How China handles the third transition will have a profound impact on poverty among the old, on financial markets, and on the overall efficiency of the economy.

An Aging Giant

China's population will age rapidly after 2010, a reflection of the one-child policy of the late 1970s and the 1980s, and increased life expectancy due to higher living standards. (See Figure 1.) By 2030 over a quarter of the world's old will live in China. This represents a major challenge: one child will have to support two parents, and four grandparents. By 2030 the absolute size of the labor force in China will begin to decline. By 2050 the ratio of workers to pensioners is projected to decline to about 3 to 1, from 10 to 1 in 1995, reflecting 300 million elderly, up from 76 million today.

After 2010, China will face a graying of the population similar to the one Japan is going through right now, and one much more rapid than is expected for India, Asia, or the OECD countries. (See Table 1.) In just three decades, China will go through the same population transition most OECD countries took more than a century to complete. By 2020, China will face the challenges of a high income country, but at a time when it will have the resources of only a middle income country.

The Problem with soes

The long-run problem is currently overshadowed by a similar problem that the State Owned Enterprises (soes) face right now. (See Table 2.) With marketization of the economy, employment growth in the soe sector is slowing, while the number of pensioners in relation to employees is rising. Pension obligations are still mostly obligations of the individual enterprise. These obligations not only pose a heavy burden on the soe s, but they also slow enterprise restructuring, because bankruptcy or sale could potentially leave pensioners without income.

Too Few Are Covered

This short-run problem pales in comparison with the long-run problem of expanding the pension system to those not yet covered at all. (See Figure 2.) Whereas China is not out of line with other low-income countries, only the urban population is covered by a formal pension system to an extent comparable with middle-income countries. With increased urbanization, the leadership's concern over social stability, and the one child policy that will further reduce family support for the old, immediate action on expanding the coverage of a formal pension system is a high priority for China.

Lots of Savings, but No Capital Market

The lack of a formal pension system is partially compensated for by a high level of individual savings. China's accumulated financial assets--the majority of which is held by households--now add up to over 100 percent of GDP (94 percent in 1994). (See Figure 3.) China's savings rate is an impressive 40 percent of GDP, compared to India's 21 percent. Chinese households represent the most thrifty segment of the economy, accounting for almost two- thirds of savings. These are held mostly in the form of bank deposits, because few alternative investment opportunities are presently available in China. This is in sharp contrast with India, for example, which shows a much more diversified portfolio of financial assets.

Savings Alone Are Not Enough

Individual savings fail to achieve certain objectives because of several market failures, which are more prominent in developing countries, and especially in former command economies such as China. Among the most important are:

These are reasons for governments to get involved. China has done so, but to date only at a sub-national level, predominantly for the urban population employed by soe's, and with approaches that will not be sustainable in the longer term.

An Unsustainable System

The current pay-as-you-go pension system in China can deal with neither the short-term problem of pensions in state-owned enterprises nor the long-term problem of old age income security. Furthermore, the current system is financially unsustainable, due to its generous retirement age of 60 (55 for women), high wage replacement rate (up to 80 percent) and benefit levels indexed to wage increases. The current system

The Chinese Government has recognized the problems associated with the current system. As in many OECD countries, there is a growing consensus within China that a substantial part of retirement income should come from fully-funded individual accounts.

Three Pillars of Reform

At the request of the Chinese authorities, the World Bank recently completed a major study of the Chinese pension system. The study has proposed for consideration by the authorities a system that combines social pooling with funded individual accounts. It provides for three pillars (See Figure 4):

Pillar I: a basic pension component to keep retirees above the poverty line. This pillar contains an element of income redistribution. Keeping the elderly above the poverty line involves some redistribution of income from higher to lower wage earners.

Pillar II: mandatory individual accounts which would fund fully the larger part of pension obligations; and

Pillar III: voluntary accounts as desired, based on voluntary private insurance or annuities.

What Would the Average Worker Get?

