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The use of"asset swaps"by institutional investors in South Africa

  • Dimitri Vittas
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    Leading financial economists have proposed the use of international asset swaps (Merton 1990, Bodie and Merton 2002) as a way of efficiently achieving international diversification without eroding the level of foreign exchange reserves and weakening local market development. International asset swaps entail limited foreign currency flows (only net gains or losses need to be exchanged). They protect foreign investors from market manipulation and expropriation risk and have much lower transaction costs than outright investments. But asset swaps are constrained by the attractiveness of local markets to foreign investors, and by various regulatory issues covering counterparty risk and collateral considerations, and accounting, valuation, and reporting rules. Institutional investors are well developed in South Africa. Their total assets corresponded in 2001 to 159 percent of GDP, a level that was surpassed by only four high-income countries. But because of the imposition of exchange controls, they lacked international diversification. In July 1995 South Africa was the first developing country that explicitly allowed its pension funds and other institutional investors to make use of"asset swaps."But the South African authorities did not authorize the use of properly specified swap contracts as described by Bodie and Merton, but rather permitted institutional investorsto"obtain foreign investments by way of swap arrangements."As the author argues in this paper, the asset swap mechanism turned out to be cumbersome and inefficient. However, it did allow institutional investors to attain some level of international diversification. Other developing countries should consider authorizing their institutional investors to engage in international asset swaps. But they should authorize the use of properly designed swap contracts, preferably based on baskets of liquid securities, permit only global investment banks to act as counterparties, require the use of global custodians, properly monitor credit risk, maintain adequate collateral, and adopt market-to-market valuation rules. Asset swaps are clearly a second-best option compared to the lifting of exchange controls. However, they may facilitate risk diversification in the presence of such controls. And they may even have a role to play in their absence.

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    Paper provided by The World Bank in its series Policy Research Working Paper Series with number 3175.

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    Date of creation: 01 Dec 2003
    Date of revision:
    Handle: RePEc:wbk:wbrwps:3175
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    1. Bodie, Zvi & Merton, Robert C., 2002. "International pension swaps," Journal of Pension Economics and Finance, Cambridge University Press, vol. 1(01), pages 77-83, March.
    2. Reena Aggarwal & Leora Klapper & Peter D. Wysocki, 2003. "Portfolio preferences of foreign institutional investors," Policy Research Working Paper Series 3101, The World Bank.
    3. Fernando, Deepthi & Klapper, Leora & Sulla, Victor & Vittas, Dimitri, 2003. "The global growth of mutual funds," Policy Research Working Paper Series 3055, The World Bank.
    4. Davis, E.P. & DEC, 1993. "The structure, regulation, and performance of pension funds in nine industrial countries," Policy Research Working Paper Series 1229, The World Bank.
    5. Mario Draghi & Francesco Giavazzi & Robert C. Merton, 2003. "Transparency, Risk Management and International Financial Fragility," NBER Working Papers 9806, National Bureau of Economic Research, Inc.
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