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7
November/December 1995
Volume 80, Number 6
Federal Reserve
Bank of Atlanta
In This Issue:
To Call or Not to Call? Optimal Call Policies
for Callable U.S. Treasury Bonds
Mergers and Acquisitions in China
FYI—Monetary Aggregates, Payments
Technology, and Institutional Factors
T
,
'
November/December 1995, Volume 80, Number 6
s.
Federal Reserve
Bank of Atlanta
President
Robert P. Forrestal
Senior Vice President and
Director of Research
Sheila L. Tschinkel
Research Department
B. Frank King, Vice President and Associate Director of Research
Mary Susan Rosenbaum, Vice President, Macropoiicy
Thomas J. Cunningham, Research Officer, Regional
William Roberds, Research Officer, Macropoiicy
Larry D. Wall, Research Officer, Financial
Public Affairs
Bobbie H. McCrackin, Vice President
Joycelyn Trigg Woolfolk, Editor
Lynn H. Foley, Managing Editor
Carole L. Starkey, Graphics
Ellen Arth, Circulation
The Economic Review of the Federal Reserve Bank of Atlanta presents analysis of economic
and financial topics relevant to Federal Reserve policy. In a format accessible to the nonspecialist, the publication reflects the work of the Research Department. It is edited, designed, produced, and distributed through the Public Affairs Department.
Views expressed in the Economic
Review are not necessarily those of this Bank or of the Fed-
eral Reserve System.
Material may be reprinted or abstracted if the Review and author are credited. Please provide the
Bank's Public Affairs Department with a copy of any publication containing reprinted material.
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cancellations should be sent directly to the Public Affairs Department. Please include the curmailing label as well as any new information. ISSN 0732-1813
Digitized forrent
FRASER
Federal Reserve Bank of Atlanta Economic Review
November/December 1995, Volume 80, Number 6
To Call or Not to Call?
Optimal Call Policies for
Callable U.S. Treasury Bonds
Robert R. Bliss and Ehud I. Ronn
JJ
Mergers and Acquisitions
in China
Jie Lin Dong and Jie Hu
Until 1984, the U.S. Treasury typically issued its long-term
bonds in callable form. A number of these securities, totaling
$93.8 billion in face value, remain outstanding. After a call protection period, usually five years prior to maturity, the Treasury can
call the bonds but must give prior notification of intent to call. This
article develops a decision rule, which takes account of the prior
notification requirement, for when it is optimal to call such bonds.
The decision of whether to call is based on the current level of
interest rates and their volatility. For a call to be optimal for the
Treasury, interest rates must be sufficiently low (relative to the
bond's coupon) and the potential benefits of waiting—on the
chance of even lower interest rates—should be insufficient to compensate for the costs of continuing to pay the higher coupon rate for
another six months. After developing these ideas, the authors use a
numerical example to demonstrate their application. They conclude
that, at least in recent years, the Treasury has called bonds optimally. The model they use, which is also applicable to agency, corporate, and municipal callable bonds, specifies conditions under which
the Treasury should call outstanding callable bonds in the future.
Mergers and acquisitions are an integral part of any market
economy, enhancing an economy's efficiency by reallocating and
recombining production resources for better use. In China, the development of mergers and acquisitions activity has played a positive role in privatizing and revitalizing the country's inefficient
state enterprises, attracting foreign investment, and rationalizing
the industrial structure. The authors of this article discuss this development in the context of China's market-oriented economic reform and provide an outline of the advantages and disadvantages
of the country's approach to mergers and acquisitions.
Three reasons emerge as forces driving mergers and acquisitions activity in China, reasons that are likely to continue fueling
its growth: the government's need to restructure and revitalize the
state-owned enterprises; the growing needs of enterprises; and the
market's potential for attracting more international capital. Because of the importance of the mergers and acquisitions market in
restructuring and modernizing the industry of China, the authors
expect its development to continue, but they observe that careful
handling of many institutional deficiencies and social problems as
well as political obstacles will be required to avoid major setbacks.
FYI—Monetary Aggregates,
Payments Technology, and
Institutional Factors
David J. Petersen
Economic theory implies that the quantity of money in the economy is linked both to the Federal Reserve's policy-making instruments and its ultimate objectives and should therefore be useful in
formulating policy decisions. The Federal Reserve defines monetary aggregates, composed of financial assets like cash and demand
deposits, expressly for this purpose.
Over time, substantial changes have been observed in the close
relationships between monetary aggregates and economic activity.
Between 1990 and 1994, growth in the Federal Reserve's M2 monetary aggregate was much slower than expected, a development that
several academic studies attribute to the proliferation of financial
assets that serve as alternatives to M2 components. As a result, the
current composition of M2 no longer completely reflects the choice
of financial assets available as means of payment or close substitutes. Thus, the aggregate's relationship with expenditure on goods
and services may no longer be direct or predictable, and M2 may
not now serve as a reliable link between policy instruments and policy goals. In addition, unforeseen instability in the macroeconomic
relationships between monetary aggregates and the Federal Reserve's goals raises broader questions about the role of aggregates
in policy making.
This article explores how the composition and character of payments assets can change in a dynamic financial system, ultimately
influencing the relationships between monetary aggregates and economic activity.
index for 1995
To Call or Not to Call?
Optimal Call Policies for
Callable U.S. Treasury Bonds
Robert R. Bliss and Ehud I. Ronn
W
I
t
•
V
J
ntil 1984, the U.S. Treasury typically issued callable long-term
bonds, a number of which remain outstanding. Corporations and
I
agencies also commonly issue bonds in callable form. 1 Issuing
J
bonds with the " c a l l " option offers the Treasury and corpora^
tions the advantage of being able to retire bonds early, thus providing flexibility in their financing, or to refinance at lower rates should
interest rates decline. However, this advantage to the issuer is offset by the
higher return that bondholders require on callable bonds.
/
An issuer's decision to call a bond has important implications. In
ing a bond, the issuer gives up the option to call it at a later time that
be even more advantageous. By not calling when it should, an issuer
more in interest than is necessary, yet if the issuer calls too soon, it
too much to repurchase the bond, thus throwing away money.
Bliss is a senior economist in
the financial section of the
Atlanta Fed's research
department. Ronn is a
professor of finance in
the College and Graduate
School of Business of the
University of Texas at Austin.
They thank Peter Abken,
Larry Wall, and Bradford
Jordan for helpful comments.
Federal Reserve Bank of Atlanta
callmay
pays
pays
T h e r e is an extensive literature o n h o w bond issuers should, and in
practice do, call outstanding bonds. These works suffer f r o m a generally
shared oversight. Jonathan E. Ingersoll, Jr. (1977), Joseph D. Vu (1986),
and Francis A. Longstaff (1992), as well as others in the literature, have
assumed that bonds are immediately callable, perhaps after the expiration
of a call protection period, w h e n in fact Treasury and m a n y other bond
calls require prior notification by the issuer of the intent to call. Ingersoll,
who looked at calls of convertible corporate bonds, and Vu, who examined
nonconvertible corporate bond calls, found that corporations appeared to
delay calling their bonds well beyond what they considered the optimal
time to do so. Longstaff found that Treasury bonds traded at prices well
above what was thought sufficient to trigger a call. However, the notification period required before a call option is exercised renders the n a i v e
rules for when to call used in these works incorrect, as shown by Robert R.
Bliss and Ehud I. Ronn (1995). Taking the notification period into account
explains the puzzling " a n o m a l i e s " observed by Longstaff. By extension,
the observed behavior of corporations in not calling their bonds w h e n
Economic Review 9
Ingersoll, Vu, and others thought it rational to do so
m a y be in part an outcome of the same effect.
To decide whether to call, an issuer should consider the current level of interest rates as well as their
volatility. For a call to be optimal f o r the Treasury,
interest rates must be sufficiently low (relative to the
callable bond's coupon rate) and the potential benefits of waiting—on the chance of even lower interest
r a t e s — s h o u l d be insufficient to c o m p e n s a t e for the
costs of c o n t i n u i n g to pay the h i g h e r c o u p o n rate.
Treasury bonds represent a liability to
the Treasury. In making an
economically
rational call decision , the Treasury
should act to minimize the net present
value of this liability.
Based on Bliss and Ronn (1995), this article develops
the arguments underlying these rules in the context of
Treasury call decisions and demonstrates their application using a numerical example.
Examination of Treasury call decisions concludes
that, at least in recent years, the Treasury has called
bonds optimally. The model discussed herein specifies conditions under which the Treasury should call
o u t s t a n d i n g c a l l a b l e b o n d s in the f u t u r e . T h e a p proach presented for implementing the decision rule
can be used for other deferred-exercise options such
as corporate, agency, and municipal callable b o n d s
and may also be applied to the valuation of callable
and puttable securities.
BfgWaMBrtaUtHW
The Historical Record
U.S. Treasury callable securities are characterized
by several features:
• Time to maturity. The Treasury has issued three
c a l l a b l e n o t e s w i t h m a t u r i t i e s of up to f i v e
years and eighty-seven callable bonds with m a turities of up to thirty years. The Treasury has
also issued a callable perpetuity that was retired
in 1935. 2
2
Economic Review
•
Call Period. All such instruments are characterized by an initial call protection period, after
w h i c h the b o n d s are c a l l a b l e on any c o u p o n
p a y m e n t date up to maturity. For d i f f e r e n t
callable instruments, this call period has varied
f r o m t w o to f i f t e e n y e a r s . Currently, all outstanding callable Treasury bonds have a call period of five years.
•
Prior Notification Period. All callable Treasury
securities require the Treasury to provide prior
notice of its intent to call the bond. Excepting^ a
few bonds issued prior to 1922, this notification
period has always been four months.
Table 1 displays the eighty-eight callable securities issued by the U.S. Treasury since 1917. It shows
that the five-year call period did not become standard
until 1962. Issuance of callable bonds ceased with the
inception of the Treasury S T R I P S program in 1985. 3
The next callable Treasury bonds to enter their call
periods are 8 percent coupon-rate bonds maturing on
August 15, 2001, and callable beginning in August
1 9 9 6 — r e f e r r e d to as the 8 ' s of A u g u s t 1996-2001
(the exact date is implicit since, currently, all outs t a n d i n g bonds mature o n the f i f t e e n t h of their respective maturity months). These bonds have a total
face value of $1,485 billion. The notification date for
the first call opportunity for this bond is April 17,
1996. T h e remaining sixteen callable issues do not
enter their call period until May 2000, and the last
callable bond, the ll 3 /4's of N o v e m b e r 2009-14, issued in 1984, is not callable until 2 0 0 9 and if not
called will mature in 2014.
Making an Optimal Call Decision
W h e n the Treasury calls a bond, it has m a d e a decision to exercise the option granted it in the terms
of the bond. After reviewing the optimal exercise of
s t a n d a r d A m e r i c a n o p t i o n s that m a y be e x e r c i s e d
immediately and at will by the optionholder, this discussion turns to the complications resulting f r o m the
contractual obligation to provide prior notification of
intent to call, which limits the T r e a s u r y ' s rights to
call the bond. Box 1 on p a g e 10 works through a numerical e x a m p l e of how to m a k e the call decision
and simultaneously determine the b o n d ' s fair value.
Early Exercise of A m e r i c a n Options. Most options, such as call options on shares of stock, c o m e
in one of t w o forms: a European-style option, which
m a y be exercised only at its expiration date, and an
November/December 1995
A m e r i c a n - s t y l e option, which m a y be exercised at
any time up to and including expiration. The optimal
exercise rule for a European option is trivial: if, at the
option's expiration, exercise would result in a positive
cash flow to the optionholder, then the option should
be exercised. The same rule applies to an American
option at its expiration if it has not been exercised.
pires, the optionholder has a choice, and that choice
has value. T h e value of being able to d e f e r the exercise decision is called the time value of the option. This value is usually positive and never negative
since the optionholder has the right to choose whether
to exercise. A s the option approaches its expiration
date, the time value erodes until, at expiration, the
time value is zero and the option value equals the intrinsic value. 4
T h e question of whether to exercise an American
option prior to expiration requires further analysis.
The value of an option may be broken down into two
parts. The first part is the option's "intrinsic value,"
which is the immediate exercise value. If the option is
"in-the-money"—that is, if the price of the underlying
asset is above the exercise price for a call option (below for a put option)—immediate exercise would result in a positive cash flow to the optionholder in the
amount of the difference between the value of the underlying asset and the strike, or exercise, price stipulated in the option contract. An " o u t - o f - t h e - m o n e y "
option (for which the price of the underlying asset is
below the exercise price for a call and above for a put)
is one for which immediate exercise would result in a
loss to the optionholder. Since the optionholder can
choose whether or not to exercise, an out-of-the-money
option would never be exercised and thus has an intrinsic value of zero.
The total value of an option is the sum of its intrinsic and time values, as Chart 1 illustrates for a call option. For this reason, out-of-the-money options, which
would not be exercised at this time, usually still h a v e
positive m a r k e t values. In these cases, the intrinsic
value is zero, but the time value is positive because
there is some chance that the price of the underlying
asset may change so that the option moves into-themoney prior to its expiration. If that chance is small,
for instance when the time to expiration is short, then
the time value will be commensurately small.
With free-standing (traded separately f r o m the underlying asset) A m e r i c a n o p t i o n s , an o p t i o n h o l d e r
can get out of his or her position either by exercising
or selling the option. A s long as the time value is
positive, it is m o r e profitable to sell and the option
will not be exercised. But when the time value has
been eroded to zero, the option should be exercised if
it is both American-style and in-the-money.
However, an option is typically worth m o r e than
its intrinsic value. B e f o r e an A m e r i c a n option ex-
Chart 1
Components of the Value of an American Call Option
Value
Federal Reserve Bank of Atlanta
Total Call
Option Value
Time Value
Price of the
Underlying
Asset
Out-of-the-Money
1
In-the-Money
Exercise Price
Economic Review
3
Table 1
History of Callable U.S. Treasury Note and Bond Issues since 1 9 1 7
Date Issued
(dated date)
19170615
19171115
19171115
19180515
19180615
19181215
19181024
19221016
19241215
19260315
19270315
19270915
19280116
19270615
19280716
19310316
19310615
19310915
19340416
19340615
19341215
19350315
19350916
19360316
19360615
19360915
19361215
19380615
19380915
19381215
19391208
19391222
19400722
19401007
19410315
19410331
19410602
19411020
19411215
19420115
19420225
19420505
19420515
19420715
Maturity
Date
Coupon
Rate
Term
(at issue)
Call Period
(years)
First Possible
Call Date
Date
Called
19470615
19421115
19470615
19421115
19470615
19470615
19381015
19521015
19541215
19560315
19320315
19320915
19321215
19470615
19430615
19430315
19490615
19550915
19460415
19480615
19521215
19600315
19470915
19510315
19540615
19590915
19531215
19630615
19520915
19651215
19501215
19531215
19560615
19550615
19500315
19540315
19580315
19720915
19551215
19510615
19550615
19670615
19510915
19511215
y/i
4
4
4'A
4%
4'A
4'A
4A
4
33A
3 Va
3 Vi
3Vi
3%
3%
3%
3 Ve
3
3A
3
3 Va
2%
2%
2%
23A
2%
2 Vi
23A
2Vi
2%
2
2A
2A
2
2
2'/2
2'/2
2Vi
2
2
2A
2Vi
2
2
30.0
25.0
29.6
24.5
29.0
28.5
20.0
30.0
30.0
30.0
5.0
5.0
4.9
20.0
14.9
12.0
18.0
24.0
12.0
14.0
18.0
25.0
12.0
15.0
18.0
23.0
17.0
25.0
14.0
27.0
11.0
14.0
15.9
14.7
9.0
13.0
16.8
30.9
14.0
9.4
13.3
25.1
9.3
9.4
15
15
15
15
15
15
5
5
10
10
2
2
2
4
3
2
3
4
2
2
3
5
2
3
3
3
4
5
2
5
2
2
2
2
2
2
2
5
4
2
3
5
2
2
19320615
19271115
19320615
19271115
19320615
19320615
19331015
19471015
19441215
19460315
19300315
19300915
19301215
19430615
19400615
19410315
19460615
19510915
19440415
19460615
19491215
19550315
19450915
19480315
19510615
19560915
19491215
19580615
19500915
19601215
19481215
19511215
19540615
19530615
19480315
19520315
19560315
19670915
19511215
19490615
19520615
19620615
19490915
19491215
19350615
19280515
19350615
19271115
19350615
19350615
19351015
19471015
19441215
19460315
19310315
19310315
19311215
19430615
19400615
19410315
19460615
19510915
19440415
19460615
19491215
19550315
19450915
19480315
19510615
19560915
19491215
19580615
19500915
19621215
19481215
19511215
19540615
19530615
19480315
19520315
Never
Never
19541215
19490615
19540615
Never
19490915
19491215
4
Economic Review
continued on next page
November/December 1995
Table 1
(continued)
Date Issued
(dated date)
Maturity
Date
19421019
19421201
19430415
19430415
19430915
19430915
19440201
19440201
19440626
19441201
19441201
19450601
19450601
19451115
19451115
19520301
19530501
19600405
19620815
19630117
19630418
19730515
19730815
19740515
19750218
19750515
19750815
19760816
19770215
19771115
19780815
19781115
19790515
19791115
19800215
19800515
19801117
19810515
19811116
19821115
19830815
19840515
19840815
19841115
19520315
19681215
19520915
19690615
19530915
19691215
19590915
19700315
19540615
19541215
19710315
19620615
19720615
19621215
19721215
19590315
19830615
19850515
19920815
19930215
19940515
19980515
19930815
19990515
20000215
20050515
20000815
20010815
20070215
20071115
20080815
20081115
20090515
20091115
20100215
20100515
20101115
20110515
20111115
20121115
20130815
20140515
20140815
20141115
Coupon
Rate
2
Vh
2
2V2
2
2Vi
2'A
2V2
2
2
2 '/2
2'A
2V2
2'A
2'/2
2%
3'A
4'A
4'A
4
41/s
7
7V2
8V2
77s
8'A
8%
8
7%
7%
8%
83A
9'/a
10%
11%
10
123A
13%
14
10%
12
1 3'A
12V2
11%
Term
(at issue)
9.4
26.0
9.4
26.2
10.0
26.2
15.6
26.1
10.0
10.0
26.3
17.0
27.0
17.1
27.1
7.0
30.1
25.1
30.0
30.1
31.1
25.0
20.0
25.0
25.0
30.0
25.0
25.0
30.0
30.0
30.0
30.0
30.0
30.0
30.0
30.0
30.0
30.0
30.0
30.0
30.0
30.0
30.0
30.0
Call Period
(years)
2
5
2
5
2
5
3
5
2
2
5
3
5
3
5
2
5
10
5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
First Possible
Call Date
Date
Called
19500315
19631215
19500915
19640615
19510915
19641215
19560915
19650315
19520615
19521215
19660315
19590615
19670615
19591215
19671215
19570315
19780615
19750515
19870815
19880215
19890515
19930515
19880815
19940515
19950215
20000515
19950815
19960815
20020215
20021115
20030815
20031115
20040515
20041115
20050215
20050515
20051115
20060515
20061115
20071115
20080815
20090515
20090815
20091115
19500315
Never
19500915
Never
Never
Never
19580915
Never
Never
Never
Never
Never
Never
Never
Never
19580915
Never
Never
Never
Never
19930515
19930515
19920215
19940515
19950215
n.a.
