Emerging Markets Exec Summary

Institutional Investment in the UK from Emerging Markets SPECIAL INTEREST PAPER CITY OF LONDON CORPORATION

EXECUTIVE SUMMARY

Institutional Investment in the UK from Emerging Markets is published by the City of London.

The author of this report is Trusted Sources.

This Special Interest Paper is intended as a basis for discussion only. Whilst every effort has been made to ensure the accuracy and completeness of the material in this report, the author, Trusted Sources, and the City of London, give no warranty in that regard and accept no liability for any loss or damage incurred through the use of, or reliance upon, this report or the information contained herein.

December 2013 Š City of London PO Box 270, Guildhall London EC2P 2EJ www.cityoflondon.gov.uk/economicresearch

Institutional Investment in the UK from Emerging Markets SPECIAL INTEREST PAPER CITY OF LONDON CORPORATION

EXECUTIVE SUMMARY

www.cityoflondon.gov.uk/economicresearch

Institutional Investment in the UK from Emerging Markets

Purpose of the report This report, by Trusted Sources, was commissioned by the City of London to examine the changing patterns of institutional investment from emerging markets, in particular Brazil, Russia, India and China (the BRICs) into developed markets, such as the UK and US. The report looks at the drivers underpinning these trends, including the macroeconomic conditions in each BRIC country and the conditions and regulations determining investment behaviours, including recent regulatory reforms. This summary provides a concise overview; the full report goes into full detail and can be downloaded here.

Context – why do this now?

Emerging markets are playing an ever more important role in global financial markets – the World Bank estimates that, led by the BRICs, emerging markets will hold more than half of the global stocks of financial capital by 20301(see Chart 1).

These economies are continuing to rapidly grow in terms of productivity and income, leading to a growing pool of private savings as the citizens of these countries become wealthier, and increased portfolios for institutional investors such as pension funds and insurance companies. These changes are happening alongside increasing integration into global markets, with policy reforms enabling these countries to engage more directly in global markets.

Per centage points of global growth

Chart 1: Emerging markets’ increasing contribution to global growth

4.0

Emerging markets

3.5

Developed markets

3.0 2.5 2.0 1.5 1.0 0.5 0.0 1980-1989

1990-1999

2000-2006

2007-2011

2012 - 2022*

* estimated by IMF Sources: IMF World Economic Outlook databaseand BBVA research, Emerging Trends in Developing Countries,October 2013.

2500

Other emerging markets China

2000

2

1

India

World Bank, Global Development Horizon (2013),Capital for the future: Savings and investment in an interdependent world.

Russia

1500

Brazil

Per centage points of global growth

SPECIAL INTEREST PAPER CITY OF LONDON CORPORATION

4.0

Emerging markets

3.5

Developed markets

3.0 outward capital flows from emerging markets have been historically low, this has been Although changing in recent years, as shown in Chart 2, whereby emerging market institutions, particularly 2.5 corporates and government fund managers in the BRICs, have been looking for ways to improve 2.0 investment returns and diversify risks by investing savings into foreign assets: 1.5

n into developed markets, which offer a wide range of financial products and investments; and n into1.0 other emerging markets, where both returns and risks can be higher.

0.5

As a result, these countries are expected to become increasingly important sources of investment capital in global 0.0 markets going forward.

1980-1989

1990-1999

2000-2006

2007-2011

2012 - 2022*

Chart 2: Outward direct investment (ODI) flows from emerging markets

2500

Other emerging markets China

2000

India Russia

1500

Brazil

USD Billion

1000

500

0

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Source: UNCTAD, 2013

Growth potential Alternatives funds There is clearlyCash then potential for growth, though based on the experience of developed markets such as the US and Japan, it cansecurities often take decades for pension, life and mutual funds to diversify their portfolios Fixed-income and gain international exposure.

Equities

100

Therefore, at least in the short to medium term, direct investment from official and corporate sources will be the main form of outward investment from emerging markets.

80

r cent of portfolio

In the medium to long term, however, as growth stabilises, the domestic capital markets deepen and the economy matures, investors will seek to diversify their portfolios. The extent to which they then participate 60 in global investment depends on the governing regulatory framework and the attractiveness of the opportunities available elsewhere.