For an average worker who joins the system in the future, the pension after 40 years of service would be about 60 percent of net wages (60 percent replacement rate). For this worker, an average of 24 percentage points would come from Pillar I and the rest would come from Pillar II. For a worker whose salary is 40 percent below average, the expected replacement rate would be about 80 percent, with 40 percentage points coming from Pillar I. For a worker with wages 40 percent above average, the replacement rate would be about 51 percent, with 15 percentage points coming from Pillar I.

What About the Costs? The mandatory component of contributions would be at 17 percent of wages (9 percent for Pillar I and 8 percent for Pillar II), provided the returns on invested funds are appropriate. The system assumes a gradual move to retirement at the age of 65, and indexing of benefits with the consumer price index. The system crucially depends on increased coverage: the older soe population needs to be supplemented by the generally younger TVE workers.

Big Balances

If China decides to implement the proposed reforms, or similar reforms towards a partially funded and sustainable system, pension funds will become major players in China's financial markets. (See Figure 5.) By 2030, the accumulated surplus of Pillar I and Pillar II together would add up to some 13 trillion Yuan, equivalent to about 27 percent of GDP, or US$1.6 trillion.

In terms of share in GDP, this exceeds the pension assets of Germany by a large margin, and compares with the U.K. and Denmark in 1980, and Canada in 1990. (See Figure 6.) With those sums outstanding, and with an annual Y500 billion, or US$60 billion in new investment money from excess premiums, China's pension funds will be large on the domestic capital markets, as well as on the international markets. On current trends, and assuming that a partially funded pension scheme is adopted, China's pension assets by 2030 will be fourth in the world after the United States, Japan, and the U.K, even when we assume no private life insurance for China.

Familiar Patterns

If China decides to adopt plans similar to the ones proposed by the World Bank, its pension assets will develop along the lines of those of Japan. Adoption of the plan would lead to an immediate buildup of assets that would mirror Japan's situation around 1970. (See Figure 7. Please note that the figure has a logarithmic scale.) Within a few years, China would build up pension assets in amounts similar to those of Japan in 1980. By about 2017, China would be a bigger market than Japan is today. The World Bank proposal suggests that China give a prominent role to private management of pension funds. Under these circumstances, the privately managed part of China's pension assets could, by 2017, be significantly larger than those of Japan today. As many of you know, over 65 percent of pension assets in Japan are managed by the Ministry of Finance through the Fiscal Investment and Loan Program.

Managing the Money

Crucial for the sustainability of the system is a solid rate of return for the invested balances. (See Figure 8.) Higher rates of return will permit lower contributions, all else being equal. For the simulations shown in Figure 5, it was assumed that by 2010 the average return on invested balances was 4 percent. Contribution rates would rise rapidly at lower rates of return. For Pillar I, for example, for each percentage point of lower return on invested balances, the sustainable contribution would rise by about 0.6 percent of wages. The higher the contribution rates, the higher the chances of evasion. The latter would have potentially damaging consequences for the sustainability of the pension system.

Required Reforms

For adequate rates of return, two reforms are essential (See Figure 9.):

Not Yet There

The two conditions for a successful, sustainable pension system are far from met in China. Financial reforms will likely have to await fiscal reforms. Only when the budget can afford to finance a much larger share of public investments can the current repression of the financial sector be relaxed. General government budget revenues are currently only 11 percent of GDP or perhaps 18 percent if extra-budgetary funds are included. The World Bank estimates that this is at least 6 percentage points short of the expenditures needed to finance the stated priorities of the Government.

Even if fiscal revenues recover, questions remain concerning the management of the pension funds. Management of the relatively minor funds that the municipal pension schemes currently accumulate are the responsibility of local Planning Bureaus. Early evidence suggests that the rates of return on these funds are below bank lending rates.

If China can overcome these difficulties, the cost of transition to a funded pension system could be less than for many other economies. Its rapid growth, relative youth of workers not yet covered, and the potential for increasing productivity of workers moving from agriculture to industry, gives China a golden opportunity to prevent the pension problem from turning into a pension crisis.