19950815
n.a.
n.a.
n.a.
n.a.
n.a.
n.a.
n.a.
n.a.
n.a.
n.a.
n.a.
n.a.
n.a.
n.a.
n.a.
n.a.
n.a.
Note: "n.a." indicates not applicable because the bond is not yet callable.
http://fraser.stlouisfed.org/
Federal Reserve Bank of Atlanta
Federal Reserve Bank of St. Louis
Economic
Review
5
To summarize, for immediately exercisable American o p t i o n s , the t w o n e c e s s a r y c o n d i t i o n s f o r an
immediate exercise are that (1) the option is in-them o n e y — t h a t is, e x e r c i s e of the o p t i o n p r o d u c e s a
positive cash flow to the optionholder—and (2) the
time value has eroded to zero so that there is no value
in delaying exercise of the option.
By comparing the option's market value to its intrinsic value, one can tell if the time value has eroded. If they are identical, then the difference—the time
v a l u e — m u s t be zero. Because callable Treasury
b o n d s (and m o s t callable c o r p o r a t e b o n d s ) require
prior notification before they can be called, even after
their call protection has expired, these two simple decision rules must be adjusted to reflect this fact.
The Deferred Exercise Decision. Treasury bonds
are callable only on coupon payment dates after the
call protection period has passed. The b o n d ' s call option is akin to an American-style option in that it may
be exercised prior to its expiration at the b o n d ' s m a turity date. However, it is unlike an American option
in that exercise can take place only at discrete times,
not continuously t h r o u g h o u t the life of the option.
Such options are referred to as Bermuda options. For
valuation purposes, the distinction caused by the discrete exercise dates is unimportant and, in any case,
is a c c o m m o d a t e d by the technique outlined below.
Of greater importance is the notification requirement
that results in deferred exercise.
The notification requirement compels the Treasury
to announce, 120 days in advance of the coupon payment date on which it will call the bond, that it intends to do so. 5 T h e r e is thus a separation in time
b e t w e e n the date w h e n the d e c i s i o n to e x e r c i s e is
m a d e and the date when actual exercise takes place.
T h e n a i v e call strategy is to call the bond if its
market price is at or above the call price. 6 T h e strategy is based on an arbitrage illusion: that by calling
the bond one pays less than its market value. This
argument ignores the problem of deferred exercise.
Interest rates can c h a n g e in the m e a n t i m e , and the
value at the time the call is completed m a y be above
or below the call price. Because of the deferred exercise and the fact that the call option itself is not separately traded, the rules outlined above for the exercise
of an American-style option must be modified.
Treasury b o n d s represent a liability to the Treasury. In m a k i n g an economically rational call decision, the T r e a s u r y s h o u l d act to m i n i m i z e the net
present value of this liability. On a call notification
d a t e , the T r e a s u r y ' s c h o i c e s are to e i t h e r call the
b o n d — i n w h i c h c a s e it will pay the final c o u p o n
Economic Review
6
and repay the principal at the next coupon date four
months hence—or not call the bond, in which case it
will still make the coupon payment at the next coupon
date and will be left with the callable bond as a continuing liability.
Since the coupon must be paid regardless, the call
decision boils d o w n to deciding whether to pay the
principal in four months or continue to have the liability of the callable bond in four months. The amount of
the principal to be paid, if the bond is called, is k n o w n
with certainty: Treasury bonds are callable at par. But
the value of the not-called callable bond four months
hence cannot be known with certainty as of the notification date. Therefore, the Treasury needs to estimate
the expected value of the callable bond in four months
if it is not called. 7 Doing so requires a m e t h o d for
valuing a callable bond.
A callable bond is a c o m p o u n d security composed
of two parts. The first part is a regular, noncallable
b o n d of the s a m e c o u p o n rate and maturity as the
callable bond. T h e second part is the option to call
the bond away f r o m the bondholder. T h e Treasury
h a s , in e f f e c t , sold the n o n c a l l a b l e b o n d and purc h a s e d a call option on a n o n c a l l a b l e b o n d . Since
these two are inextricably linked—that is, the option
cannot be split off and traded separately—the option
is called an e m b e d d e d option. The value of the noncallable bond portion d e p e n d s on the c o u p o n rate,
maturity, and the term structure of interest rates. The
value of the call option depends on the time to expir a t i o n of the o p t i o n , the v a l u e of t h e n o n c a l l a b l e
bond, and, most importantly, the volatility of interest
rates. T h e m o r e volatile interest rates are, the m o r e
valuable the call option will b e to the bond issuer.
Volatile interest rates increase the likelihood that the
bond i s s u e r m a y f i n d it a d v a n t a g e o u s to call t h e
bond, f o r i n s t a n c e to r e f i n a n c e at a l o w e r interest
rate. If the bond is called, it will be to the bondholders' disadvantage: they will have to reinvest at a lower rate than they were earning on the bond that was
called away. Therefore, the higher interest rate volatility is, the less valuable the callable bond will be to the
bondholder. Thus, valuing the callable bond requires
both a model for interest rate movements and an estimate of the volatility of interest rates.
In practice, the two portions of the callable bond
are valued by c o m p u t i n g the v a l u e of the callable
bond as of the n o t i f i c a t i o n date if it h a s not been
called and then comparing that value with the present
value of the principal and next coupon. 8 The present
value of the principal and coupon may be computed
f r o m the term structure and the known principal and
November/December 1995
c o u p o n a m o u n t s . 9 Valuing the n o t - c a l l e d c a l l a b l e
bond requires an interest rate model and an estimate
of the volatility.
Box 1 illustrates in simplified f o r m how to value a
c a l l a b l e b o n d using a b i n o m i a l tree, g i v e n a term
structure and a volatility of interest rates. Implicit in
this valuation are the optimal call decisions at each
node of the tree conditional on the assumed (fixed)
interest rate volatility of 20 percent, the time horizon
and interest rate at that node, and the assumption that
all possible future decisions will be (or would have
been) optimally decided. Of course, if it turns out to
be optimal to call now, the future decision points will
never be reached, but to know if it is optimal now requires looking into the future and seeing what will be
o p t i m a l then if the bond is not called now. By reworking the problem for a 15 percent volatility, the
call decisions change and the current fair value of the
bond will rise. O n e can vary the volatility until the
fitted ( m o d e l ' s fair value) price equals the desired
target value. T h e volatility that m a k e s the m o d e l ' s
value equal to the quoted price is called the implied
volatility. T h e target value the Treasury is interested
in is the value of the callable bond if it is called. The
level of volatility that makes the value of the callable
bond if it is not called j u s t equal the value if it is
called is referred to as the threshold volatility.
In order to be able to compute the threshold volatility, the call option must be "in-the-money forward."
This term is equivalent to " i n - t h e - m o n e y " for a regular, immediate exercise option and implies that the
optionholder (bond issuer) will not lose by exercising. In this case, it is " f o r w a r d " because the determin a t i o n is d o n e on a f o r w a r d - l o o k i n g , risk-neutral,
e x p e c t e d - o u t c o m e basis. W h e t h e r the b o n d is int h e - m o n e y forward is determined by examining the
values of two hypothetical bonds, S and L, both noncallable and both with the s a m e coupon rate as the
callable bond under consideration. S matures at the
next coupon date, and L has the same maturity date as
the c a l l a b l e b o n d . T h e b o n d h o l d e r c a n m a k e t h e
c a l l a b l e b o n d w o r t h 5 by d e c i d i n g to call, so the
c a l l a b l e b o n d c a n n o t be worth m o r e than S to the
bondholder. Similarly, the bondholder can make the
callable bond worth L by simply deciding never to
call, so the callable bond cannot be worth more than L
to the bondholder. Therefore, the value of the callable
bond must be less than or equal to the m i n i m u m of
the values of these two fictitious bonds: that is, V <
min{5, L}. If L < S, it is necessarily the case that V is
strictly less than S, the option is not i n - t h e - m o n e y
forward, and it is impossible to compute the thresh-
Federal Reserve Bank of Atlanta
old volatility: no matter how low the volatility, h o w
worthless the call option, how valuable the callable
bond (to the bondholder), the callable bond can never
be worth as much as S. Thus, it can never be optimal
to call a bond that is out-of-the-money f o r w a r d — t h a t
is, when L < S. If L > S, the not-called bond can be
worth more than S (the value of the called bond), so
calling may minimize the value of the liability.
Once it has been determined whether the call option is in-the-money forward, the threshold volatility
is used to determine whether the option has any time
value remaining. If the true market volatility equals
the threshold volatility, the Treasury will be indifferent to calling or not calling, so either action will be
Examination of Treasury call decisions
concludes that, at least in recent years,
the Treasury has called bonds
optimally.
rational. If, however, the true volatility is greater than
the threshold volatility, then the call option is m o r e
valuable than would justify a call; the expected value
of the liability is reduced below what is required to
pay off (call) the b o n d ; and the T r e a s u r y will not
wish to call. It would be better to keep the liability
than to pay the principal. Lastly, if the true volatility
is lower than the threshold volatility, the call option
is less valuable than needed to justify a call, the liability is more valuable than the principal needed to
pay off the bond, and, hence, the Treasury will wish
to call and will issue a call notification to be able to
do so.
To determine the true volatility against which to
compare the threshold volatility, the Treasury cannot
use the implied volatility of the callable bond. T h e
implied volatility is sensitive to the price of the particular bond that may reflect the market's expectation of
what the Treasury will do and hence be useless for determining what the Treasury should do. Furthermore,
price quotes for individual issues are frequently imprecise. N e w l y issued " o n - t h e - r u n " b o n d s are very
liquid but trade at a premium because of this liquidity.
Older, seasoned "off-the-run" issues—and all currently
callable b o n d s are o f f - t h e - r u n — a r e illiquid, so the
Economic Review
7
Table 2
Analysis of Threshold Volatilities
(March 7 988-September 1994)
Quote
Date
Full
Price
Tm
S
L
71/2'S of August 1988-93
880331
98.08
880930
96.31
890331
93.29
890929
97.30
900928
99.15
910328
101.35
910930
102.34
Called February 1992
5.37
4.88
4.37
3.38
2.88
2.38
1.88
101.31
100.81
100.17
100.65
100.84
101.45
101.73
97.80
OTM
96.20
OTM
93.49
OTM
97.27
OTM
98.94
OTM
101.47
7.5%
103.55
66.2%
Call was optimal
7's of May 1993-98
921231
101.76
Called May 1993
5.37
102.26
104.61
20.3%
Call was optimal
81/2'S of May 1994-99
931231
102.96
Called May 1994
5.37
103.04
116.14
62.8%
Call was optimal
7%'s of February 1995-2000
940930
101.83
Called February 1995
5.38
101.96
103.59
11.0%
Call was optimal
Note: The full price is the market price, including accrued interest. The term Tm is the time to maturity in years. The term 5 is the present
value of an otherwise equivalent noncallable bond that matures in four and one-half months. (The use of four and one-half months, rather
than the four months dictated by the 120-day rule, is a consequence of the available data base, which contains end-of-month, rather than
the desired midmonth, bond prices.) The term L is the present val ue of an otherwise equivalent noncallable bond to Tm. The term <jj is the
threshold volatility; a value of " O T M " indicates that the option is out-of-the-money and a threshold volatility could not be computed.
posted quotes may reflect stale information. In order
to avoid these problems, what are called normal levels
of implied volatilities, aggregated cross-sectionally,
are used as a benchmark. Box 2 discusses the implied
volatilities for a typical callable bond. The chart shows
that normal levels of implied volatilities vary between
7.5 p e r c e n t and 20 p e r c e n t . If a currently c a l l a b l e
b o n d ' s threshold volatility is higher than 20 percent, it
is clearly high relative to normal values, so it is likely
that the true market volatility is below the threshold
v o l a t i l i t y and a call is i n d i c a t e d . If the t h r e s h o l d
8
Economic
Review
volatility is below 7.5 percent, it is low and the bond
should not be called since it is likely the true volatility
is above the threshold level. Between 7.5 percent and
20 percent, the analysis produces no clear recommendation. Fortunately, in most cases threshold volatilities are outside this ambiguous range. 1 0
In s u m m a r y , the necessary and sufficient conditions for calling a deferred-exercise callable bond are
that (1) the option must be in-the-money forward to
guarantee that calling is optimal under at least some
volatility, and (2) normal interest rate volatility must
November/December 1995
be low enough relative to the threshold level that the
time value has clearly eroded to zero and calling is
thus optimal.
.Examining the Optimality of the
Treasury's Call Decisions
Normal market volatility,- which ranges f r o m 7.5
percent to 20 percent, is used to establish the optimality or suboptimality of past Treasury call decisions. It is d e e m e d optimal if the Treasury calls a
bond w h e n e v e r the threshold volatility e x c e e d s 20
percent; conversely, if the Treasury calls w h e n the
option is out-of-the-money or the threshold volatility
is below 7.5 percent, the call is deemed suboptimal.
It is also deemed suboptimal if the Treasury fails to
call a bond when the option is in-the-money and the
threshold volatility is above 20 percent.
T a b l e 2 r e p o r t s the e m p i r i c a l r e s u l t s of r e c e n t
March 1988-September 1994 Treasury call decisions
and analyzes these decisions. Three of the four issues
were called on their first possible call dates. In the
case of the 7!/ 2 's of August 1988-93, the call was delayed three and a half years, providing an opportunity
to analyze cases in which the Treasury decided not to
call a bond when it might have done s o . "
Table 2 s h o w s that, at least in recent years, the
Treasury has called bonds optimally. 1 2 They did not
call the I V i s of August 1988-93 in the period March
1988 t h r o u g h S e p t e m b e r 1990, w h e n the intrinsic
value was zero, and they did not call prematurely in
March 1991, when the threshold volatility was in the
" n o r m a l " range. However, in September 1991 when
both c o n d i t i o n s o c c u r r e d — n o t e that the t h r e s h o l d
volatility of 66.2 percent is well above normal—the
Treasury did call the bond. For the 7's of May 1993-98
and the 8'/ 2 's of May 1994-99, both necessary conditions were m e t at the first call date, and the bonds
were properly called. With the 77/x's of February 19952 0 0 0 , the analysis is m o r e a m b i g u o u s . T h e option
was clearly in-the-money, but the threshold volatility
is not above the normal range. On the other hand,
neither is the threshold volatility below the normal
range, in which case calling the b o n d w o u l d h a v e
been clearly incorrect.
Bliss and Ronn (1995) extended this analysis to
f o r t y - f o u r c a l l a b l e b o n d s that h a d m o v e d b e y o n d
their call protection period in the four decades beginning in the 1930s. That study concludes that, while
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Federal Reserve Bank of Atlanta
Federal Reserve Bank of St. Louis
one cannot j u s t i f y e a c h Treasury call decision, the
overall T r e a s u r y pattern of call d e c i s i o n s a p p e a r s
consistent with financial principles.
T h e first notification date for the 8's of August
1996-2001 is April 17, 1996; no Treasury decision is
required until that date. If today's (February 1, 1996)
term structure remains unchanged on April 17, 1996,
the threshold volatility will be 51.3 percent. Thus, if
the decision were m a d e in April based on t o d a y ' s
term structure, the bond should be called. Indeed, it
would take a parallel upward shift of at least 227 basis points in the term structure b e f o r e the optimal
decision would be to refrain f r o m calling the bond
(when the resulting threshold volatility is less than
7.5 percent).
Conclusion
A s the 8's of A u g u s t 1996-2001 a p p r o a c h their
first call opportunity in August 1996, the requisite notification period implies that the Treasury will have to
decide by April 17, 1996, whether to exercise its right
to call the bond. This article derives the considerations that go into m a k i n g an optimal call decision.
Taking into account the required prior notification period of intent to call, two criteria must be met. First, the
call option must be in-the-money forward, which can
be ascertained by comparing the values of two similarcoupon rate, noncallable bonds, one maturing on the
next call date and the other on the callable bond's maturity date. If the call option is in-the-money forward,
the value of the long bond will exceed the value of the
short bond. If that first condition is satisfied, one then
determines whether the call option has time value remaining by computing the threshold volatility. Normal
market volatilities serve as a benchmark for evaluating
threshold volatilities. From 1987 through 1994, these
have typically been in the 7.5 percent to 20 percent
range. B o n d s with threshold volatilities b e l o w this
normal range should not be called even if the call options are in-the-money.
Using these two criteria, this article e x a m i n e s the
optimality of the T r e a s u r y ' s observed call decisions
and concludes that, on balance, these decisions have
been reasonably correct. Finally, these call-decision
criteria can be applied to other securities with delayedexercise provisions, including callable corporate,
agency, and municipal bonds as well as convertible
corporate bonds.
Economic Review
9
Box 1
Valuation Using a Binomial Tree
The following numerical example demonstrates the
requirements for an optimal call policy. To simplify exposition, consider a simple variant of the Treasury
callable-bond problem: a three-year 8.5 percent annualpay coupon bond, which is currently callable with a oneyear notification. If notification is given today, the bond
will be retired next year; if notification is given one year
from today, the bond will be retired in two years' time.
