Contractual Savings and

Financial MarketsAlberto R. Musalem, Gregorio Impavido and Thierry TresselFinancial Sector Development DepartmentFinancial Sector Vice PresidencyThe World Bank

2

Definition and Importance of Contractual Savings

Funded pensions plans: accumulation period Annuities: pensions pay out Life insurance Funded unemployment benefits, gratuity, end of

service indemnity Other contingencies - down payment for a house,

education, weddings, funerals Supply long term savings

3

Financial assets of contractual savings, selected countriesCountries 1970 1980 1990 1993 1998Switzerland 51.00 70.00 88.51 106.82 131.01 /1

life 32.29 39.81 49.44

pension 56.22 67.01 81.57

United Kingdom 43.00 38.81 86.91 137.36 167.85life 17.77 36.87 65.22 87.79

pension 21.04 50.04 72.14 80.06

The Netherlands 45.00 66.90 108.11 130.46 166.45life 21.13 36.06 47.25 60.34

pension 45.77 72.05 83.21 106.11

United States 40.00 43.01 69.20 82.07 113.59life 17.72 25.85 31.10 31.85

pension 25.29 43.35 50.97 81.74

Chile 1.00 29.28 45.61 54.12 /2life 5.59 8.60 12.13

pension 23.69 37.01 41.99

South Africa 40.00 39.27 78.13 111.87 109.31life 17.20 43.94 72.25 63.49

pension 22.07 34.19 39.62 45.82

Malaysia* 18.00 20.08 47.18 50.25 59.82life 3.26 7.02 9.04 9.17

pension 16.82 40.16 41.21 50.65

Singapore* 17.00 41.00 115.13 102.39 116.58life 8.44 12.00 14.36

pension 106.69 90.39 102.22

Notes: * Prior to 1990, the data do not include the funds invested directly by individual workers in housing and other approved assets.

/ 1 1996; 2/ 1997.

Source: 1970 data from Davis (1995) and national central banks, as quoted by Vittas (1998); all other data from World Bank database

and OECD 2000 Institutional Investors Statistical Yearbook

4

Contractual savings and M2 as percentage of financial assets (1996)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

m2%

ctr%

5

CONTRACTUAL SAVINGS % OF CAPITAL MARKETS (STOCKS AND BONDS) Comparing Two Years During the 1990s

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

120.00%

6

Financial Market Effects

Increase demand for shares and bonds, market capitalization and volume traded: increase depth and liquidity

Increase demand for long term bonds Increase supply of long term loans Improve regulations and transparency Foster financial innovation, competition and

efficiency Improve corporate governance

7

Market capitalization and contractual savings assets, 1996 (% GDP)

MC/GDP

CS/GDP0 .5 1 1.5

0

.5

1

1.5

2

AUS

AUT

BEL

CAN

CHE

CHL

DEU

DNKESPFIN

FRA

GBR

GRCHUN

ISLITA

JPN

KOR

NLD

NOR

NZL

PRT

SGP

SWE

THA

USA

ZAF

8

Value traded and contractual savings assets, 1996 (% GDP)

VT/GDP

CS/GDP0 .5 1 1.5

0

.5

1

1.5

AUS

AUTBEL

CAN

CHE

CHL

DEU

DNK

ESP

FINFRA

GBR

GRCHUN ISL

ITA

JPN

KOR

NLD

NOR

NZL

PRT

SGP

SWE

THA

USA

ZAF

9

Causality

In countries with developed capital markets, direction of causality between contractual savings and either market capitalization or value traded is not clear.

In countries with underdeveloped capital markets, either contractual savings causes market capitalization and value traded, or causality runs both ways.

In developing countries, pension funds cause market capitalization while life and non-life insurance cause value traded.

In Malaysia and Singapore there is no causality in either way between institutions and mkt capitalization or value traded.

10

Market Capitalization Estimator: Error Components 2 Stage Least Square

(EC2SLS), N=281, 26 unbalanced panels (21 OECD and 5 non-OECD countries, 1975-97)

Positive impact: contractual savings, non-life ins., value traded, real return on stocks

Negative Impact: real return on money, real interest rate, book reserves, stock price index volatility

Step dummy: developing countries with positive coefficient Endogenous variables: asset returns Exogenous variables: all other Diagnostics: various specification tests passed

11

Value Traded Estimator: EC2SLS, N=233, 26 unbalanced panels (21

OECD and 5 non-OECD countries, 1975-97) Positive impact: contractual savings share portfolio, non-

life insurance share portfolio, real return on money Negative impact: real interest rate Step dummy: developing countries with positive coefficient Diagnostics: various specification tests passed

12

National Saving Effects

Mandatory plan and credit constraints increase household saving but watch welfare effects

Non-captive funding for public sector promotes its saving

Significant shift to funding promotes saving Transition cost financed by cutting the non-pension

public sector deficit increases Government saving System coverage and retirement ages are increased Uncertain effect from voluntary plan (tax incentive)

13

Contractual Savings and Growth

Potential increase in saving Decline in the cost of capital: equity and debt Flatten the term structure of interest rates Reduce the country risk premium Promote efficiency gains Virtuous cycle: higher growth increases saving thus

furthering growth

14

Social and Financial Risk Mitigation Effects

Beneficiaries improve management of longevity, death and other risks

Reduce debtors refinancing risks, including governments, by lengthening the maturity of debts

Reduce pressure on banks to engage in excessive term transformation risks

Reduce enterprise vulnerability to interest rate and demand shocks due to improved financial structure (higher equity/debt ratio)

Reduce capital markets volatility

15

Debt-equity ratios of listed companies and contractual savings assets, 1997 (% GDP)

