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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. Free subscriptions and limited additional copies are available from the Public Affairs Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, N.W., Atlanta, Georgia 30303-2713 (404/521-8020). Internet: http://www.frbatlanta.org. Change-of-address notices and subscription 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 http://fraser.stlouisfed.org/ 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 20 Economic Review 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 http://fraser.stlouisfed.org/ 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 Review 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 http://fraser.stlouisfed.org/ Federal Reserve Bank of Atlanta 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- DigitizedFederal for FRASER Reserve Bank of Atlanta 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 Federal Reserve Bank of Atlanta Working Papers T he Research Department of the Federal Reserve Bank of Atlanta publishes a working paper series to convey the research of staff economists and visiting scholars and stimulate professional discussion and exploration of economic and financial subjects. 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