Otherwise, the bond will mature in three years' time.
Further, assume that the one-year rate of interest is
currently 8 percent, with a volatility of 20 percent, and
follows a binomial multiplicative random walk. The
implication is that, over the next year, the interest rate
will either rise to 8 x 1.2 = 9.6% with a probability of
0.5 or decline to 8/1.2 = 6.67% with an equal probability, and similarly for year 2. Chart A presents the resulting tree in graphical form.
Chart A
The Interest Rate Process
Today
Year 1
Year 2
8%x1.2 2 = 11.52%
/
/
8% x 1.2 = 9.6%
\
8%
8%
\
8%/1.2 = 6.67%
^
\
8%/1.22 =5.56%
This interest rate tree is consistent with a term structure of interest rates that is virtually flat at 8 percent.
Naturally, similar interest rate trees can be constructed to
reflect the prevailing yield curve and prevailing volatility
of interest rates.'
Using this interest rate tree one may value the threeyear 8.5 percent coupon bond using backward induction.
The principle of backward induction begins by valuing
the bond at maturity, then works backward to the present. At each stage, the optimal decision is based on the
possible future outcomes, given the current conditions at
that time, and the optimal decision for each of those
possible outcomes. Backward induction also takes full
account of the delayed-notification call option embedded in this bond.
Economic
10
Review
Thus, consider the bond's value at the three possible
interest rates at year 2—that is, 5.56 percent, 8 percent,
or 11.52 percent. If call notification was not given the
previous period, then the bond at year 2 is a one-year
8.5 percent coupon bond. The value of this bond, including the year-2 coupon, is equal to the current $8.50
coupon plus the discounted present value of the $108.50
end-of-year principal and final coupon payment, 8.5 +.
108.5/(1 + r), where r is the then-prevailing rate of interest (5.56 percent, 8 percent, or 11.52 percent). On the
other hand, if notification had been given at year 1, its
value at year 2 would simply be the final coupon and
principal payments of $108.50.
Stepping back to year 1, recognize that the Treasury
has the right to call the bond, with one-year notification.
That call should be made only when it is in the Treasury's best interest to do so. The Treasury will choose to
do so when such a call minimizes the value of its liability (generally, when interest rates have fallen sufficiently
low). Suppose that at year 1 interest rates have risen to
the point at which the one-year interest rate is 9.6 percent; the year-1 value of the bond, excluding the current
coupon, is given by the lower of (1) the bond's value if
notification is given today and the bond is called at year
2, discounted back to year 1 (the value of such a bond is
simply the present value of principal and last coupon, or
$108.50 discounted at the prevailing 9.6 percent rate of
interest: 108.5/1.096 = $99.00) or (2) the expected value
of the bond at year 2 if it is not called today, discounted
back to year 1. This value is equal to the discounted expected value of the payoffs: 2
0 5
105.79 + 108-96
_
1.096
Since the value (after paying the next coupon) of the bond
if called ($99.00) is greater than the value if not called
($97.97), the bond should not be called, and its expected
value equals $97.97 or, including the current coupon,
97.97 + 8.5 = $106.47 at year 1 if interest rates rise.
If, on the other hand, interest rates have declined to
6.67 percent next year, the value of the bond if it is
called will be the discounted present value of principal
and last coupon, or $108.50 at the prevailing 6.67 percent rate of interest: 108.5/1.0667 = $101.72. If call notification is not given at year 1, the bond's year-2 value,
discounted back to year 1, will be
0.5
m 9 6 + 11L29
=$103.24.
1.0667
November/December 1995
Chart B
Valuation of a Callable 8.5 Percent Bond
Today
Year 1
Year 2
8.5 +
8.5 + min<™ . 5
1.096
A 5
io
H ! l
m%
Maturity
Year
i 2 i l = l05.79
1.1152
108.5
( a 1 w 7
1.096
X
,.5A5106.47 + 1 1 0 . 2 2 ^ 1 0 a 3 2
1.08
1 .C
\
/
8.5 +
- = 108.96
1.08
108.5
3.5 + i ^ l = 111.29
1.0556
108.5
\
. , 108.5
„ r108.96 + 111.29 = 110.22
.5 + mirv,
—,0.51.0667
1.0667
In this case the value of the bond if called will be less,
so giving call notification at year 1 will be optimal if interest rates drop to 6.67 percent. Including the current
coupon, the year-1 value of the bond is $110.22 if interest rates fall.
Finally, stepping back to the present, the Treasury
chooses to minimize the value of its liability by selecting the lower of a one-year bond, which would result by
its giving notification today (108.50/1.08 = $100.46), or
the discounted expected value if call notification is not
given—[0.5(105.79 + 108.96)/1.096 = $97.97], The fact
that the value if it is not called is lower implies that the
Treasury should refrain from giving the one-year call
notification for the bond at this time. 3
Chart B presents the value of this bond at each node
of the interest rate tree. The key ingredients are the use
of the prevailing rate of interest in discounting cash
flows; the delayed notification period, which causes the
bond to be priced as a one-period coupon bond when it
is called (the bond's value would equal the option's exercise price of par if there were no delayed notification
requirement); and the backward induction valuation process, which sets the bond's value, under a no-call notification policy, equal to the discounted expected value of
its payoffs next period.
Federal
Reserve Bank of Atlanta
\
To see the sensitivity of the call decision to prevailing interest rate volatility, note the impact on the bond's
value—as well as the call/no-call decision—if volatility
were to fall to 15 percent. In that case, a reproduction of
the steps derived above would demonstrate that the
bond's value is $100.46, and the Treasury should exercise its right to call the bond.
Notes
1. For the details of constructing a tree to match a given
term structure of interest rates, see Appendix B of Bliss
and Ronn (1995).
2. In option terminology, this is the discounted expected
value using the so-called risk-neutral probabilities.
3. The technique of building an interest rate tree and employing backward induction is used to determine whether
the bond should be called at this time. This process also
produces a fair value for the bond, given this interest rate
model. The model thus indicates whether the market
price for the callable bond is "rieh" or "eheap." Furthermore, the binomial interest rate tree can be used to value
the wide universe of embedded-option bonds, including
agency, corporate, and municipal bond issues.
Economic Review
11
Box 2
Measuring Market Interest Rate Volatilities:
The Example of the Treasury IVA's of 11/15/2009-14
The previous discussion has motivated the importance of ascertaining the normal level of interest rate
volatility priced in the marketplace, which serves as a
benchmark for the estimated threshold volatilities. The
1154's of November 2009-14 is the only callable bond to
be included in the STRIPS program and may therefore
have received more attention in pricing than other
callable securities. This bond also provides one of the
longer time series of implied volatility observations for
an individual security. For these reasons, the IPX's of
November 2009-14 is a reasonable candidate for the estimation of market volatility. Using the twin inputs of
(1) the observed market price of this bond and (2) the
noncallable term structure of interest rates given by the
prices of the C-STRIPS, 1 it is possible to calculate a
time series of the volatility implied by the price of this
bond. By definition, implied volatility is that value of
interest rate volatility that equates the market price of
the bond to its fair value under the interest rate process
described in the above numerical example. 2 It is also
one of the longer time series of implied volatilities for
any individual bond. Furthermore, the C-STRIPS prices
constitute efficient estimates of the noncallable term
structure of interest rates. It is thus of interest to inspect
the chart below, which plots these implied volatilities
for the post-1988 period for this bond.
One conclusion that can be gleaned from the chart is
that implied volatilities on such bonds typically range
from 5 percent to 20 percent and lie for the most part in
the 10 percent to 15 percent range. These numbers will
be useful in examining the optimality of the Treasury's
past call decisions since they are an indication of the
volatility the Treasury should consider when making the
call/no-call decision. The threshold volatility is then
compared with normal levels: this is the volatility at
which the Treasury would be indifferent about the
choice to give the call notice or abstain from calling the
bond. Thus, if a bond's threshold volatility is large relative to normal market volatilities, the indication is that
there is no time value remaining in the call option and
the Treasury should call the bond. On the other hand, if
the threshold volatility is small, there must be time value
remaining in the option at normal levels of volatility,
and the Treasury should refrain from calling the bond.
Implied Volatilities of IIVi's of 2 0 0 9 - 1 4 Treasury Bond
(Using Treasury coupon STRIPS term structures)
implied
Volatility
20
-r
10
12
1989
1990
1991
1992
1993
1994
1995
Quote Date
Economic Review
November/December 1995
2. Formally, this interest rate process posits a lognormal distribution for the rate of interest. It is a special case of the
interest rate processes presented in Black and Karasinski
(1991) in that it omits a mean-reversion parameter. Black
and Karasinski's interest rate model is able to match the
term structure of interest rates as well as the term structure of volatility.
Notes
1. Strictly speaking, using C-STRIPS causes the term structure of interest rates to be upward-biased relative to the
Treasury's true alternative, which is to issue on-the-run
bonds whose liquidity enhances their value relative to the
off-the-run bonds and STRIPS.
Notes
1. Noncallable, or plain vanilla, bonds pay a fixed, usually
semiannual coupon until a stated maturity date when the
principal is repaid. The cash flows paid from such bonds to
investors are fixed and unchanging. In contrast, the issuer of
a callable bond retains the right to redeem (call) the bond at
designated times prior to its stated maturity date by repaying the principal, and sometimes for corporate bonds a call
premium, after which coupon payments cease.
2. In addition, three puttable securities have been issued, the
last of which matured in 1962. All three issues matured
without the options being exercised. One of these, the 2's of
March 1933, issued in March 1932, paid both principal and
interest in U.S. gold coins. Interestingly, another certificate
was issued at the same time with the same maturity but without the put option or gold coin payment provisions. This unadorned certificate carried a 3.75 percent coupon.
3. The acronym STRIPS stands for "separate trading of registered interest and principal securities." A stripped bond
has the coupon and principal payments unbundled, sold,
and subsequently traded separately. The C-STRIPS arc the
coupon issues; the P-STRIPS refer to the principal or corpus of the underlying coupon bonds. It is also possible to
rebundle (or reconstitute) previously stripped bonds. The
last callable bond, the 1 Was of November 2009-14, is eligible for stripping. However, valuing the "tail" of the
bond, those cash flows from November 2009 onward
proved inconvenient, as the number and timing of cash
flows were dependent on future call decisions and were
therefore uncertain. These conditions made callable bonds
unattractive for stripping. To appeal to the STRIPS market, the Treasury ceased issuing its long bonds in callable
form.
4. For deep in-the-money put options and for call options on
dividend-paying stocks, the time value may become zero
prior to expiration of the option.
5. Treasury could announce a call more than 120 days prior
to any coupon payment date in the call period. But the
closer the actual exercise (coupon) date, the less uncertainty there is about future interest rates. It is therefore
never rational for the Treasury to give notification of intent to call any earlier than it has to (possibly allowing for
a few days' delay in promulgating the decision).
Federal Reserve Bank of Atlanta
6. This naive decision rule has been used by Ingersoll (1977)
and Vu (1986) when examining corporate bonds and by
Longstaff (1992) for Treasury bonds.
7. It is not that the Treasury should attempt to predict which
way interest rates will move or what the price will actually
be in four months. Expected value refers to the average of
the possible future values that the bond may take on in four
months using the risk-neutral probability distribution.
Risk-ncutral probabilities are a technique for valuing options. The technique is based on the, at least theoretical,
ability to "lock in" the risk-neutral expected value by replicating the callable bond using a dynamic strategy of buying and selling noncallable bonds of various maturities.
Transactions costs and other market frictions make actual
dynamic replication difficult in practice.
8. To see that this procedure is equivalent to deciding on the
basis of expected value as of the actual call date, let P be
the principal amount, C be the next coupon amount, r be
the four-month interest rate, and E(CB{) be the risk-neutral
expected value of the callable bond, if it is not called, in
four months. The original rule is "call if the expected value
of the not-called bond exceeds the principal," that is, if
£(Cfi,) > P. Adding the unavoidable coupon and taking
present values, one gets
C + E(Cfi ) ^ C + P
1+r
1+r
The value at the notification date of the callable bond if it is
not called, CB0, is the present value of its expected value
plus the coupon, CB0 = [C + £(Cfi,)]/(l + r), and the value
of a "short bond," S, with the same coupon, maturing on the
next coupon date, is the present value of the principal plus
remaining coupon, S = [C + P\/(\ + r). Therefore, it follows
that E(CB}) > P is equivalent to CB0 > S.
9. There are numerous ways of measuring term structures
(see, for instance, Bliss 1994), but perhaps the simplest is
to use the prices of Treasury coupon STRIPS.
10. Bliss and Ronn (1995) provide a means of narrowing
down the ambiguous range somewhat by determining the
current market volatility rather than relying on averages
over time.
Economic Review
13
11. The delay also led some investors to be lulled into complacency and then complain that the Treasury had not told
them that these issues actually might be called, thus unfairly depriving them of high-yielding investments (Wall
Street Journal, April 10 and October 10, 1991).
12. In contrast, Bühler and Schultze (1993) investigated the
German government's call decisions and concluded that rational call opportunities were frequently missed. They attribute this to a governmental policy not to harm "widows
and orphans" by depriving them of valuable investments.
References
Black, Fischer, and Piotr Karasinski. "Bond and Option Pricing When Short Rates Are Log-Normal." Financial Analysts Journal (July/August 1991): 52-59.
Bliss, Robert R. "Testing Term Structure Estimation Methods." Federal Reserve Bank of Atlanta unpublished working paper, April 1994.
Bliss, Robert R., and Ehud I. Ronn. "The Implied Volatility of
U.S. Interest Rates: Evidence from Callable U.S. Treasuries." Federal Reserve Bank of Atlanta Working Paper
95-12, November 1995.
Btihler, Wolfgang, and Michael Schultze. "Analysis of the Call
Policy of Bund, Bahn, and Post in the German Bond Mar-
14
Economic Review
ket." Lehrstuhl für Finanzierung, Universität Mannheim,
Working Paper 93-1, 1993.
Ingersoll, Jonathan E., Jr. "An Examination of Corporate Call
Policies on Convertible Securities." Journal of Finance 32
(May 1977): 463-78.
Longstaff, Francis A. "Are Negative Option Values Possible?
The Callable U.S. Treasury Bond Puzzle." Journal of Business 65 (October 1992): 571-92.
Vu, Joseph D. "An Empirical Investigation of Calls of NonConvertible Bonds." Journal of Financial Economics 16
(June 1986): 235-65.
November/December 1995
ergers and
Acquisitions
in China
Jie Lin Dong and Jie Hu
/
Dong is the president of E-W
Communications, Inc., and the
publisher of China Finance.
She thanks Qi-Hao Miao,
deputy director of the Institute
of Scientific and Technological
Information of Shanghai, for
providing useful documents.
Hu, an economist in the financial section of the Atlanta
Fed's research department,
thanks his Atlanta Fed colleagues for helpful comments.
Federal Reserve Bank of Atlanta
n the mid-1980s, China's government experimented with arranging
mergers among state-owned enterprises in an attempt to enhance
the efficiency of these enterprises. As market-oriented economic
reform entered the 1990s, a wave of voluntary mergers and acquisitions involving the state-owned enterprises, collective enterprises,
and private enterprises as well as foreign investors has swept the country.
This article provides a detailed description of the Chinese mergers and
acquisitions market and seeks to serve t w o purposes: The first is to provide
a starting point for understanding mergers and acquisitions activity in China as it figures into international investment markets. The other is to provide a rudimentary analysis of the advantages and disadvantages of China's
approach to mergers and acquisitions, that is, its efforts to transform stateowned enterprises in a centralized planning economy into profit-pursuing
firms in a market economy. Given that research in the Chinese mergers
and acquisitions market is virtually nonexistent, it would be essentially impossible at this point to present a complete e c o n o m i c analysis regarding
the latter issue. The article instead is devoted mostly to the first point—that
is, documenting what is taking place in China's mergers and acquisitions
market and providing some discussion from the perspective of financial
economists.
Turning briefly to evaluating the merits of China's approach seems important, however. While the Chinese mergers and acquisitions market has
evolved out of several driving forces and serves multiple purposes, economists have taken a special interest in its role in privatizing or revitalizing state-owned enterprises. Researchers are looking to developments in
China as particularly important for a couple of broad reasons. O n e is that
Economic Review
15
BMIBH
the direct political motivation behind the emergence
and development of the Chinese mergers and acquisitions m a r k e t is the n e e d to s o l v e the p r o b l e m s of
state-owned enterprises. The other is that the problem
of how to revitalize these enterprises inherited f r o m
a c e n t r a l i z e d p l a n n i n g e c o n o m y is o n e s h a r e d by
the countries of Eastern Europe and the f o r m e r Soviet Union. In light of the importance of this issue, it
m a y be helpful to compare the Chinese mergers and
acquisitions approach (along with some other m e a sures) with R u s s i a ' s privatization voucher p r o g r a m
for revitalizing s t a t e - o w n e d enterprises. F o l l o w i n g
that discussion is a description of the mergers and acquisitions m a r k e t and a discussion of its e c o n o m i c
significance in general.
.Becoming a Market Economy
For a centralized planning economy to transform itself into a market economy, one of the most difficult
tasks is to convert state-owned enterprises into marketoriented, profit-pursuing firms that can contribute to
output and productivity growth. While the n u m b e r of
n e w private enterprises in China is growing fast, that
growth is not offsetting the inefficiency of the stateo w n e d enterprises, which are contributing to rising
i n f l a t i o n a n d e a t i n g a w a y i n v e s t m e n t f u n d s that
might otherwise be effectively used. Moreover, many
state-owned enterprises face possible bankruptcy,
which threatens to put workers out in the streets and
create accompanying social problems (discussed
more fully below).
