax revenue result in excessive government budget deficits, which might come at a very high cost and even trigger a financial crisis. Thirdly, as privatized pension system aggravates inequity, China should do more to ease the regressive effects of the individual accounts. Fourthly, social security privatization put the pension assets at the risks of economic circle or external shocks, government’s involvement and regulations are indispensable to control the risks.

In document Pension Reform in China: Challenges and Answers (Page 74-77)