40

3 20

Institutional Investment in the UK from Emerging Markets

Methodology In order to look at these different aspects, this study has taken three main approaches: n A review of published research and data to identify the current state of institutional investment for each BRIC country, the extent of its development and its growth potential. n Structured interviews with 15 market participants in London, Beijing, Delhi, Kolkata, Rio de Janeiro and Moscow to investigate the expectations and outlooks of fund managers in these countries and any restrictions to outward portfolio investment. n A workshop in London with 12 senior industry experts to discuss and confirm research conclusions.

Overall key findings – growth Key overall findings from the research are summarised in the following section, and headline findings for the individual countries then follow.

Growth potential – general The research undertaken reinforces that there is a significant growth potential in assets under management for the BRICs in general. The rate of growth is likely to be faster than developed markets, given the relatively lower current base in terms of GDP and assets under management. Table 1 shows the position of the BRICs across a range of institutional investors, and it can be seen that, for example, pension fund assets as a percentage of GDP have a long way to go, compared with the US at 70%, Canada at 64% and Chile at 58%; likewise for insurance. Countries with the largest upwardly mobile population such as India and China will see the fastest growth in assets under management in the institutional investment sector.

It is worth noting that high-net worth individual investor outflows have long been a part of the overall picture and have benefitted the property sector and wealth management industries of developed markets, as highlighted by the specialist financial services professionals interviewed for this study.

Table 1: Size of BRIC’s institutional investment sector in terms of assets under management (AUM) in USD billion and their international portfolio investments relative to total AUM as of 2012

China India Brazil Russia

AUM of sovereign wealth funds (SWFs)/ official investment managers

1142

N/A

N/A

AUM of pension funds

1214

129

299

78

AUM of insurance companies

1240

302

204

38.4

AUM of mutual funds Total AUM in institutional sector

174.5

473

87

1100

17.5

4069

518

1603

308.4

241

2

22.1

48.3

6%

0.4%

1.4%

16%

International portfolio investment assets International portfolio investment as a % of total AUM in the institutional sector

4

Source: IMF Coordinated Portfolio Investment Survey data 2012 and TS estimates from official data sources.

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In terms of the drivers for these increasing capital flows from emerging markets into developed ones, the discussions with asset management industry experts highlighted two key factors.

First, the desire for broad portfolio diversification across geographies and assets classes will be stronger among collective wealth instruments as investors seek stable and safe returns. Evidence from the early signs of diversification in the BRICs and other emerging markets, led in particular by the sovereign wealth funds in the Gulf, China and Singapore, and the pension funds in Chile, demonstrates investors’ clear preference for stable developed market assets when investing abroad.

Secondly, with globalisation and increased labour mobility, present and future generations in the BRICs are much more likely to invest abroad than their predecessors, and exposure to and understanding of foreign markets will contribute to such development.

Potential growth at different rates While all four of the BRICs have strong potential for growth, they are at different stages of capital market integration. Table 1 demonstrates that each has large and growing pools of institutional capital that are likely to be deployed into the global economy over the next decade, which will happen to different degrees and at various speeds.

According to the IMF, China is among the world’s top net capital exporters, accounting for 12% (USD193bn) of capital exported into the global economy in 2012. In the same year, Russia was the only other capital exporter among the other BRICs and accounted for 4.7% (USD75bn) of global capital exports; conversely, India and Brazil imported about 7% (USD88bn) and 4.3% (USD54bn) of global capital respectively.2 China’s large accumulated capital pool from consistent surplus trade balances and controlled currency fluctuation is likely to fuel further growth in its international portfolio flows. Its institutions have looked at balancing their portfolios by seeking emerging market opportunities through high-growth equities and high-yield bonds, alongside stable returns from investments in the developed markets.

The other BRICs may be expected to follow this pattern, and have good growth potential. Brazil has a well-developed financial system, and Russia has few controls on investment outflows, and India has a vast and growing population of young middle class families whose savings and investments are likely to grow rapidly as key reforms are implemented. For example, Indian mutual funds are allowed to invest up to 5% of their assets under management abroad but are currently only investing 2%. Likewise, Chinese insurance firms utilise only a small portion – 2% of assets under management – of their 15% limit to invest abroad. This reflects the fact that currently most investments are made in domestic securities.

On the other hand, Brazil’s collective investment vehicles have shown impressive growth in a high interest rate environment and are currently trying to use the full scope allowed them in order to invest abroad.