D e v e l o p i n g mergers and acquisitions is one m e a sure C h i n a h a s a d o p t e d to s o l v e this p r o b l e m , an
a p p r o a c h that differs f r o m those of East E u r o p e a n
countries and the f o r m e r Soviet Union in m a n y aspects. Consider, for example, Russia's voucher prog r a m f o r r e v i t a l i z i n g s t a t e - o w n e d e n t e r p r i s e s . In
N o v e m b e r 1992 the Russian government decided to
privatize its state-owned enterprises by distributing
vouchers to its citizens, w h o would use the vouchers
to bid, directly or t h r o u g h i n v e s t m e n t f u n d s , for a
share of the state-owned enterprises w h e n they were
put up for auction. The voucher program offered several promising characteristics: (1) It was implemented swiftly, and that s w i f t n e s s was t h o u g h t to be a
virtue by its promoters following the idea of Poland's
"big b a n g " (Jeffery D. S a c h s 1992). 1 In about o n e
year, 7,000 Russian state-owned enterprises were privatized through the voucher auction (Lynn D. Nelson
16
Economic
Review
and Irina Y. Kuzes 1994). (2) The program by design
aimed at equity, with every citizen given an equal
n u m b e r of vouchers. (3) The p r o g r a m ' s single purpose was to achieve privatization of state-owned enterprises, with e f f i c i e n c y e n h a n c e m e n t e x p e c t e d to
f o l l o w as a natural result, at least in the long run.
However, the voucher program has failed both to revitalize the s t a t e - o w n e d enterprises and to achieve
and maintain equity, according to some economists
(Nelson and Kuzes 1994). Because the voucher auctions have injected neither capital nor better managem e n t skills and t e c h n o l o g i e s into the s t a t e - o w n e d
enterprises, privatization has not improved productivity as expected. The program's failure to maintain equity among the people is, despite all its good intentions,
one of its most significant shortcomings (Nelson and
Kuzes 1994). Enterprise insiders and voucher speculators have eaten away the lion's share of the stateowned enterprises while c o m m o n people are left at a
great disadvantage. Such a result should perhaps not
be surprising in a country lacking established institutions—visible and invisible—essential for a successful market environment.
Unlike the Russian government, which apparently
chose the voucher program as a means of achieving
radical political goals by d e m o l i s h i n g the old econ o m i c system swiftly (see Nelson and Kuzes 1994),
the Chinese government seems to have more pragmatic considerations. China seeks to combine economic
growth with the transformation of state-owned enterprises and has adopted a policy of r e f o r m i n g t h e m
gradually, one by one. The idea behind the mergers
and acquisitions approach, as well as other measures,
is to let the state-owned enterprises be voluntarily acquired by or merged with other, better state enterprises, c o l l e c t i v e e n t e r p r i s e s , p r i v a t e e n t e r p r i s e s , and
foreign business interests. Such an approach has combined o w n e r s h i p t r a n s f e r with m a n a g e m e n t a d j u s t ments, technology upgrading, and capital injections.
While the one-by-one approach may privatize ownership more slowly, it may help avoid the painful shock
of finding the e c o n o m i c environment and r e f o r m e d
enterprises abruptly mismatched. The government has
m o r e time to rectify p r o b l e m s that arise during the
process and to establish a compatible market environment. T h e disadvantage of this approach may be that
the solution will not keep pace with the fast deterioration of the state-owned enterprises. It is too early yet
to evaluate the virtues and vices of China's approach.
Given the unsatisfactory results of other, speedier approaches in Russia and some other Eastern European
countries—for example, Poland—it will be interesting
November/December 1995
to see whether China's gradualism will succeed in reforming the state-owned enterprises.
T h e discussion that follows focuses primarily on
China's mergers and acquisitions market itself—how
it has c o m e into existence, what its characteristics
are, and how it m a y develop in the future. T h e privatization issue will be considered again as appropriate.
Table 1
Industrial Output by Enterprise Type
(Percent)
Type of Enterprise
1978
1994
State-owned
77.6
34.1
Collective
22.4
40.9
0.0
25.0
Private and foreign
A General Background of
China's Economy
E c o n o m i c R e f o r m : 1978-95. The mergers and acquisitions market in China has emerged as a logical
outgrowth of the country's economic reform, which
began in 1978 in the agriculture sector. The centralized planning e c o n o m y was on the verge of collapse,
and the key idea behind reformation was to replace
the existing c o m m u n e system with the family farming network. T h e result was dramatically improved
agricultural output. In 1984 the government began ref o r m i n g industrial enterprises as well, with a goal of
converting them into profit-seeking units. U n f o r t u nately, high inflation following the political upheaval
in 1989 stalled the reform. In early 1992 when Deng
X i a o Ping launched a campaign to revitalize the econ o m i c reform program, it picked up again and began
to extend to other parts of the economy such as the financial sector and the tax system.
China's economic reform has obtained some positive results. In the last seventeen years, China has kept
a near double-digit real (inflation-adjusted) g r o w t h
rate. P e r capita gross d o m e s t i c p r o d u c t ( G D P ) f o r
1994 was only $431, but actual purchasing power was
m u c h higher because of low price levels (The State
Administration of Statistics of the People's Republic
of China [SAS] 1995b). Foreign direct investments
increased at an average annual rate of 40.7 percent between 1983 and 1993 (Knight-Ridder 1994); at the
end of 1994, 206,000 joint ventures and foreign subsidiaries had i n v e s t m e n t s of $ 2 9 1 . 4 3 billion ( S A S
1995b). Total exports had reached $120 billion by the
end of 1994, total imports were $115 billion, and the
foreign currency reserve reached $51.6 billion (SAS
1995b), which was ranked one of the largest in the
world. In D e c e m b e r 1990, Shanghai Securities Exchange ( S H S E ) was established, and in April 1991,
Shenzhen Stock Exchange (SZSE) followed suit, both
growing rapidly in the last couple of years.
Given the Chinese e c o n o m y ' s rapid growth and its
enormous potential, the emergence and development
http://fraser.stlouisfed.org/
Federal Reserve Bank of Atlanta
Federal Reserve Bank of St. Louis
Source: SAS (1995a).
of its mergers and acquisitions market are likely to be
significant in the international economic community.
As will be discussed, one difference the market will
make is in opening up an additional channel for foreign investors to participate in the Chinese economy.
A Taxonomy of Enterprise O w n e r s h i p . A s the
essence of mergers and acquisitions is restructuring the
ownership of enterprises, a taxonomy of the current
ownership of industrial enterprises in China might be
i n f o r m a t i v e as b a c k g r o u n d for the discussion. It is
important to remember, of course, that the ownership
structure of these enterprises has been changing constantly and any simple classification such as the one
presented here can serve only as a reference point for
further understanding.
Ownership of enterprises in China may be sorted
into three categories: state ownership, collective ownership, and a combination of private and foreign ownership. The state-owned enterprises vary in size, and
their production scope covers heavy industry, light industry, and the service sector. They contributed 34.1
percent of C h i n a ' s total industrial output in 1994, a
m u c h lower share than that of sixteen years earlier
(SAS 1995a; see Table 1). The collective enterprises
are usually small and are concentrated in light industry,
agriculture-support industry, and the service sector.
Their total capacity, however, has expanded rapidly
since 1978, and these enterprises contributed 40.9 percent of the total industrial output in 1994. The private
enterprises are mostly in the service sector, and foreign
enterprises cover a broad spectrum of manufacturing.
They together contributed 25 percent of the total industrial output in 1994; most of these enterprises did not
exist in 1978. A subcategory of the private industrial
enterprises is 8 million so-called sole proprietors (see
Table 2), which are not merger or acquisition targets
given that their average number of employees is small.
Economic Review
17
State-owned Enterprises. A state-owned enterprise
is one established by the government, o w n e d nominally by "all the people of China," and managed by
government-appointed bureaucrats. Before 1980, no
s t a t e - o w n e d e n t e r p r i s e p u r s u e d p r o f i t s but instead
served as a government agency carrying out directives
from its superiors. These directives specified the goods
to be produced or distributed and the compensation to
be received by workers. The raw materials and bank
credits needed for the operation were allocated to the
enterprise directly or indirectly by the State Planning
Commission and the Ministry of Finance. The administrative superior of a state-owned enterprise was one
or a few of the following bodies: the ministry in charge
Table 2
N u m b e r of Industrial Enterprises by O w n e r s h i p
(Thousands)
Ownership
1978
1994
State-owned
n.a.
102.2
Collective
n.a.
1,863.0
15,240.0
24,945.0
0
44.5
150.0
8,007.4
Township/village
Private and mixed-ownership
(excluding sole proprietors)
Sole proprietors
(rural and urban)
Source: SAS (1995a).
of the industry in which the enterprise was categorized, the provincial government, or the city governm e n t . T h e m a n a g e r s ' goal was solely to f u l f i l l the
government plan, without having to consider business
decisions, such as input and output prices, which were
fixed by the government.
Entering the 1980s, the government began experim e n t i n g with r e f o r m m e a s u r e s aimed at e n h a n c i n g
the efficiency of state-owned enterprises (Jinlian Wu
1987). T h e reform advanced along two lines, one being to devolve decision rights to the enterprise managers and the other, to reform the price system, the
tax system, and the financing system so that the economic environment would be m o r e like a market and
state-owned enterprises would respond to market signals. The results have been mixed, and m a n y probl e m s r e m a i n u n s o l v e d : u n s u c c e s s f u l a l i g n m e n t of
incentives for labor, m a n a g e m e n t , and the g o v e r n -
18
Economic Review
ment; lack of management experience and skills needed in a new environment undergoing market-oriented
transitions; a g g r e s s i v e c o m p e t i t i o n f r o m collective
enterprises and foreign enterprises; and high operation
costs owing to material wastes, shirking, redundant
workers, and backbreaking welfare burdens. 2
Collective Enterprises.
A collective enterprise is
nominally owned by its "guardian" or "sponsor," usually another company, a social organization, or a government agency, but it is usually quite independently
operated by its m a n a g e m e n t team. M o r e often than
not, the initial capital of a c o l l e c t i v e e n t e r p r i s e is
c o n t r i b u t e d by the g u a r d i a n or b o r r o w e d f r o m the
state banks or other institutions using the guardian's
i n f l u e n c e and c o n n e c t i o n s . In t h e f i r s t c a s e , t h e
guardian m a y be entitled to a portion of the enterprise's profits; and in the latter, the guardian is usually entitled to an annual fee f r o m the enterprise. The
m a n a g e m e n t team, which acts like a de facto owner,
cannot claim the residual profits but has discretion
about h o w to reinvest the profits and whether to disburse them as bonuses within the explicit or implicit
limits set by the c o m p a n y charter and g o v e r n m e n t
regulations. Production by a collective enterprise is
not planned by the government. Its managers decide
what goods to produce or what services to provide,
but they do so, of course, within the parameters of
having to obtain raw materials and credits in the marketplace. Prior to 1978, a collective enterprise often
found itself ignored by the e c o n o m i c planning system. During the 1980s, they benefited from economic
r e f o r m s a n d , with t h e i r c o m p e t i t i v e a d v a n t a g e of
m a n a g e m e n t flexibility, low labor costs, and autonomy regarding the retained after-tax profits, they began to thrive in the m o r e m a r k e t l i k e e n v i r o n m e n t .
Their success m a y partly explain why more and more
collective enterprises have been set up under the encouragement of rural townships and urban municipalities since e c o n o m i c r e f o r m started. (See Table 2,
w h i c h lists t o w n s h i p e n t e r p r i s e s , a s u b c a t e g o r y of
collective enterprises, separately.)
Private and Foreign-owned
Enterprises. For ideological reasons, private enterprises were all but nonexistent before 1978. They were allowed to c o m e into
existence then under the explosive pressure of mass
unemployment manifested in the h o m e c o m i n g flood
of city youths, who had been coaxed and coerced to
the countryside during the cultural revolution (196676). T h e first s u c h e n t e r p r i s e s w e r e usually small
businesses in the service sector, most of them operated by an individual or a family. While a small portion
of them have subsequently grown into bigger opera-
November/December 1995
tions and forayed into manufacturing, most have remained small in both scale and scope. The number of
firms that are wholly or partly owned by foreigners, in
the form of joint ventures or independent companies,
has m u s h r o o m e d throughout the nation since 1978,
thanks to the open-door policy to attract foreign capital. The role of both private and foreign-owned enterprises is expected to grow quickly.
Joint-Stock Companies. In the late 1980s, the Chinese government began implementing ownership ref o r m for state-owned and collective enterprises. The
ultimate goal is to limit the g o v e r n m e n t ' s role in a
state-owned enterprise to that of a shareholder with
limited liabilities. For collective enterprises, reform
involves redefining or clarifying the ownership shares
of the involved parties, after which the enterprise is
called a joint-stock company. A joint-stock company
may have several classes of shares: those held by ind i v i d u a l i n v e s t o r s , t h o s e held by institutions, and
those held by the government. T h e individual shares,
which are listed on the stock exchanges, include Ashares, which are traded a m o n g domestic investors,
and B - s h a r e s , w h i c h are traded a m o n g f o r e i g n investors; the institutional shares, called C-shares, are
traded on the Stock Trading and Quotation System
( S T A Q ) or the National Electronic Trading System
( N E T S ) . T h e state s h a r e s m a y be p u r c h a s e d only
through negotiation with the g o v e r n m e n t . In 1994,
the n u m b e r of state-owned enterprises converted into
j o i n t - s t o c k c o m p a n i e s i n c r e a s e d to 2 5 , 8 0 0 f r o m
13,000 in 1993 and 9 , 4 4 0 in 1992 (Jinshen Z h a n g
1995). Over the s a m e period, about 3 million collective enterprises converted to joint-stock c o m p a n i e s
( Z h a n g 1995). C u r r e n t policy m a k e s it likely that
most state-owned enterprises and collective enterprises will follow suit.
T h e c o n v e r s i o n of e n t e r p r i s e s i n t o j o i n t - s t o c k
c o m p a n i e s is significant in the d e v e l o p m e n t of the
mergers and acquisitions market in a couple of important ways. O n e is that it lays a rudimentary foundation for ownership transfer through public offerings
and merger and acquisition activities b e c a u s e after
the conversion it is easier to transfer ownership from
o n e party to another. Well before the stock market
came into existence in China, some joint-stock companies began to exploit the operational advantage of
r e s t r u c t u r i n g their o w n e r s h i p by selling stocks to
their o w n e m p l o y e e s as well as other institutions.
Another significance is m o r e profound: without unlimited f i n a n c i a l b a c k i n g f r o m the g o v e r n m e n t , a
joint-stock c o m p a n y converted f r o m a state-owned
enterprise is expected to compete in the market like a
Federal
Reserve Bank of Atlanta
collective or private enterprise. A natural consequence
is that some state-owned enterprises m a y c o m e out
alive and well while others will end up facing bankruptcy, a result that expedites the development of the
m e r g e r s and a c q u i s i t i o n s m a r k e t b e c a u s e the last
hope for some of these enterprises m a y lie in being
acquired or merged.
Driving Forces behind Mergers and
Acquisitions
M e r g e r s and acquisitions are an integral part of
any market economy, enhancing an e c o n o m y ' s efficiency by reallocating and r e c o m b i n i n g production
resources for better use. As China pushes its marketoriented economic reform into the 1990s, there seem
to be three reasons behind the emergence of its mergers and acquisitions market, reasons that are likely to
continue driving the market's development.
The government is essentially being forced to restructure and revitalize the state-owned enterprises,
especially the u n p r o f i t a b l e ones (for e x a m p l e , see
Anding Li 1995). The plan involves three steps: severing the g o v e r n m e n t f r o m these enterprises by redefining the government's role as a shareholder with
limited liabilities; revitalizing large and some mediumsized state-owned enterprises by further devolving decision rights to management and continuing economic
reform toward a fair and competitive market; and selling and renting the small and s o m e m e d i u m - s i z e d
state-owned enterprises to competent public or private
entities. This policy has basically opened the door for
mergers and acquisitions of small and medium-sized
state-owned enterprises. For large state-owned enterprises, the possibility of letting some be partially or
wholly privatized remains a sensitive issue but is being considered by the government.
A second force behind the growth of the mergers
and acquisitions market is that it is called for by the
growing needs of the enterprises themselves as they
seek to implement their development strategies (Jixiang
Ni and Zhigang Zhu 1994). Profitable enterprises, either collective or state-owned, may need to expand
their capacities, upgrade their technologies, diversify
or streamline their products, invest in a new industry
or divest from an existing business, enter into a new
geographic area, and the like; the mergers and acquisitions market provides them an efficient channel for
achieving these goals. The many unprofitable enterprises also stand to benefit, potentially breathing in
Economic Review
19
new life through being acquired by or merged with
other enterprises. In other words, industrial growth in
the last fifteen years has brought the Chinese econom y to a point of readiness for an active mergers and
a c q u i s i t i o n s m a r k e t that will f a c i l i t a t e its internal
structural adjustments.
T h e third d y n a m i c e n c o u r a g i n g d e v e l o p m e n t of
C h i n a ' s m e r g e r s and a c q u i s i t i o n s m a r k e t is that it
helps e n t e r p r i s e s attract m o r e international capital
(Ni and Zhu 1994). F o r e i g n i n v e s t m e n t s in C h i n a
usually take one of three forms—establishing and operating a joint venture with a local partner, investing
in listed stocks, or acquiring or merging with an existing enterprise. Joint ventures are the most c o m m o n
f o r m of foreign investment since 1978; because they
involve the detailed operation of a project, the foreign investor usually needs to possess expertise in the
particular business. Investing in the stocks of Chinese
f i r m s is a purely financial market activity, and the
opportunities are available to the general public; the
investment targets are limited, however, to the compan i e s listed in the d o m e s t i c a n d f o r e i g n s t o c k e x changes.
In comparison with these means of investment, investing in a Chinese firm through merger or acquisition offers several advantages: (1) The investor m a y
choose to attend to the acquired firm's daily business,
but he or she may not necessarily have to do so. Such
a f o r m of investment may, therefore, be suitable for
i n d u s t r i a l c o m p a n i e s as well as g e n e r a l i n v e s t o r s
through holding companies. (2) Potential investment
targets are much more numerous than those listed on
the stock exchanges. (3) Cash flow may be generated
in a shorter time than in the case of a joint venture
since a plant does not have to be built f r o m scratch.
(4) The investor m a y have full control of the acquired
company, which is not attainable in a joint venture
b e c a u s e the law stipulates that the m a n a g e m e n t of
a joint venture must be equally shared by local and
foreign investors irrespective of their capital shares.
(5) M o s t importantly, a m e r g e r or acquisition deal
m a y be attractive to an investor because it offers land
use at little or no cost, ready-made distribution channels, skilled labor, technical and commercial information, and so f o r t h — e v e n when a target has been a
money-losing enterprise.
D r i v e n by these f o r c e s , m a n y voluntary m e r g e r
and acquisition activities sprouted in China in the late
1980s and early 1990s, with the active s u p p o r t of
local governments. The long-anticipated official
s a n c t i o n of the central g o v e r n m e n t w a s issued on
N o v e m b e r 14, 1993, w h e n it passed the l a n d m a r k
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d o c u m e n t A Resolution
on Several Issues in Establishing a Socialist Market Economic System, which
formally acknowledged the value and legitimacy of
private enterprises and endorsed more liberal reform
measures for state and collective enterprises.
An Overview of China's Mergers and
Acquisitions Market
H i s t o r i c a l D e v e l o p m e n t s . Of the f a c t o r s c o n tributing to the economic motivation for opening up
the mergers and acquisitions market, the severe problems of the s t a t e - o w n e d e n t e r p r i s e s h a v e d o n e the
most to tilt the political balance toward government
acceptance of mergers and acquisitions. The inefficiency of the state-owned enterprises is a long-standing
problem, and in the context of the market-oriented ref o r m the survival of m a n y of these has b e c o m e an
imminent issue as they hinder further economic development and reform. Nearly half of them are incurring losses, and many if left to their o w n resources
would h a v e already gone bankrupt. In recent years,
the government has allocated 60 percent to 70 percent
of annual fixed-assets investments f r o m banks—all
are state banks—to state-owned enterprises, largely to
bail out those suffering losses (see Mark Spiegel 1994,
for example). Such nonproductive fiscal expenditures
account for the m a j o r portion of the fiscal deficit and
contribute to the c o u n t r y ' s recurrent high inflation,
which in 1994 was 24.1 percent for the nation and
much higher for some m a j o r cities (SAS 1995b).
Early government attempts in the mid-1980s to ref o r m the state-owned enterprises included measures
to arrange mergers and acquisitions. The result, however, was less than satisfactory if not in fact a failure
(Deqiao Hu 1994). A m o n g the arranged mergers only
a f e w generated some synergy, which usually dissipated very quickly, and many turned out to be disastrous
b e c a u s e of c o n f l i c t s of interests that m a t e r i a l i z e d .
Little efficiency enhancement should h a v e been expected, though, given that the mergers and acquisitions essentially involved m a n a g e m e n t a d j u s t m e n t s
and production replanning without consideration of
ownership issues, capital injection, or technology upgrading and given that, being arranged by the gove r n m e n t , the a c t i v i t i e s l a c k e d the m o t i v a t i o n f o r
success of profit-seeking enterprises.
Since the late 1980s, the government has been experimenting with other r e f o r m s for state-owned ent e r p r i s e s — f o r e x a m p l e , letting i n c u r a b l e f i r m s g o
November/December 1995
bankrupt and transferring the ownership of some other firms to the public through free-market-style mergers and acquisitions. The bankruptcy experiment has
progressed slowly b e c a u s e there is no social safety
net for absorbing released workers, and private j o b
growth is not fast enough to absorb the workers either. T h e mergers and acquisitions market has gained
vitality, though, in the 1990s. State-owned enterprises
m a y merge a m o n g themselves, and enterprises and
private enterprises are also allowed to join the game
on equal footing. In contrast to the mergers and acq u i s i t i o n s of the m i d - 1 9 8 0 s , the a c t i v i t i e s in this
r o u n d are v o l u n t a r y , and they m a y cross k i n d s of
o w n e r s h i p , industries, and r e g i o n s . In 1993 alone,
more than 2,900 enterprises, most of them small and
m e d i u m - s i z e d , w e r e m e r g e d or sold in the sixteen
m a j o r cities of China, including Tianjin, Shanghai,
G u a n g z h o u , W u h a n , and S h e n z h e n ; 6 billion yuan
($1 = 8.3 yuan) of assets changed hands, and 400,000
e m p l o y e e s were reassigned ( X i n h u a N e w s A g e n c y
1994). In addition, the role of the securities market in
mergers and acquisitions has been exploited. In October 1992, the first acquisition of a public c o m p a n y
through the secondary securities market was accomplished, and several other companies have followed
the example. 3
Foreign investors are participating in the current
mergers and acquisitions market and are at least halfheartedly welcomed. Their participation injects more
capital into China, which is good news, especially to
the local governments. On the other hand, the central
government is concerned about the loss, or the possible loss, of control over certain industries to foreign
investors. T h e o f f i c i a l policy has s w u n g back and
forth, reflecting the government's ambivalence. Foreign investors in this arena must maneuver without a
complete set of guiding laws, and the lack of such a
f r a m e w o r k m a y work for or against their activities.
For example, because the policy area is gray, some
m e r g e r s a n d a c q u i s i t i o n s t r a n s a c t i o n s by f o r e i g n
companies are structured as joint ventures while others are plain vanilla mergers and acquisitions.
T h e Chinese government finds the results of merger and acquisition activities largely encouraging (Hu
1994). A s expected, these activities have revitalized
some state-owned enterprises and relieved some of
the g o v e r n m e n t ' s f i n a n c i a l burden. O n e result has
b e e n m o r e e f f i c i e n t a l l o c a t i o n of p r o d u c t i o n r e s o u r c e s as assets h a v e been e n l i v e n e d by t r a n s f e r
f r o m the low e f f i c i e n c y state-owned enterprises to
the new owners. International investors are also reacting positively, clearly attracted by the additional
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Federal Reserve Bank of Atlanta
Federal Reserve Bank of St. Louis
investment channel C h i n a offers (see Hu 1994, for
example).
Privatization. Privatization of many state-owned
enterprises is likely to be the most long-lasting type of
merger and acquisition activity. For example, Vantone
Company, one of the largest private enterprises that
has prospered from the booming real estate business
in Hainan Island, has m a d e inroads into retail and
pharmaceutical businesses by acquiring state-owned
enterprises. The company started with initial capital
of 60,000 yuan in 1990 and by 1993 had become a
p r o f i t a b l e c o n g l o m e r a t e with assets of 3.5 billion
yuan (Vantone C o m p a n y 1993). Another well-publicized example is the Wuhan Dadi Science and Technology Company, a private enterprise that acquired
the medium-sized state-owned Wuhan Matches Plant
at the end of 1993 at a price of about 70 million yuan
(Liang Chang 1994).
A l o n g with p r i v a t i z a t i o n has c o m e s i g n i f i c a n t
growth in the number of entrepreneurs as the mergers
and acquisitions market has provided opportunities
for people to start and expand their own businesses.
In recent years, many small firms have been bought
out by independent entrepreneurs or the f i r m s ' e m ployees (Hu 1994).
M e r g e r and A c q u i s i t i o n Targets. T h e C h i n e s e
g o v e r n m e n t has several criteria for deciding which
enterprises can be allowed to enter the mergers and
acquisitions market: First, the merger or acquisition
should be carried out gradually so that the economy
will not be subject to a shock. Second, control of the
crucial outputs important to national security and economic health should be maintained. Third, the mergers and acquisitions market should m o v e forward on
an e x p e r i m e n t a l basis ( p r e f e r a b l y e m b r a c i n g f i r s t
those enterprises facing the most difficulties) as the
g o v e r n m e n t k e e p s s o m e flexibility in a d j u s t i n g its
policy. In this spirit, the g o v e r n m e n t has stipulated
that (1) the mergers and acquisitions of state-owned
enterprises should b e c o m p a t i b l e with the g o v e r n ment's industrial strategy; (2) state-owned enterprises
r e l a t e d to n a t i o n a l security, m i l i t a r y d e f e n s e , advanced proprietary technologies, scarce mineral mining, and other specified areas cannot be sold to private
or foreign investors; (3) a state-owned enterprise in a
pillar industry such as energy, transportation, or communications may be partially sold, but a majority share
m u s t be retained by the g o v e r n m e n t ; and (4) any
merger or acquisition deal of a large state-owned enterprise that is the backbone of an industry must be
reviewed individually (Bureau of State Assets Management 1995).
Economic Review
21
M o s t state-owned enterprises that are put on the
m a r k e t f o r sale or m e r g e r by the g o v e r n m e n t are
small or medium-sized, have a long history of operating losses or a lack of promising products, and are
subject to a high level of debts. Selecting enterprises
with these characteristics is consistent with the central government's motivation to revitalize the m o n e y losing state-owned enterprises and to test and start
the mergers and acquisitions market with small and
medium-sized enterprises.
When a large or profitable state-owned enterprise
needs outside capital, the central government seems to
prefer to let it go public rather than to sell it. The securities market, however, is still in its developmental stage
China seeks to combine economic
growth
with the transformation of state-owned
enterprises and has adopted a policy of
reforming them gradually, one by one.
and each year stingy quotas, explicit or implicit, are
issued to the local governments for initial public offerings. To list in the securities markets in foreign countries (such as on the N e w York Stock Exchange or the
Hong Kong Stock Exchange), a Chinese company has
to get approval directly from the central government,
and getting such approval is next to impossible for
most state-owned enterprises. This situation has
forced some large or profitable state companies, which
need capital injections and technology upgrading, to
venture into the mergers and acquisitions market and
sell themselves. They are able to do so because of the
consent or support of the local g o v e r n m e n t s , which
are eager to attract capital to the local economy. Some
cities have thus stepped ahead of the rubric policies of
the central government and become pioneers in the socalled ownership revolution.
A s m e n t i o n e d a b o v e , the g o v e r n m e n t a l s o puts
m a n y c o l l e c t i v e e n t e r p r i s e s , p r o f i t a b l e or u n p r o f itable, on the market for sale. They are usually small
or medium-siz,ed, and the government has f e w e r restrictions on their merger and acquisition deals. Private enterprises have had such a brief development
22
Economic
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history that they do not figure as merger and acquisition targets; their ownership transfer, if any, usually
occurs within a circle of friends and relatives. Privateto-private merger and acquisition deals are u n c o m mon not because of government discouragement but
b e c a u s e t h e s e e n t e r p r i s e s are not d e v e l o p e d f u l l y
enough to be attractive merger or acquisition targets.
As discussed above, many merger and acquisition
deals for state-owned and collective enterprises are
executed after they h a v e been converted into jointstock companies. A mergers and acquisitions transaction for a joint-stock c o m p a n y target is technically
easier b e c a u s e of the c o m p a n y ' s clearer o w n e r s h i p
definition.
T h e Institutional E n v i r o n m e n t . C o m m i t t e d to
making its transitions gradually, the government has
been conservative in institutionalizing procedures for
a d d r e s s i n g i s s u e s in the m e r g e r s a n d a c q u i s i t i o n s
market. B e c a u s e existing e c o n o m i c institutions are
not designed for a free market operation, rules m u s t
be drafted as the game is being played, with the frequent result that they may be both vague and redundant. Existing institutions are intended to address the
specific issues of the legality of deals, valuation of assets, and facilitation of transaction. The complicated
and often confusing nature of government control over
merger and acquisition activity has evolved somewhat
out of rational consideration of the issues but also
simply out of the bureaucratic machine.
Which regulatory agencies are involved in a merger and acquisition case depends on the ownership of
the t a r g e t a n d the t y p e of a c q u i r e r , a m o n g o t h e r
things. When the target is a state-owned enterprise, at
least five government branches will be consulted: the
Economic Planning Commission, the Administration
for State Assets, the Administration for Industry and
C o m m e r c e , the department in charge of the industry
of which the target c o m p a n y is part, and the C o m mission for Restructuring E c o n o m i c Systems. If the
acquirer is a foreign investor, the Ministry for Foreign Trade and E c o n o m i c Cooperation will also be
included. For a publicly traded company, the Securities Regulatory C o m m i s s i o n of China has a role.
T h e size and i m p o r t a n c e of the target c o m p a n y
usually determines which level of the government is
involved. A deal involving a small state-owned enterprise p r o b a b l y controlled by the local g o v e r n m e n t
can u s u a l l y b e a p p r o v e d locally. A m e d i u m - s i z e d
state-owned enterprise is likely to be jointly supervised by both the local and the central government,
and the negotiations have to be carried out on both
fronts. Most large state-owned enterprises are under
November/December 1995
the direct control of the central government, and any
merger or acquisition deal involving these companies
would be carefully reviewed by the central government.
T h e question of who represents a state-owned enterprise being targeted for merger or acquisition is often a point of contention between local governments
and the central g o v e r n m e n t as well as between the
g o v e r n m e n t and the c o m p a n y ' s m a n a g e m e n t . T h e
central government recently tried to reassert its control in the matter by stipulating that (1) the management of a state-owned enterprise has no right to sell
the c o m p a n y without authorization; (2) only the designated agent, in most cases the Administration for
State Assets, can represent a state-owned enterprise
in a merger and acquisition deal if the enterprise has
not already been converted into a joint-stock company; (3) a joint-stock c o m p a n y is the property of its
shareholders, w h o h a v e decision weights according
to their shares, and the rights of the state shares are to
be exercised by the Administration for State Assets;
and (4) the acquirer of a state-owned enterprise may
be an individual or an institution (Ni and Zhu 1994).
W h e n the merger and acquisition target is a collective enterprise, the m a t t e r is simpler. A s discussed
earlier, a collective company, whose ownership is often v a g u e , is usually c o n t r o l l e d by the c o m p a n y ' s
m a n a g e m e n t while another company, a government
agency, or a social institution acts as its guardian. Because collective enterprises tend to have a looser relationship with the government and their production
focus is mostly on c o n s u m e r products, the government has less interest in their merger and acquisition
deals. In most cases, a deal is negotiated exclusively
between the acquirer and the management of the target company, with final approval obtained f r o m the
guardian and a formal application filed with the government.
To acquire a joint-stock company, all an investor
needs to do is to amass a controlling stake through
stock purchase in the secondary market or negotiation with the shareholders, a practice similar to that
in most western countries. Acquiring a public company through the secondary market requires careful observation of securities laws and regulations: Foreign
investors are not allowed to buy A-shares or take more
than 5 percent of the ownership by holding B-shares.
They may, in principle, purchase C-shares and state
shares by dealing directly with the holders.
There are 174 property exchanges, established by
the local g o v e r n m e n t s and m a j o r financial institutions in recent years, that serve to facilitate merger
Federal
Reserve Bank of Atlanta
and acquisition transactions and enforce government
regulations. Specifically, the e x c h a n g e s collect and
disclose i n f o r m a t i o n about m e r g e r and acquisition
prospects, assist both sides in procedures, and provide
other consulting services. They also furnish information and experience to the government in formulating
merger and acquisition policies on issues such as asset evaluation, debt settlement, and employee placem e n t . F o u r t e e n of the e x c h a n g e s o p e r a t e at t h e
provincial level, 104 at the city level, and 56 at the
lower municipal levels (Ni and Zhu 1994). 4 While a
few exchanges are active and developing quickly, the
rest are not ready to function properly. In all likelih o o d , m a n y of the city a n d l o w e r m u n i c i p a l exchanges will be consolidated to the provincial level
and networked nationwide.
Because the mergers and acquisitions market is in
an experimental stage, most related regulations are in
the form of provisional rules, which will be revised
into permanent laws over time. Continual changes in
the regulations should therefore be expected, and they
will be open for interpretation as they are evolving.
Such a legal environment offers investors both opportunities and risks: while investors may find more freedom in structuring and negotiating deals, they m a y
also lack solid legal protection. China is speeding up
the process of establishing a legal system in line with
international standards. Each year sees progress in the
passing of laws and in the clarifying of legal issues.
However, full establishment of properly functioning
legal institutions is a long-term goal.
^Foreign Investors
For the Chinese g o v e r n m e n t foreign capital and
management skills are vitally important in the mergers and acquisitions market if the country is to achieve
its p r e s u m e d e c o n o m i c goals. For international investors the mergers and acquisitions market in China
offers another channel for participating in this growing e c o n o m y and reaping financial rewards.
Investment Channels. Foreign investors have
three channels for carrying out equity investments in
China: one is to buy listed stocks of Chinese companies, another is to set up a joint venture with a local
company, 3 and the third is to acquire part or all of a
Chinese company. T h e three channels span a spectrum of investment characteristics, with stock m a r kets and joint ventures at either end and acquisitions
in between.
Economic Review
23
Stock Markets. T w o stock e x c h a n g e s h a v e been
established in China since late 1990, one in Shanghai
and the other in Shenzhen. By the end of 1994, 289
stocks were listed, some of which were accessible to
foreign investors (Shanghai Securities Exchange
1995 and Shenzhen Stock Exchange 1995). Besides
that, approximately twenty Chinese stocks are listed
on the Hong K o n g Stock Exchange, N e w York Stock
E x c h a n g e , and other markets. Even t h o u g h the domestic exchanges are experiencing rapid growth and
a f e w m o r e stock exchanges are likely to be established, it seems certain that the listed companies will
remain a small fraction of the 100,000 state companies and millions of collective enterprises. Such an
investment channel therefore will remain of narrow
scope even if the access barrier for foreigners is c o m pletely dismantled. S o m e investors m a y also hesitate
to c h o o s e this channel b e c a u s e of the e x c e s s price
volatility and the irregularities typical of infant stock
markets (Economist Intelligence Unit 1995a) as well
as the fact that the stock markets are subject to the
g o v e r n m e n t ' s intervention. Investing in stocks does
o f f e r t h e a d v a n t a g e of l i q u i d i t y , t h o u g h , w h i c h
streamlines an investment process down to portfolio
m a n a g e m e n t ( b u y i n g and selling) and t h e r e b y relieves the investors of involvement in the operational
details of the underlying companies. Because it does
not require fine-tuning the m a n a g e m e n t of a company, s u c h an i n v e s t m e n t c h a n n e l is a c c e s s i b l e to a
wide variety of investors who m a y not possess technical expertise in the underlying business.