2

IMF, October 2013, Global Financial Stability Report, Statistical Appendix.

5

Per centage points of gl

2.0 1.5

Institutional Investment in the UK from Emerging Markets 1.0 0.5 0.0

1980-1989

2500

China 2000

1990-1999

2000-2006

2007-2011

2012 - 2022*

Other emerging markets China India Russia

Position, strengths and challenges 1500 Brazil

USD Billion

In terms of both volume and liberalisation, China is leading the way. A key strength is the size and sophistication of its two main sovereign wealth funds – CIC and SAFE-IC – which have access to a USD3.4 1000 trillion FX reserve. These two official investment managers have the most opportunity to invest abroad, in terms of regulation and fund size. As a result, they have invested in a broad range of overseas assets, 500 encompassing equities, fixed income and alternatives (see Chart 5).

Other 0strengths include the growing expertise of its pension and life insurance companies, broad interest 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 in diversification and the ability to attract skilled staff. The size of its capital account surplus and the share of its life and pension industries as a percentage of GDP also offer clear advantages.

Chart 5: CIC overseas investment portfolio in terms of assets Alternatives Cash funds Fixed-income securities Equities 100

80

Per cent of portfolio

60

40

20

0 2008

2009

2010

2011

2012

Source: CIC, 2012

550

Growth of portfolio investment (RHS)

150

Portfolio investment (LHS)

6

110 -50 0 2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Per cent change, yoy

USD Billion

While440the official investment managers have taken up a wide range of investments, there are100 still some ODI (LHS) challenges, in particular terms of encouraging retail investors to participate in China’s Qualified Other investmentin (LHS) Domestic Institutional Investor (QDII) programme. This was set back in its early stages by the 2007/08 330 Reserve assets (LHS) 50 financial crisis, where domestic investors experienced significant losses through investment in foreign assets.

Nonetheless, there is huge potential, and the resilience of Europe and growing signs of global 220 economic recovery, should encourage retail investors to invest internationally.

0

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Move to developed markets The research confirms that the outlook for more Chinese money to be invested in developed markets is positive. The interviews with industry experts highlight that this upward trend will be driven by both topdown and bottom-up factors, which include: n the liberalisation of the capital account, which is very high on the government’s reform agenda; n the internationalisation of the renminbi, which allows traders and investors to make payments directly in renminbi in select clearing houses; and n the strong demand for investment options, especially from high-net worth individuals, but also the growing middle classes. “ If the domestic market in China grows at the current momentum, financial reform will result in the country’s overall institutional investors’ sector portfolio to look similar to that of developed markets such as Japan or the US where 30% of the overall insitutional portfolio is invested abroad.”

Head of Distribution, Beijing Experts have also highlighted that the substantial Chinese assets, both government and private wealth, are in search of deep and liquid markets with a wide range of opportunities. This makes developed markets with global financial centres, such as London and New York, particularly attractive.

UK opportunities The interviews with industry experts highlight that while the US has a deeper financial market, its regulations – especially on sovereign wealth fund investments – are more restrictive than those of the UK. The UK’s strengths include an attractive legal system and transparent regulations with information rights, although a smaller scale of assets than the US. Interest from key Chinese public sector representatives in providing information on how state-owned enterprises can invest in the UK and other developed markets has been increasingly evident over the past few months. Part of this attraction lies in these overseas markets’ ability to offer high yielding and countercyclical investments, such as infrastructure assets.

Overall then, it seems likely that China will continue to see growing demand from its domestic savers for higher investment returns and meaningful diversification into international jurisdictions which are perceived to be safe.

7

1500

Brazil

1000

USD Billion

Institutional Investment in the UK from Emerging Markets 500

0

India

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Alternatives Cash funds

Fixed-incomeand securities Position, strengths challenges

India’s outward capital flows have been growing, although at a slower rate than China, as can be Equities seen100 in Chart 6. There are a number of factors underpinning this, including attractive domestic growth potential on the one hand, and an on-going and significant current account deficit, high inflation (and a concomitant preference towards gold as a savings instrument), and strong limits on institutional outflows 80 on the other.