Joint Ventures. On the other end of the spectrum as
investment opportunities for foreigners are joint ventures, which have been the most c o m m o n f o r m of direct i n v e s t m e n t s in C h i n a since e c o n o m i c r e f o r m
began in 1978. A new joint venture enjoys preferential tax treatment: no tax for the first two years and
half tax f o r the n e x t t h r e e . T h e r e are d r a w b a c k s ,
though, b e c a u s e capital invested in a joint venture
m a y have a low level of liquidity and cash flow m a y
not be realized for a long time because of plant construction. A joint venture involves detailed management, and investors using this approach are usually
companies already in the same business.
Acquisition. Acquisition of part or all of an existing company is an investment approach that in some
respects falls between the above two. Compared with
setting up a joint venture, acquisition takes a shorter
time to start production and see cash flow. It is also
easier for the investors to sell the acquired firm after
r e p a c k a g i n g it. To protect a g a i n s t this risk, m a n y
joint ventures are restricted f r o m ownership transfer
24
Economic
Review
by contract. Investors may choose to get involved in
the technical and managerial details of an acquired
c o m p a n y , as they w o u l d d o in investing in a joint
venture. Or they m a y choose not to get involved, as
in stocks. Either way, an investor's degree of control
of m a n a g e m e n t is predicated by the share of ownership. Since the daily operation m a y not be necessarily
attended to if so chosen, such an investment opportunity may be accessible to a bigger pool of investors,
w h o are not n e c e s s a r i l y e x p e r t s in that p a r t i c u l a r
trade, through holding companies.
Investing through acquisition also offers the advantage of less government intervention than f o r m i n g
a joint venture or purchasing listed stocks. Acquisition is a means around several restrictions. In some
industries, for example, there is a c a p on ownership
share of foreign investors in a joint venture. Furtherm o r e , m a n a g e m e n t in any j o i n t v e n t u r e has to be
equally shared between the foreign and local shareholders, irrespective of their ownership shares. In the
stock markets, a foreign investor cannot o w n m o r e
than 5 percent of a c o m p a n y ' s stock. In comparison,
a foreign investor m a y acquire either part or all of a
target company, and his control of the m a n a g e m e n t is
always weighted fairly by his share.
S p e c i a l C o n c e r n s . Foreign investors m a y h a v e
concerns about whether the contract in a merger and
acquisition deal (or any other commercial deal) will
ultimately be honored and whether business disputes
will be fairly arbitrated. For protection, many insert a
clause in the contract that allows them to bypass the
Chinese courts. Such a clause specifies that disputes
would be taken to the China International Economic
and T r a d e A r b i t r a t i o n C o m m i s s i o n ( C I E T A C ) for
j u d g m e n t s . C I E T A C was created in the late 1980s
when the Chinese government joined the international agreement 1958 N e w York Convention on the Enforcement of Foreign Arbitration Awards. By doing
so, the government promised to honor any arbitration
involving Chinese institutions or c o m p a n i e s , m a d e
either in China or abroad.
CIETAC has earned a reasonably good reputation,
according to a report by Business China (Economist
Intelligence Unit 1995b). The commission consists of
professional arbitrators, including ninety f r o m other
countries, and awards are rendered within forty-five
days of the close of arbitration proceedings. According to the same report, about 80 percent of recent cases
e n d e d up in a j u d g m e n t rather than a conciliation,
compared with 50 percent some years ago. A CIETAC
award is final and binding according to Chinese law
and is not subject to revision of any courts. CIETAC
November/December 1995
has b e c o m e popular among foreign investors and is
the busiest arbitration center in the world, handling
m o r e cases than the well-known, much-used Stockholm C h a m b e r of C o m m e r c e . O n e uncertainty has
been whether the local courts would, in the environment of regional protectionism c o m m o n in China, effectively enforce the commission's arbitration award
if problems resulted. So far most judgments and conciliation have been honored without the need for enforcement; when enforcement has been needed,
problems have been minimal.
these problems are resolved over time, the demandsupply imbalance may change.
China has applied to reenter the World Trade Organization, and if the application is accepted development of the mergers and acquisitions market is likely
to accelerate. China will have less domestic market
protection, and its businesses will face more international competition. One consequence is likely to be an
increase in bankruptcy for money-losing enterprises,
some of which may become acquisition targets. Even
currently profitable enterprises may benefit f r o m being merged to reposition themselves for the more intense competition.
T h e Future of China's Mergers and
Acquisitions Market
For the Ch inese governmen t foreign
As outlined earlier, China's strategy in developing
its mergers and acquisitions market is driven by the
g o v e r n m e n t ' s desire to r e f o r m low-efficiency stateowned enterprises, adjust the industrial structure, and
attract foreign investments. Those goals are likely to
remain strong ones, guiding the country's economic
development, and the mergers and acquisitions market
is likely to m o v e forward, albeit along a bumpy path.
Several issues will be relevant to its development.
E c o n o m i c Issues. Currently, the mergers and acquisitions market is a b u y e r s ' market and subject to
i m b a l a n c e . For e x a m p l e , in the Enterprise O w n e r ship Exchange Fair sponsored by Hunan province in
1993, only 4 out of 161 enterprises were sold on the
spot (Ni and Zhu 1994). O n e factor contributing to
this situation may be that it will take some time for
the idea of mergers and acquisitions to become fully
appreciated and exploited by the industrial circle in
China, as was true for the stock markets. It is important to r e m e m b e r that China was a central planning
economy only sixteen years ago. A second important
factor is that the mergers and acquisitions market is
still in the experimental stage according to the gove r n m e n t ' s strategic plan, as discussed earlier, and a
lot of policy uncertainties will not be fully resolved
until the g o v e r n m e n t h a s g a i n e d m o r e c o n f i d e n c e
from the experiments. It also makes a difference that
the business norm, including intermediation agencies
and operational protocol, has not been established
yet. As a result, deals often fall through because of
miscommunication or unreasonable expectations. A
f o u r t h f a c t o r s h a p i n g the current i m b a l a n c e in the
market is that information is not properly dispersed,
and neither domestic nor international investors are
fully aware and c o n f i d e n t of the opportunities. As
Federal Reserve Bank of Atlanta
capital and management skills are vitally
important in the mergers and
acquisitions
market if the country is to achieve its
economic goal.
T h e potential benefits to C h i n a f r o m foreign investments are enormous, and it would b e a rational
choice for the g o v e r n m e n t to m a i n t a i n a policy of
welcome for international investors. Given the country's population of 1.2 billion, the consumer market
along with the investment market is practically impossible to saturate if the economy stays on a reasonably healthy and stable path. T h e g o v e r n m e n t h a s
planned that in the next ten years China will invest
$500 billion in its infrastructure alone, and a sizable
portion of that amount needs to c o m e f r o m international capital markets. The energy industry, for e x a m ple, will need to raise $20 billion in foreign capital
before 2000 (Knight-Ridder 1995). The mergers and
acquisitions market provides a valuable channel for
attracting f o r e i g n capital, and against this g e n e r a l
backdrop it is likely to become m o r e open to international investors, with a d j u s t m e n t s in policy details
occurring f r o m time to time.
Institutional Issues. For a healthy m e r g e r s and
acquisitions market to develop, the institutional environment needs to resolve policy uncertainties, provide information services, and establish a compatible
Economic Review
25
financing system. T h e first of these areas concerns, in
particular, C h i n a ' s policy toward ownership r e f o r m —
specifically, h o w fast state and collective enterprises
are allowed to be converted to joint-stock companies.
A s discussed, a joint-stock company m a y be easier to
deal with in a transaction than a state or collective
enterprise. At another level, the policy to encourage
or discourage such conversions is closely related to
the government's attitude toward privatization, which
significantly dictates the depth of the mergers and acquisitions m a r k e t . Privatization is still a politically
sensitive word at this point, but the g o v e r n m e n t is
liberal enough to list ownership reform as a priority
in its e c o n o m i c a g e n d a , and the " C o r p o r a t e L a w "
passed in 1994 has provided a legal ground for such
reforms. 6 While m o r e state and collective enterprises
are expected to be converted and some to be privatized, privatization does not seem to be keeping pace
with ownership reform.
Asset-Evaluation
Agencies. T h e asset-evaluation
agencies are set up by the government to address potential underpricing of state assets in mergers and acquisitions transactions. G i v e n that the spirit of f r e e
m a r k e t s is to let b u y e r and seller d e t e r m i n e a f a i r
price through free negotiations, one may question the
necessity of such evaluation agencies. A partial reply
is that in China a state-owned enterprise often suffers
severe " a g e n c y p r o b l e m s , " which is to say that the
interest of the state m a y not be always properly represented by the designated managers or the local gove r n m e n t o f f i c i a l s . In f a c t , it is not u n c o m m o n f o r
either managers or local g o v e r n m e n t s to underprice
s t a t e a s s e t s in o r d e r to a d v a n c e p e r s o n a l or local
gains. On the other hand, as part of the government
the asset-evaluation agencies m a y have the problem
of conflict of interest when a state-owned enterprise
is involved in a merger and acquisition deal. It has
been suggested that the evaluation agencies should be
severed f r o m the government to enhance their independence.
Securities Market. The development of China's securities market may have a positive impact on mergers
and acquisitions activities in that it provides a better
investment atmosphere. In particular, it may provide
information and liquidity for acquiring a listed company, and it is also a possible exit for cashing out of an
acquisition. In the last three or four years, the institutional framework has been established for the primary
and secondary stock markets, which are e x p a n d i n g
with amazing speed. But it is not known if or when
foreign investors will be allowed to acquire more than
5 percent of a company through the stock market.
26
Economic Review
Financial System. C h i n a ' s banking system, under
tight control of the government, still operates on the
Soviet model, which provides little service and support to the mergers and acquisitions transactions unless so directed by the g o v e r n m e n t as in some rare
cases in the past. In recent years, gradual reform has
begun to separate the functions of the central bank,
the policy b a n k s (banks that carry out the g o v e r n m e n t ' s industrial policy instead of pursuing profits),
and the commercial banks. Banks have a long way to
go, however, before they become competitive and efficient and able to provide financing for mergers and
acquisitions activities.
Related to financing of mergers and acquisitions
activities is the issue of credit rating, which is an unfamiliar concept to most Chinese people. Without a
system to evaluate the creditworthiness of business
entities as well as individuals, a crucial link in the
chain of finance is missing. Bad debts among stateowned enterprises have caused periodic systemic
crises in recent years. A few cases of credit disputes
involving Chinese companies in international activities have also been reported. Such an environment is
not only hazardous to the development of the mergers
and acquisitions market but also inhibits foreign investment and stunts the growth of the domestic financial m a r k e t s in g e n e r a l . E s t a b l i s h i n g i n d e p e n d e n t
credit rating agencies will be only the first step in
solving the problem. More importantly, cultivating a
civilization pillared by the idea of indi vidual responsibilities will be a long-term project—and no easy job
in a country where people were deprived of individual
decisions for thirty years before they were unfettered
but also lost in the collapse of communist ideology.
Political and Social Issues. Several political and
social issues will influence the d e v e l o p m e n t of the
mergers and acquisitions market. T h e first is unemployment. Some background will shed light on the seriousness of this problem. According to government
statistics, the total population in China is 1.2 billion,
with 14 million babies born each year (see Ding Li
1995 and SAS 1995a). There are 768 million people
currently aged between 15 and 59. The labor force is
about 600 million (see Table 3), and m o r e than 10
million people enter the job market each year. Among
the 168 million in the urban work force, 2.7 percent are
unemployed and 10 percent are on welfare while nominally employed by a state-owned enterprise. A m o n g
the 446 million in the rural labor force, 13 to 25 percent are estimated to be oversupplied and 50 million100 million of them are migrating a m o n g the cities
looking for a job. By 2000, there will be 500 million
November/December 1995
in the rural labor force while only 200 million will be
needed in agriculture and 100 million in the township
enterprises. The remaining 200 million will look for
jobs to the cities, which at the current pace of development will be able to absorb only 20 million of them
by then (Ding Li 1995). With such dire long-term
prospects for the labor market, the immediate unemployment pressure is no comfort at all. Half the stateowned enterprises, even though (under the direction
of the government) they are eating away 60 to 70 percent of the fixed-assets investments from banks, are
still losing money. This unsustainable fiscal policy not
only fuels the rising inflation but also strands the government in a difficult dilemma: if it keeps subsidizing
the low-efficiency state-owned enterprises, desperately
needed fast economic growth and j o b creation will remain seriously hindered; if it lets the state-owned enterprises go on their o w n , m a n y of t h e m will f a c e
bankruptcy and the result will be immediate massive
unemployment.
1995). O n e such group consists of the old guard, who
believe that the privatization of state-owned enterprises and the development of private enterprises are
ideologically unacceptable. Without convincing alternative proposals, however, they are losing their audience. Another group is m a d e up of economists and
sociologists disturbed by the fact that some mergers
and acquisitions deals h a v e g e n e r a t e d e g r e g i o u s l y
unequal wealth distribution. Their argument is best
appreciated in those cases in which people have exploited legal l o o p h o l e s to get rich q u i c k . Workers
who have lost their jobs and others whose interest has
Table 3
Employment of Civil W o r k Force, 1994
(Thousands)
446,541
Rural
Township/village enterprises
The mergers and acquisitions activities are a doubleedged sword to cut through the unemployment problem. On one side, an acquisition may save many jobs
by revitalizing a potentially bankrupt enterprise and
m a y help the economy create m o r e jobs and lessen inflation pressures by relieving the government of a fin a n c i a l b u r d e n . O n the o t h e r h a n d , an a c q u i s i t i o n
often results in immediate downsizing of the bloated
work force, which transforms a latent economic inefficiency into a conspicuous social problem. The government is therefore likely to maintain a cautious policy
toward any work-force cuts following an acquisition
or a merger at the same time that it is encouraging the
development of the mergers and acquisitions market.
In other words, the government m a y p r e f e r to h a v e
big/strong fish eat small/weak fish without spitting
out the bad parts; and contracts in a mergers and acquisitions deal may often preclude shutting down factories and laying off workers (Joyce Barnathan 1995).
Some other measures promulgated by the government,
such as the establishment of a social safety network,
may also help. According to the Labor Ministry, about
95 million, or two-thirds, of urban workers n o w have
unemployment insurance, up 20 percent from 1993.
Under the plan, a worker who loses a j o b receives 70
to 80 percent of his or her salary for two years as une m p l o y m e n t c o m p e n s a t i o n , t h e n 20 to 50 p e r c e n t
thereafter as welfare, or the worker can choose a lump
sum compensation with which to start a small business (Knight-Ridder 1995).
A second issue is the political resistance by several g r o u p s against mergers and acquisitions (Jia L u
Federal
Reserve Bank of Atlanta
120,182
168,160
Urban
State-owned enterprises*
112,140
Collective enterprises*
32,850
Private and mixed-ownership
enterprises (excluding
sole proprietors)
10,920
Sole proprietors
12,250
* Includes employment in nonprofit organizations such as government agencies, hospitals, and schools.
Source: SAS (1995a).
been hurt may very well join forces with this opposition group, and the matter could be further complicated by concerns about strategic national interests in
some cases involving foreign investors. Given these
realities, people w h o support the idea of mergers and
acquisitions have cautioned against possible slips if
the market develops too fast without an adequate legal environment in place. However, they believe that
as long as tactical prudence is exercised in the process, the o p p o s i t i o n will not b e s t r o n g e n o u g h to
stunt the market's development.
The third issue is the possible loss of state assets
(Ni and Zhu 1994). In mergers and acquisitions activities, many state assets are transferred, at a price, to
private ownership. Given the market's immaturity and
the deficiency of the regulatory and legal systems, the
g o v e r n m e n t h a s a c o n c e r n that s o m e t r a n s a c t i o n s
Economic Review
27
may be or m a y appear to be carried out to the state's
disadvantage and result in a loss of its assets. O n e
complaint is that intangible assets, such as business
and technology know-how, trade secrets, and brand
n a m e recognition, tend to be undervalued the most.
Although the potential problem of state asset losses
m a y not be enough to justify wiping out the mergers
and acquisitions market, it is important that the transfer of state assets to private owners be accomplished
in an orderly m a n n e r and at a fair price. Establishment of business p r o t o c o l and the m a t u r i n g of the
market may help to eliminate the loss or the appearance of loss of state assets.
It has been observed that local governments tend
to weigh the potential problem of state asset losses
less than the added value brought by mergers and acquisitions activities (Qing Xiao 1994), a position that
adds to the contention between the central and local
governments. The 1994 tax law stipulating that stateo w n e d enterprises belong to and must submit their
profits to the central government has prompted local
g o v e r n m e n t s to sell state-owned enterprises w h o s e
c u r r e n t c o n t r o l is in the g r a y a r e a . T h e b a n k law
passed in 1994 has rightly reduced local-government
say on the control of bank credit allocation, and the
problems of m a n y local state-owned enterprises are
likely to be aggravated. The local governments m a y
in turn have an incentive to adopt m o r e lenient policies toward mergers and acquisitions.
W h e t h e r China's general e c o n o m i c development,
which is the b a c k d r o p for the mergers and acquisitions market, can follow a steady path is also an important question. O n e m a j o r risk lies in the lack of an
efficient system of social institutions—the lack of an
effective judicial system to e n f o r c e contracts, a tax
collection system fully c o m p a t i b l e with the m a r k e t
economy, a sustainable social welfare system, an independent central bank and a market-oriented banking
system, a credit-rating system, and the like. Progress
28
Economic
Review
in these areas has been m a d e but not as quickly as
one might have hoped. A m o n g other reasons, r a m pant corruption throughout the society, resulting from
the lack of efficient checks and balances of power as
the c o u n t r y is u n d e r g o i n g d r a m a t i c social c h a n g e ,
m a y serve as an indicator for h o w quickly the system
can be in place.
Conclusion
T h i s article has p r o v i d e d an introduction to the
m e r g e r s and a c q u i s i t i o n s m a r k e t in C h i n a , p l a c i n g
the emergence of that market in the context of China's market-oriented economic reform. It attempts to
analyze the direct and indirect driving forces behind
mergers and acquisitions activities and reviews relevant historical developments and current challenges
to development of a strong mergers and acquisitions
market.