60

Per cent of portfolio

This comparatively slow growth has especially been the case for portfolio investments, for a range of macro-economic reasons, including the current account deficit, currency volatility and slowing 40 economic growth. Between 2003 and 2011, India’s outward direct investment assets increased 20 times from USD5.8 billion to USD118 billion accounting for 6% of GDP – portfolio investments, however, remained 20 0.1% of GDP. at only 0

2008 2009 Chart 6: India’s international investment assets

550

2010

2011

2012

Growth of portfolio investment (RHS)

150

Portfolio investment (LHS) 440

ODI (LHS)

100

Other investment (LHS) Reserve assets (LHS)

50

220

USD Billion

0 110 -50 0 2003

2004

2005

2006

2007

2008

2009

2010

2011

Per cent change, yoy

330

2012

Source: Reserve Bank of India, 2012.

Move to developed markets While India’s financial system is still developing in terms of depth and coverage, the demographic driver in India is clearly stronger than in other BRICs. If reforms are implemented, therefore, there will be a huge potential for overseas institutional investment to be developed over the longer term: “ Going forward, the main trigger for portfolio investments to be made abroad would be an attractive growth differential and further financial sector liberalisation and reform.”

Senior Economist, India

8

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The signs are that the outlook for reform is positive, especially after the new governor of the central bank (Reserve Bank of India), Raghuram Rajan, took office. Mr Rajan has vowed to revolutionise the Indian financial system by undertaking key structural reforms to make it more modernised, competitive and accessible to the vast demography. Certain changes to the pension and insurance sectors have already been made or proposed which will increase the role of foreign institutions in the industry and attract FDI into the country. The diversification of these sectors will help mobilise funds and create more pooled investment vehicles for retail investors.

UK opportunities Interviews with industry experts highlight that in the short-term, investment from India into the UK will predominantly be in the form of direct investment. However, exports of retail investments will increase as reform is implemented and the country’s current account position improves.

Brazil Position, strengths and challenges Brazil has in many ways one of the most well-developed financial systems of the emerging market economies, but regulations on outflows are still very cumbersome. These stringent restrictions have contributed towards a strong preference for domestic investment, alongside steep domestic real interest rates, which have made sovereign bonds the preferred choice of investment.

In recent years, however, this has begun to change, as double-digit local rates have steadily declined to near historical lows, meaning it has become harder for investment funds to meet performance targets in low-risk sovereign bonds.

At the same time, the country has suffered a prolonged economic slowdown and stock market turbulence in the past 12-18 months. These factors have spurred domestic institutional investors to look elsewhere in order to diversify risk and ensure more stable returns.

Move to developed markets Though still at an early stage, these trends are driving opportunities for global asset managers, investment banks and international private equity funds. Recent activities in the pension fund industry for instance, show that several funds are determined to overcome current limitations in order to continue diversifying their portfolios through international capital markets. They have begun to hire international asset managers in order for them to help them do so. “ Brazilian pension funds are showing signs of increasing interest in investing abroad.

In particular, smaller and privately managed pension funds are likely to respond quickly to market forces and take up attractive overseas investment opportunities.”

Pension Fund Manager, Brazil It is also the case that key developments such as the scheduled launch of Brazil’s first four outward investment vehicles designed for local pension funds in Q1/14 and further regulatory easing will create opportunities for fund flows both into and out of the Brazilian capital market.

9

Institutional Investment in the UK from Emerging Markets

While there is no expectation of Brazilian investment entering developed markets in the next three years at a very large scale, increasing outbound Brazilian fund flows will nevertheless be a likely development in the longer term. Growth potential for the global asset management industry in Brazil clearly exists over the coming decade, particularly if regulatory changes are eventually enacted.

UK opportunities Although there remain only a small number of firms able to administer external investments and limited outward investment vehicles, leading UK-based asset managers will be in a prime position not just to evaluate the response of Brazilian pension funds to further investments into foreign equities but also to capitalise on future opportunities should they arise.

In terms of asset allocation, increasing institutional investment flows from Brazil have predominantly been directed towards developed market securities which provide stable returns, particularly US equity and debt instruments.3 With longer term development in outbound flows, institutional investors are likely to seek similarly stable UK securities.

Russia Position, strengths and challenges Russia has already seen significant domestic private wealth flowing into international investment vehicles, ahead of its emerging market counterparts as a result of its liberalised controls on capital outflows and currency convertibility.