The development of mergers and acquisitions activity in China has played a positive role in revitalizing its inefficient state enterprises, attracting foreign
investment, and rationalizing the industrial structure.
The merger and acquisition activity has inevitably led
to the privatization of some state and collective enterprises, w h i c h is still a s e n s i t i v e i d e o l o g i c a l issue.
While further development of the mergers and acquisitions market is important in restructuring and m o d ernizing the industry of China, careful handling of
m a n y institutional deficiencies and social p r o b l e m s
as well as political obstacles will be required to avoid
m a j o r setbacks in the future. It is hoped that this article's broad overview of the development of China's
mergers and acquisitions m a r k e t will invite f u r t h e r
study of this important dynamic in China's economic
system.
November/December 1995
Notes
1. The "big bang" of Poland refers to the period of rapid economic structural changes implemented by the government
around 1992, including the privatization of state enterprises
en masse (through voucher distributions).
2. Workers in a state enterprise are entitled to permanent employment, free housing, free medical care, and other fringe
benefits. Running a state enterprise could be like running a
small welfare state.
3. Baoan Group, a public company listed on the Shenzhen
Stock Exchange, acquired Yanzhong Company, listed on the
Shanghai Securities Exchange, in October 1992. The acquisition stirred a great deal of attention and debate at the time.
4. China is administratively divided into about thirty provinces,
each covering two types of municipalities—cities and counties. Unlike in the United States, in China a county is a
small city.
5. A less common form of this approach is for a foreign company to set up a subsidiary in the country that is 100 percent
owned by itself.
6. The Corporate Law is legislation regarding registration,
governance, and other matters related to business entities.
References
Barnathan, Joyce. "The Next Hot Spot for Mergers and Acquisitions: Shanghai." Business Week, March 13, 1995, 56.
Bureau of State Assets Management. "Tentative Regulations
on Ownership Transfer of State Enterprises." Shanghai
Eastern Europe." American Economic Association
Economic Daily, January 1, 1995, 1.
The Central Committee of the Communist Party of China. A
Resolution on Several Issues in Establishing
Market Economic System. 1993.
a Socialist
Chang, Liang. "A Variety of Mergers and Acquisitions." China
Times, March 2-9, 1994, 29-30.
The Economist Intelligence Unit. Financing Foreign Operations: China. March 1995a.
. "Smoother Resolution." Business China, April 3,
1995b, 5-6.
Hu, Deqiao. "The Breakthrough of China's Enterprise Ownership Reform." The Reform of China, no. 3 (1994): 9-12.
Knight-Ridder Financial, Inc. "China Power Industry Needs
$20 Billion in Foreign Investment before 2000." December 29, 1994.
. "Majority of Chinese Workers Enjoy Unemployment
Insurance." February 8, 1995.
Li, Anding. "The Key Points of the State-Owned Enterprise Reform." The People's Daily (overseas edition), February 8,
1995, 4.
Li, Ding. "Sustaining a High Employment Rate Is among Our
Strategic Goals." The People's Daily (overseas edition),
February 10, 1995, 4.
Lu, Jia. "Ownership Issue Sparks Disputes of Left and Right
in China." China Times, June 12-16, 1995, 6-7.
Nelson, Lynn D„ and Irina Y. Kuzes. "Evaluating the Russian
Voucher Privatization Program." Comparative Economic
Studies 36 (Spring 1994): 55-67.
http://fraser.stlouisfed.org/
Federal Reserve Bank of Atlanta
Federal Reserve Bank of St. Louis
Ni, Jixiang, and Zhigang Zhu. "A Study on the Ownership
Transfer of the State-Owned Enterprises." Economic Research 10, no. 10 (1994): 42-47.
Sachs, Jeffery D. "Privatization in Russia: Some Lessons from
Papers
and Proceedings 82 (May 1992): 43-48.
Shanghai Securities Exchange. Shanghai Securities Market
Yearbook: 1994. 1995.
Shenzhen Stock Exchange. Shenzhen Stock Market
1994. 1995.
Yearbook:
Spiegel, Mark. "Gradualism and Chinese Financial Reforms."
Federal Reserve Bank of San Francisco Weekly Letter, no.
94-44, December 30, 1994.
State Administration of Statistics of the People's Republic of
China (SAS). 1995 Statistical Yearbook of China. Beijing:
China Statistics Publishing, 1995a.
. The Communiqué of Statistics on the National
Econo-
my and Social Development. February 28, 1995b.
Vantone Company. Annual Report. 1993.
Wu, Jinlian. "Some Thoughts on the Strategic Choices of Reforms." Xinhua Digest 5 (May 1987): 56-62.
Xiao, Qing. "Local Governments Sell Out the Central Government." China Times, September 11-17, 1994.
Xinhua News Agency. "China Is Speeding Up Its Enterprise
Ownership Reforms." February 24, 1994.
Zhang, Jinshen. "The Ownership Reform in a Steady and Positive Progress." The People's Daily (overseas edition),
February 8, 1995,4.
Economic Review
29
Monetary Aggregates,
Payments Technology,
and Institutional Factors
David J. Petersen
/
/
/
1
The author is an analyst
in the macropolicy section
of the Atlanta Fed's
research department.
30
Economic
Review
I
I
I
pproximately every six weeks, Federal Reserve officials meet
in Washington to decide the near-term course of monetary policy. T h e Federal O p e n Market C o m m i t t e e can, for example,
decide to change its federal f u n d s rate target (alternatively, the
®
-stock of bank reserves) or maintain policy as it currently stands.
What is the basis for this decision? Ideally, policy decisions are based on
current and forecast economic conditions vis-à-vis some ultimate goals for
the e c o n o m y , such as price stability or s o m e target for real ( i n f l a t i o n adjusted) economic growth. The e c o n o m y ' s position relative to the Federal
Reserve's goals would then largely determine both the direction and magnitude of changes in monetary policy at any given time.
Consequently, in settling on a policy choice the Federal Reserve spends
considerable resources monitoring economic performance, often by analyzing data on the real e c o n o m y and inflation. It is c o m m o n l y believed, however, that there are potentially long lags between monetary policy actions
and e c o n o m i c responses. If monetary policy is to be a prescriptive tool,
variables that forecast the near-term paths of growth and inflation can be
valuable in attempting to prevent undesirable macroeconomic outcomes. In
formulating policy actions, policymakers must also determine how large a
c h a n g e in policy is n e c e s s a r y to correct f o r e s e e n d e v i a t i o n s f r o m their
goals. Implicitly or explicitly, they must thus estimate the relationship between the federal f u n d s rate and gross domestic product ( G D P ) or inflation,
and such an estimation must arise f r o m knowledge of the linkage between
the Federal Reserve's policy instruments and its goals, that is, the channels
through which monetary policy operates.
Basic economic theory suggests that an e c o n o m y ' s stock of money can
serve as both a forecast variable and an intermediate link between the Fed-
November/December 1995
eral Reserve's policy instruments and its goals. More
precisely, the quantity of m o n e y in the e c o n o m y is
linked to national i n c o m e and ultimately the price
level. Thus, m o n e y should be useful in formulating
monetary policy. The Federal Reserve defines monetary a g g r e g a t e s , c o m p o s e d of f i n a n c i a l assets like
cash and demand deposits, expressly for this purpose.
Over time, some instability in the macroeconomic relationships between these monetary aggregates and
national income has been observed, believed to be a
r e s p o n s e to c h a n g e s in o t h e r e c o n o m i c v a r i a b l e s .
Since about 1990, for example, growth in the Federal
Reserve's M2 monetary aggregate (see Table 1) has
been much slower than expected. Given interest rates
and growth in nominal output (described in current
prices), the Board of G o v e r n o r s ' model for M 2 dem a n d overpredicted g r o w t h in the aggregate by an
average 2.5 percentage points each quarter from the
b e g i n n i n g of 1990 t h r o u g h the end of 1993 (Sean
C o l l i n s and C h e r y l L. E d w a r d s 1994). S o m e evid e n c e suggests that this u n e x p e c t e d shortfall arose
f r o m the proliferation of alternative financial assets
that r e s e m b l e m a n y c o m p o n e n t s of the M 2 m o n e y
measure. Several studies (for example, John V. D u c a
1993 and Collins and E d w a r d s 1994) have examined
the potential of some mutual f u n d s as substitutes for
M 2 savings-type assets like certificates of deposit. In
general, these studies argue that the increased liquidity of mutual f u n d shares and a steep yield curve (with
long-term interest rates much higher than short-term
interest rates) m a d e stock and bond f u n d s attractive
alternatives to M 2 savings instruments. In addition,
many mutual f u n d companies and brokerages permit
the electronic transfer of balances between banks and
mutual f u n d s as well as limited check writing, making these mutual f u n d balances look a lot m o r e like
money.
Because of these innovations, the current composition of M 2 probably no longer completely reflects
the choice of financial assets available to the public
as means of payment and close payments substitutes.
Thus, the a g g r e g a t e ' s relationship with expenditure
on goods and services m a y no longer be reliable or
predictable. The implication is that M 2 in turn may
not n o w serve as a reliable link between policy instruments and policy goals, raising broader questions
about the role of monetary aggregates in policy making. This article seeks to provide a rudimentary explanation for h o w the composition and character of
p a y m e n t s assets can c h a n g e e n d o g e n o u s l y in a dynamic financial system (that is, because of other factors inside the s y s t e m ) , ultimately i n f l u e n c i n g the
Federal
Reserve Bank of Atlanta
macroeconomic relationships between monetary aggregates and economic activity.
Why Is Money Important?
Since the passage of Humphrey-Hawkins legislation in the late 1970s, the Federal Reserve has been
given explicit responsibility for maintaining an environment of low inflation and high employment. The
central bank cannot, however, control these quantities
directly. Instead, the tool at its disposal is the ability
to control reserve-market interest rates (federal f u n d s
Table 1
Current Measures of Money and Liquid Assets
M1 = Currency (of the nonbank public)
+
Demand deposits
+ Other checkable deposits, including N O W ,
Super N O W , and ATS accounts, credit union
share drafts
+ Travelers' checks of nonbank issuers
M2 = M1
+ Savings and small-denomination time deposits
at all depository institutions (including retail
repurchase agreements)
+ Money market deposit accounts
+ General-purpose and broker/dealer money market
mutual fund shares (including tax-exempt)
M3 = M2
+
Large-denomination time deposits at all depository
institutions
+ Term repurchase agreements at commercial banks
and thrifts
+
Institution-only money market mutual fund shares
(including tax-exempt)
+ Term Eurodollar balances at depository institutions
and MMMFs
+ Overnight repurchase agreements at commercial
banks1
+
Overnight Eurodollar balances'
'As of February 1996
Economic Review
31
and discount rates) or the quantity of bank reserves
that must be held by banks against many of their outstanding deposits, like checking accounts. T h e Federal Reserve is the monopoly provider of base money,
defined as currency and bank reserves, enabling it to
limit the quantity of cash and transactions deposits in
circulation.
A s indicated above, money is also directly related
to the Federal R e s e r v e ' s ultimate goals. In a developed economy, little national output is consumed by
precisely the same individuals who produce it, requiring that individuals trade the goods they produce to
satisfy their wants. Simple barter between two parties
is always a possibility, but it requires that each party
have exactly the item the other desires. In a large and
specialized e c o n o m y in which each individual conducts many transactions daily, this condition rarely
holds and is certainly inefficient. Money is the mechanism that enables the complex purchase of all goods
and services to take place most efficiently. To simplify, assume that only new goods and services are purc h a s e d e a c h year. T h e n , in the m o s t basic m o n e y
model, if each dollar were used in only one transaction, the quantity of money would roughly equal the
nominal output of goods and services. Moreover, if
each dollar were used in any fixed number of transactions per unit of time, the quantity of money would be
directly proportional to nominal output.
T h i s relationship can be represented m a t h e m a t i cally by the equation of e x c h a n g e , M • V = P • Y,
where M denotes the stock of money, V is the velocity of m o n e y (the n u m b e r of transactions conducted
using each dollar per unit of time), P represents the
price level, and Y denotes real expenditures so that
PY represents total nominal expenditures. If each dollar were used in only one transaction, velocity would
equal one. And if each dollar were used in any fixed
n u m b e r of t r a n s a c t i o n s per unit of t i m e , v e l o c i t y
would be equal to some constant. If so, then changes
in the quantity of m o n e y should be associated with
proportional changes in nominal spending given payment habits that are fixed (that is, each dollar is spent
a constant n u m b e r of times per year). Furthermore, if
the p r i c e level d o e s not i n s t a n t a n e o u s l y a d j u s t to
c h a n g e s in m o n e y (because of, for e x a m p l e , longterm wage contracts), changes in m o n e y could result
in higher real economic growth. Since real growth in
output is constrained ultimately by the supply of real
resources, the change in the quantity of m o n e y will
be equal in the long run to the approximate difference
between nominal and real growth, which is measured
as a change in the price level.
Economic
32
Review
The direct relation between the quantity of m o n e y
in circulation and both Federal Reserve instruments
and objectives suggests that m o n e y would prove useful as an i n t e r m e d i a t e g a u g e f o r the c e n t r a l b a n k .
Even if an aggregate is not targeted in a formal sense
by adjusting monetary policy in response to the aggregate's divergence f r o m its target path, the aggregate
m a y be used as an i n f o r m a t i o n variable, p r o v i d i n g
signals on the effects of monetary policy or the paths
of inflation and real growth. To be a useful intermediate target or information variable, however, whatever
quantity is designated as money must be somehow related to the central b a n k ' s tools, and the velocity of
this m o n e y must be at least predictable.
M o n e y versus Monetary Aggregates
T h e case for the quantity of m o n e y as an intermediate target or information variable for monetary policy has a solid theoretical foundation. The next step
is to build a taxonomy for deciding precisely which
assets constitute money. One hint for helping choose
the appropriate composition of a monetary aggregate
can be derived f r o m theoretical relationships. Both
the links b e t w e e n Federal R e s e r v e instruments and
m o n e y and between money and spending rely on the
fact that m o n e y can be characterized as a financial
asset that allows transactions to take place. Coins and
currency pass this test. Balances held in checking accounts are also accepted in exchange for goods and
services and are considered m o n e y using this criterion. These assets, however, possess another c o m m o n
characteristic: they serve as stores of value. As such,
they allow wealth to be held in cash or as d e m a n d
deposits without the immediate intention to spend it
on goods and services. In this respect, though, currency and checking account balances resemble many
other financial assets. M a n y of them, like most other
bank deposits, can be transferred to demand deposits
or currency quite easily and are frequently used as
short-term alternatives because currency and checking accounts bear little or no interest. If these other
assets are likely to be converted to payments media
in the near term, should they not also be included in
monetary aggregates?
As an added complication, some assets possess a
m i x t u r e of both this savings characteristic and the
transactions property. Savings deposits (a significant
p o r t i o n of w h i c h w e r e f o r m e r l y k n o w n as m o n e y
market deposit accounts) can be used as a temporary
November/December 1995
store of purchasing power. They can also be used to
pay certain bills. M o n e y m a r k e t m u t u a l f u n d s f r e quently offer a yield at least as high as that on a savings d e p o s i t a c c o u n t , i m p l y i n g that they might b e
superior saving instruments. Yet, many of these f u n d s
also authorize assetholders to write a limited number
of checks drawn on them, albeit with the requirement
that the checks are for high m i n i m u m amounts, often
more than $500. In sum, while some assets that serve
as m o n e y can be clearly identified, others that possess some moneylike characteristics ("near-monies")
defy precise classification.
make this substitution in the short term while others
may want to hold savings instruments for many years.
A m o n g borrowers, many will place the proceeds f r o m
security issuance into investment projects, but these
projects will have different probabilities of p a y o f f ,
different time horizons, and different income streams.
Moreover, some spending units will want to borrow to
finance current consumption, making their unsecured
debt (for example, credit card debt) more risky. These
differences among savers and borrowers result in the
proliferation of financial contracts differentiated in
terms of risk, maturity, liquidity, and yield.
Where Do Near-Monies Come From?
Improvements in payments technology and
The relationships a m o n g these different types of
assets are easier to understand w h e n examined in the
context of financial intermediation, where spending
units (people, businesses, and the g o v e r n m e n t ) are
separated into t w o g r o u p s : those w h o save part of
their income and those who borrow. For the purposes
of this discussion, also a s s u m e that these spending
units are not permitted to trade with f o r e i g n e r s . If
each spending unit chooses to spend exactly as much
as it earns, there will be no savings and consequently
nothing available for others to borrow. If, however,
individual spending differs f r o m individual income
for any of the units, some will have a surplus of inc o m e o v e r c o n s u m p t i o n that they will save. O t h e r
spending units desire a level of consumption that exceeds their income and will wish to borrow. T h e issuance of primary securities (financial claims held by
a lender against the ultimate borrower) allows surplus
units to transfer unspent income to deficit units in return for future principal and interest or dividends. Examples of primary securities would include equities,
mortgages, loans, and bonds. This transfer of income
a l l o w s s o m e s p e n d i n g units to a c c u m u l a t e w e a l t h
over time in the f o r m of financial assets while their
c o u n t e r p a r t s a m a s s debt. T h e o u t s t a n d i n g stock of
these primary securities then serves as a measure of
both aggregate financial wealth and debt.
similar institutional changes also result in
So far, spending units have been grouped only by
their preference for consumption. Closer examination
reveals that some spending units are risk-averse while
others are risk-neutral or desire to take risks. Those
who take more risks will, of course, demand additional c o m p e n s a t i o n for doing so. Also, most spending
units will ultimately want to exchange their accumulated w e a l t h f o r c o n s u m p t i o n . S o m e will w a n t to
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Federal Reserve Bank of St. Louis
less stable relationships between existing
monetary aggregates and the nominal
expenditure on goods and services.
The financial system described above provides a
reasonably good picture of the flow of funds in any
developed country. It is still, however, incomplete. In
an economy with many different spending units, the
cost of acquiring information about the best partner
for e x c h a n g i n g income (current p u r c h a s i n g p o w e r )
for primary securities (representing future purchasing
power) would be quite high. In addition, the type and
quality of debt instruments would be limited by individual savers' tolerance of risk, maturity, and liquidity as well as their ability to absorb the high m i n i m u m
d e n o m i n a t i o n s of primary securities ( f o r e x a m p l e ,
$ 1 0 , 0 0 0 worth of Treasury bills) m o s t efficient for
borrowers to issue.
These inefficiencies provide for the existence of
financial intermediaries, market-making organizations that purchase primary securities f r o m ultimate
borrowers and issue their o w n indirect debt to ultimate lenders. These intermediaries can exploit economies of scale (lower average costs associated with
higher production) in both lending and borrowing: by
serving as a clearinghouse for savers and borrowers
and e m p l o y i n g accumulated expertise in evaluating
borrowers, they are able to lend current purchasing
Economic Review
33
p o w e r at a l o w e r per-unit cost than the i n d i v i d u a l
saver. By aggregating the f u n d s they borrow, intermediaries can easily invest in primary securities with
high m i n i m u m denominations. They can also channel
borrowings into a wide variety of primary securities,
providing diversification of risk. Since the probability of all savers showing up at once to d e m a n d repayment is relatively low, intermediaries also can hold a
m o r e illiquid portfolio than the individual investor.
Financial intermediaries supply surplus-income spending units with variegated financial assets closely reflecting the degree of liquidity and risk they desire
while m a k i n g it less essential for the ultimate borrowers to issue them.
E x a m p l e s of f i n a n c i a l i n t e r m e d i a r i e s i n c l u d e
banks and other depository institutions (savings and
loans, mutual savings banks, and credit unions), life
insurance companies, pension funds, retirement
funds, finance companies, m o n e y market funds, other
mutual funds, and, broadly speaking, even the central
bank. Some of the indirect debt issued by financial
i n t e r m e d i a r i e s takes the f o r m of d e m a n d deposits,
s a v i n g s d e p o s i t s , t i m e d e p o s i t s , m u t u a l f u n d balances, and currency. In the last case, the Federal Reserve can buy Treasury debt (primary securities) in
return f o r b a n k r e s e r v e s (a central bank liability),
which must be held by banks against many deposits.
The public can swap these deposits for Federal Reserve n o t e s (also a central b a n k liability), m a k i n g
c u r r e n c y an indirect security that is issued by the
F e d e r a l R e s e r v e and held by the p u b l i c . L i k e the
direct securities that back them, the various kinds of
indirect securities enumerated above also differ somewhat in liquidity and risk but are similar in several
respects. For e x a m p l e , they have a near-certain redemption value, meaning that spending units can be
reasonably certain how much the financial claim will
be worth when they choose to redeem it for current
purchasing power. In addition, the cost of investing
in these indirect securities is relatively low, and contracts can be purchased in denominations f r o m very
small to very large (see John Gurley and E d w a r d S.
Shaw 1960, 194). Thus, most spending units should
be able to acquire them easily.
— - - T - ^ - T - ^ - — —
71ie Role of Technology and
Institutional Factors
T h e evolution of a n a t i o n ' s financial s y s t e m results in the creation of a variety of financial assets
34
Economic
Review
that spending units can hold in lieu of consumption
or investment in real assets like land or machinery.
These include primary securities and also indirect securities created by financial intermediaries. Together
these claims form a multidimensional spectrum of financial assets, distributed according to liquidity, risk,
and maturity. O n e corner of this distribution will be
occupied by the most liquid, least risky financial assets, which have a low cost of investment and nearconstant value and are easily redeemable, enabling
them to serve as ideal temporary stores of purchasing
p o w e r . In an e c o n o m y with a d e v e l o p e d f i n a n c i a l
s y s t e m , t h e s e are likely to b e i n d i r e c t s e c u r i t i e s .
Moving away f r o m this corner in any direction may
uncover a slightly higher-yielding financial asset but
most likely a marginally inferior store of value in its
liquidity, risk, or maturity.
Sifting through a g r o u p of these financial assets
that serve as good temporary stores of value, several
of t h e m (like c a s h and d e m a n d d e p o s i t s ) serve as
payments media, meaning they are generally accepted in exchange for goods and services. Some m a y be
accepted as p a y m e n t in a limited c a p a c i t y (checks
drawn on mutual funds, savings deposits) while others (certificates of deposit) are ready substitutes for
payments media, perhaps bearing m o r e interest. Still
m o r e financial assets (shares of stock, shares of many
mutual f u n d s ) may be used as savings vehicles but
are too risky, long-term, or illiquid to act as convenient substitutes for payments media.
What enables certain assets to serve as media of
exchange and makes other assets easily substitutable
for these p a y m e n t s assets? Technology and institutional factors in the f o r m of laws and customs determine h o w w e can pay for goods and services at any
time. They also serve to limit the range of acceptable
substitutes for payments media as temporary stores of
value. For example, the combination of widespread
belief in the value of Federal Reserve notes and legal
tender laws makes currency usually acceptable as a
means of payment in the United States. Similarly, legal restrictions prohibited the payment of interest on
d e m a n d d e p o s i t s and f o r b a d e t h r i f t s ' o f f e r i n g d e mand deposit accounts until the late 1970s (for a discussion of the theory u n d e r l y i n g legal restrictions,
see Neil Wallace 1983). Many passbook savings accounts at thrift institutions consequently were separated p h y s i c a l l y f r o m c u s t o m e r s ' d e m a n d d e p o s i t
a c c o u n t s at c o m m e r c i a l b a n k s . T h e s e c o n s t r a i n t s
m a d e passbook savings deposits relatively poor substitutes for payments media w h e n the use of m o n e y
m a r k e t d e p o s i t a c c o u n t s w a s not e x t e n s i v e . A n d
November/December 1995
w i t h o u t r e c e n t c o m p u t e r and t e l e c o m m u n i c a t i o n s
technology, the low speed and high cost of transferring savings deposits to a transactions account limited their use as media of exchange.
Just as technology and institutional considerations
erect b a r r i e r s a m o n g p a y m e n t s a s s e t s , t e m p o r a r y
stores of value, and pure savings vehicles, changes in
t h e s e f a c t o r s c a n w e a k e n t h e s e b a r r i e r s or m o v e
them. Advances in payments technology or changes
in regulation can enhance the ability of different financial instruments to serve as media of exchange.
Other transactions media, such as credit cards or socalled stored-value cards, m a y also be introduced. In
a d d i t i o n , c h a n g e s in t h e s e f a c t o r s c a n a l l o w assetholders to m o r e easily substitute erstwhile savings
i n s t r u m e n t s f o r transactions m e d i a , w e a k e n i n g the
distinction between them. In the 1970s, for example,
high inflation provided a powerful incentive to minim i z e h o l d i n g s of c u r r e n c y a n d d e m a n d d e p o s i t s
( w h i c h did not b e a r interest) r e s u l t i n g in i n n o v a t i v e cash m a n a g e m e n t t e c h n i q u e s , like the use of
overnight r e p u r c h a s e a g r e e m e n t s . N e w t e c h n o l o g y
m a d e speedy, low-cost transfer of savings balances to
transactions accounts and the transactions use of savings d e p o s i t s p o s s i b l e . C h a n g e s in regulation f o l lowed in recognition of these developments, making
their impact more widespread. In the early 1990s, the
steep yield curve also encouraged the minimization
of currency and d e m a n d deposits, interest-checking
accounts, and other assets that bear a short-term rate
of interest in favor of higher-yielding savings assets.
With the steep yield curve, the ability to transfer balances via the telephone, and the capacity for limited
check writing, many stock and bond mutual fund balances are now much better substitutes for traditional
media of exchange.
3/acroeconomic Consequences
I m p r o v i n g t e c h n o l o g y and s h i f t i n g institutional
factors result in new payment methods or close money substitutes over time. They have also created hybrid assets with savings and transactions properties of
varying degrees, like savings deposits or mutual f u n d
balances. Consequently, sharp distinctions between
m o n e t a r y and n o n m o n e t a r y financial assets are no
longer as readily observable as they once were. Like
plate tectonics, these forces can be expected to continue reshaping the financial landscape, but in ways
that are difficult to predict. Thus we cannot say ex-
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haustively what money will look like at any point in
the future, but history suggests that the set of assets
qualifying as money will likely increase.
T h e s e d e v e l o p m e n t s present a problem for rulebased definitions used to construct monetary aggregates. Economic theory dictates that money comprises
those assets that serve as media of exchange. Strictly
a d h e r i n g to t h i s r u l e m e a n s that m o n e y i n c l u d e s
stores of v a l u e that are generally only m a r g i n a l l y
useful as methods of payment. The above analysis also suggests that more types of financial assets will be
included as time passes. Relaxing this restriction to
include close money substitutes will make the definition of money grow inexorably wider. Since the Federal R e s e r v e can limit only the supply of currency
and some bank deposits, in either case the monetary
aggregate b e c o m e s m u c h m o r e d i f f i c u l t to control
and perhaps only as predictable as nominal expenditure itself.
Improvements in payments technology and similar
institutional changes also result in less stable relationships between existing monetary aggregates and
the nominal expenditure on goods and services. The
equation of exchange allows us to equate a monetary
aggregate to nominal expenditure, provided that this
expenditure is made exclusively with financial assets
inside that aggregate. With changing technology and
shifting regulation, goods and services can be purchased with new kinds of payments assets, or even
near-monies. Expenditures can increase at the same
t i m e the m o n e t a r y a g g r e g a t e r e m a i n s u n c h a n g e d ,
failing to capture these transactions. Reexamining the
equation of exchange, PY can increase while M rem a i n s constant. To m a i n t a i n the equality, velocity
must increase sufficiently to offset gains in nominal
expenditure. These observed changes in velocity will
occur whenever the set of monetary or near-monetary
assets shifts, a process that is likely to continue but
difficult to predict.
While we cannot say precisely h o w velocity will
change in the future, history suggests that it is likely
to drift upward. As mentioned earlier, the M 2 monetary aggregate substantially underpredicted growth in
nominal national expenditure during the early 1990s.
Measured ex post, velocity (mechanically defined as
the ratio of nominal expenditure to M 2 ) rose in an
unpredicted manner. Relationships b e t w e e n m o n e y
targets and economic activity have broken down before. In m a n y respects, M 2 ' s problems parallel the
breakdown in the relationship between the M1 aggregate and national income in the late 1970s. A s indicated above, this breakdown occurred in the face of
Economic Review
35
Table 2
Monetary Aggregates Prior to 1980
M1 = Currency
+ Demand deposits at commercial banks
M2 = M l
+ Savings balances at commercial banks
+ Time deposits at commercial banks
- Negotiable C D s at large banks
M3 = M2
+ Savings balances at thrift institutions
+ Time deposits at thrift institutions
M4 = M2
+ Negotiable C D s at large banks
M5 = M3
+ Negotiable C D s at large banks
Source: Thomas D. Simpson (1980).
technological and regulatory changes that encouraged
the substitution of interest-bearing assets for traditional transactions balances like demand deposits. In
particular, thrifts and credit unions gained the ability
to offer negotiable orders of withdrawal ( N O W ) accounts and share drafts, providing payments services
similar to those previously available only through dem a n d d e p o s i t s at c o m m e r c i a l b a n k s . A d v a n c e s in
technology enabled automatic transfers f r o m savings
accounts to demand deposit accounts, preauthorized
bill p a y m e n t s , and t e l e p h o n e t r a n s f e r s , p e r m i t t i n g
what are n o w called savings deposits to function more
like money. As a response to these developments, the
36
Economic
Review
Federal Reserve redefined the monetary aggregates
in 1980 (see Table 2).
Conclusion
Economic theory suggests that the m o n e y stock is
a u s e f u l link b e t w e e n Federal R e s e r v e i n s t r u m e n t s
and objectives in m o n e t a r y policy. T h e quantity of
m o n e y must be controllable, however, and the velocity of m o n e y be fixed or m o v e in a predictable manner. P o l i c y m a k i n g r e q u i r e s a d e c i s i o n on w h i c h
financial assets correspond to m o n e y in theory. Thirty years ago, it was relatively easy to sort financial
assets into m o n e t a r y and n o n m o n e t a r y c a t e g o r i e s
based on a strict m e d i u m - o f - e x c h a n g e basis or paym e n t s m e d i a plus close substitutes. Not coincident a l l y , g r o w t h in t h e old M l m o n e t a r y a g g r e g a t e
(consisting solely of currency plus demand deposits
at c o m m e r c i a l b a n k s ) w a s b e t t e r c o r r e l a t e d w i t h
growth in expenditure than it is today.
A n e x a m i n a t i o n of the f i n a n c i a l s y s t e m r e v e a l s
that there is f u n d a m e n t a l l y little that distinguishes
monies, near-monies, and nonmonetary financial assets a m o n g good stores of value. Preferences, technology, and institutional arrangements determine the
boundaries a m o n g these assets, and changes in these
factors have moved them. T h e proliferation of new
payments assets, close substitutes, and mixed savingstransactions assets makes it difficult, if not impossible, to draw a line between what is money and what
is not f o r m o n e t a r y policy p u r p o s e s . For the s a m e
reason, existing monetary aggregates can lose their
ability to predict changes in national expenditure, and
redefinition necessitates confronting the same issue.
T h e addition of more financial assets to the monetary
aggregates is unlikely to be a durable solution and
will result in the decline in the share of the aggreg a t e ' s assets that are directly linked to Federal Reserve policy instruments.
November/December 1995
References
Collins, Sean, and Cheryl L. Edwards. "M2 Plus Household
Holdings of Bond and Equity Mutual Funds." Federal Reserve Bank of St. Louis Review 76 (November-December
1994): 7-29.
Duca, John V. "Should Bond Funds Be Included in M2?"
Federal Reserve Bank of Dallas Research Paper No. 9321,
June 1993.
Gurley, John, and Edward S. Shaw. Money in a Theory of Finance. Washington, D.C.: Brookings Institution, 1960.
http://fraser.stlouisfed.org/
Federal Reserve Bank of Atlanta
Federal Reserve Bank of St. Louis
Simpson, Thomas D. "The Redefined Monetary Aggregates."
Federal Reserve Bulletin (February 1980): 97-114.
Wallace, Neil. "A Legal Restrictions Theory of the Demand
for 'Money' and the Role of Monetary Policy." Federal
Reserve Bank of Minneapolis Quarterly Review (Winter
1983): 1-7.
Economic Review
37
iäidex for 1995
l •--
Economic History
Krikelas, Andrew C., "Review Essay—
An Economist's Perspective on History: Institutions, Institutional
Change, and Economic
Perfor-
mance," January/February, 28-32
Roberds, William, "Financial Crises
and the Payments System: Lessons
from the National Banking Era,"
Septembcr/October, 15-31
Tallman, Ellis W., and Jon R. Moen,
"Private Sector Responses to the
Panic of 1907: A Comparison of
New York and Chicago,"
March/April, 1-9
Financial Institutions
Bliss, Robert R. "Policy Essay—RiskBased Bank Capital: Issues and Solutions," September/October, 32-40
Frame, W. Scott, "Examining Small
Business Lending in Bank Antitrust
Analysis," March/April, 31-40
Roberds, William, "Financial Crises
and the Payments System: Lessons
from the National Banking Era,"
September/October, 15-31
Tallman, Ellis W., and Jon R. Moen,
"Private Sector Responses to the
Panic of 1907: A Comparison of
New York and Chicago,"
March/April, 1-9
Woosley, Lynn W., and James D. Baer,
"Commercial Bank Profits in 1994,"
May/June, 11-31
Financial Markets
Abken, Peter A., "Using Eurodollar
Futures Options: Gauging the
Market's View of Interest Rate
Movements," March/April, 10-30
Bliss, Robert R. "Policy Essay—RiskBased Bank Capital: Issues and Solutions," September/October, 32-40
38
Economic Review
Bliss, Robert R„ and Ehud I. Ronn,
"To Call or Not to Call? Optimal
Call Policies for Callable U.S. Treasury Bonds," November/December,
1-14
Wall, Larry D., "Some Lessons from
Basic Finance for Effective Socially
Responsible Investing," January/
February, 1-12
Chang, Roberto, "Is a Weak Dollar
Inflationary?" September/October,
114
Leeper, Eric M., "Reducing Our Ignorance about Monetary Policy Effects," July/August, 1-38
Petersen, David J., "Monetary Aggregates, Payments Technology, and
Institutional Factors," November/
December, 30-37
/nflation
Chang, Roberto, "Is a Weak Dollar
Infl ationary?" September/October,
114
Tallman, Ellis W., "Inflation and Inflation Forecasting: An Introduction,"
January/February, 13-27
/nternational Finance
Dong, Jie Lin, and Jie Hu, "Mergers
and Acquisitions in China," November/December, 15-29
.Macroeconomics
Chang, Roberto, "Is a Weak Dollar
Inflationary?" September/October,
114
Krikelas, Andrew C., "Review Essay—
An Economist's Perspective on History: Institutions, Institutional
Change, and Economic
Perfor-
mance," January/February, 28-32
Leeper, Eric M., "Reducing Our Ignorance about Monetary Policy Effects," July/August, 1-38
Tallman, Ellis W., "Inflation and Inflation Forecasting: An Introduction,"
January/February, 13-27
-Monetary Policy
Bliss, Robert R. "Policy Essay—RiskBased Bank Capital: Issues and Solutions," September/October, 32-40
Payments System
Petersen, David J., "Monetary Aggregates, Payments Technology, and
Institutional Factors," November/
December, 30-37
Roberds, William, "Financial Crises
and the Payments System: Lessons
from the National Banking Era,"
September/October, 15-31
Tallman, Ellis W., and Jon R. Moen,
"Private Sector Responses to the
Panic of 1907: A Comparison of
New York and Chicago,"
March/April, 1-9
/Regional Economics
Cunningham, Thomas J., "Structural
Booms: Why the South Grows,"
May/June, 1-10
Roberds, William, "Review Essay—
'Privatopia' and the Public Good,"
May/June, 32-36
Uceda, Gustavo A., "Testing the Informativeness of Regional and Local
Retail Sales Data," July/August,
39-49
Welfare Economics
Roberds, William, "Review Essay—
'Privatopia' and the Public Good,"
May/June, 32-36
November/December 1995
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