It has though been slower in developing its institutional investment sector, with the Russian market for vehicles mobilising domestic collective savings being rather underdeveloped. Thus outward institutional investment from such vehicles remains relatively small (2.3% of GDP based on data from the IMF and Bank of Russia). Some capital is invested abroad and goes mainly towards debt securities via investment vehicles in Luxembourg and well-established centres such as Jersey in the Channel Islands.

Move to developed markets While there is currently very little international diversification of domestically managed portfolios, there are some signs that this may be developing. The existence of a regulatory framework for insurance and pension funds that provides for international diversification means that the conditions have already been created for steadily increasing portfolio investment outflows from Russia.

UK opportunities In terms of the private wealth invested internationally, much is presently held in entities domiciled in the British Virgin Islands and the Cayman Islands. It is managed largely by wealth management firms and family offices based in Europe and invested in global assets. The UK has a substantial share of this Russian wealth market, although it is difficult to formally quantify.

The IMF estimates the UK accounted for the third largest share of Russian portfolio investment assets at 14% (or USD6,840m) in 2012, behind Ireland and Luxembourg. The existence of established channels for Russian investment flows into the UK and relatively liberal stance on outward investment, mean that institutional investment is likely to grown in line with the Russian economy.

10

3

IMF, 2012 Coordinated Portfolio Investment Survey, as at December 2013.

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Developed markets as destinations for institutional investment Emerging market institutional investors are likely to continue investing in developed markets such as Europe and the US, as investors continue to diversify their portfolios both in terms of asset and geographical allocation. “ Insurance and pension funds investing overseas continue to opt for safe assets with regular and stable returns, such as US treasuries and high-yield European securities.�

Head of Distribution, Emerging Markets Investment Manager Regulatory initiatives such as the QDII programme in China should strengthen the growth of capital flows into overseas markets. Established international financial centres offering deep and liquid capital markets and investment expertise, coupled with developed regulatory and legal frameworks protecting investors’ property rights, will continue to provide attractive investment opportunities for these funds.

Given the history and success of developed markets financial sectors, especially those in the US and the UK, financial services such as asset management, financial consulting, agencies, brokers and managers of alternative assets such as real estate based in these markets, are likely to see an expansion in interest from emerging market investors.

11

Institutional Investment in the UK from Emerging Markets

Opportunities for the UK as an institutional investment hub Official flows from emerging market countries – including from sovereign wealth funds, corporates and state-managed pension funds – are currently diversifying their foreign holdings from developed market government bonds to other asset classes. The UK has been successful in providing access to a wide range of investment opportunities, emerging as a global hub for social investment, and a centre for renminbi trading, with the latest data showing the UK accounts for 62% of renminbi currency trading outside of mainland China and Hong Kong. The UK also specialises in funds offering emerging market equity and bond portfolios; property agencies, managers and brokers; and other alternative asset classes such as hedge funds, private equity and infrastructure which are attractive to emerging market investors.

As the infrastructure for private collective savings outflows from emerging market countries improves – albeit at varying speeds from country to country – there will be three types of opportunity for the UK to attract further institutional investment: n Asset management firms from countries with successful specialisation in financial services, such as the UK, will enjoy increasing scope for raising assets under management in emerging market countries on the strength of their proven skill and expertise in global investing. n Emerging market institutional investors such as sovereign wealth funds and state-managed pension funds will look to diversify their foreign holdings to other asset classes such as real estate, hedge funds, private equity and equity interests in infrastructure assets, benefitting countries offering access to a wide range of financial services sub-sectors such as the UK. n The UK is well placed to attract private portfolio investment flows from the emerging markets owing its reputation as an international financial centre, offering both UK securities and a wide range of international investment opportunities – that is, a “one-stop shop” for portfolio diversification. Hence the potential of the UK to attract inflows from emerging markets is contingent on its continued success in serving as an intermediary for investment into other emerging (as well as developed)countries.

In conclusion, the UK’s reputation in terms of the range of financial services offered, depth of technical expertise and ability of the local workforce, and its stable and transparent regulation, has resulted in strong growth in institutional investment flows from emerging markets, and this trend looks set to continue.

As one industry expert summarised: “ Emerging market investors value the UK’s mature investment environment and its transparent and open regulatory framework.”

Senior Executive, Leading SOE, China

12

Institutional Investment in the UK from Emerging Markets SPECIAL INTEREST PAPER CITY OF LONDON CORPORATION DECEMBER 2013

EXECUTIVE SUMMARY

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