Tota

l D

eb

t o

ve

r E

qu

ity

CS Financial Assets, % GDP.013976 1.9

.230171

4.14341

ARGENTIN

AUSTRALI

BRAZIL

CANADA

CHILE

FRANCE

GERMANY

INDIA

ITALY

KOREA (S

MEXICO

NETHERLA

NEW ZEALPORTUGAL

SOUTH AF

SPAIN

SRI LANK

THAILAND

UNITED K

UNITED S

16

Long-term to total debt ratio of listed companiesand contractual savings assets, 1997 (% GDP)

LT

De

bt o

ve

r To

tal D

eb

t

CS Financial Assets, % GDP.013976 1.69436

.305507

.805603

ARGENTIN

AUSTRALI

BRAZIL

CANADA

CHILE

FRANCE

GERMANYINDIA

ITALY KOREA (S

MEXICO

NETHERLA

NEW ZEAL

PORTUGALSOUTH AF

SPAIN

SRI LANK

THAILAND

UNITED K

UNITED S

17

Leverage (TDTE) vs Contractual Savings: Conditional Correlation - Market-based Financial Structure

Residual = -1.16 * (CS Fin. Assets, % Sec. Market) (t-stat = -2.47) Pooled reg., 82 obs .

Un

exp

lain

ed

Re

sid

ua

l ( T

DT

E )

CS Financial Assets, % Sec. Mark.122694 1.14333

-2.30492

6.70387

18

Leverage (TDTE) vs Contractual Savings: Conditional Correlation - Bank-based Financial Structure

Residual = 4.0 * (CS Fin. Assets, % Sec. Market) (t-stat = 2.37) Pooled regression, 74 obs.

Unexpla

ined R

esid

ual (

TD

TE

)

CS Financial Assets, % Sec. Mark.029634 .608034

-1.6972

5.48049

19

Debt Maturity vs Contractual Savings: Conditional Correlation - Market-based Financial Structure

Residual = -0.09 * (CS Fin. Assets, % Sec Mkt) (t-stat = -3.84) Pooled regression, 82 obs.

Unexpla

ined R

esid

ual (

LT

DT

D )

CS Financial Assets, % Sec. Mark.122694 1.14333

-.18621

.11524

20

Debt Maturity vs Contractual Savings: Conditional Correlation - Bank-based Financial Structure

Residual = 0.28 * (CS Fin. Assets, % Sec Mkt) (t-stat = 5.28) Pooled Regression, 74 obs.

Un

exp

lain

ed

Re

sid

ua

l (L

TD

TD

)

CS Financial Assets, % Sec. Mark.029634 .608034

-.156052

.180361

21

Development of Contractual Savings Institution

Reform pension systems to increase funding Mandatory: privately or publicly managed Voluntary Regulation and supervision of pension funds: allow banks and

life insurance companies to market pension plans Tax treatment

Developing life insurance Regulation and supervision: allow banks to market insurance Tax treatment

22

Government long-term to total debt ratio and contractual savings assets, 1996 (% GDP)

Financial Assets of CS over GDP.003 1.482

.32

.97

TUR

HUN

GRC

AUT

DEU

KOR

NZL

NOR

FRA

JPN

SWE

FIN

DNK

AUSISL

CAN

SGP

USA

ZAF

CHE

GBRNLD

Portfolios Composition

24

Pension funds portfolio composition

Source: OECD Yearbook of institutional investors and WB database

5 6 7 6 5 5 4 3 3 2

3841 41

3433 34

3231 28

25

119 8

7 9 98

76

3

3636 38

39 38 37 4446 52

59

10 8 6

14 15 1512 13 11 11

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998

Cash and deposits Bills and bonds Loans Shares Other

25

Pension funds portfolio composition (Common Law)

Source: OECD Yearbook of institutional investors and WB database

6 6 7 6 6 6 4 3 3 2

41 43 42

35 34 35

31 3126

23

4 3 3

3 3 3

3 2

2

2

39 39 40

41 41 4049 51

5762

10 9 815 16 16 13 13 12 11

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998

Cash and deposits Bills and bonds Loans Shares Other

26

Pension funds portfolio composition (non-Common Law)

Source: OECD Yearbook of institutional investors and WB database

2 2 2 2 2 4 4 4 4 4

1216

21 2328

32 34 33 3641

75 7064 61 52

49 43

35 2916

3 4 6 7 13 1013

20 23

28

8 8 7 7 5 5 6 8 8 11

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998

Cash and deposits Bills and bonds Loans Shares Other

27

Pension funds portfolio composition (MYS and SGP)

Notes: 1/ 100% of assets are invested in non-tradable govt. securities. Money is channeled through the Consolidated Fund to investment holding companies of the Singapore Government. No public disclosure of their operations is required or made. Source: WB database

Malaysia: EPF Singapore: CPF /1

28

Share of long-term bonds in bonds portfolio

80%

82%

84%

86%

88%

90%

92%

94%

96%

1982 1984 1986 1988 1990 1992 1994 1996

Life Pension funds Non-life

Source: OECD Yearbook of institutional investors and WB database

29

Share of foreign bills and bonds in bills and bonds portfolio

0%

5%

10%

15%

20%

25%

1982 1984 1986 1988 1990 1992 1994 1996

Life Pension funds Non-life

Source: OECD Yearbook of institutional investors and WB database

30

Share of foreign stocks in stocks portfolio

0%

5%

10%

15%

20%

25%

30%

35%

1982 1984 1986 1988 1990 1992 1994 1996

Life Pension funds Non-life

Source: OECD Yearbook of institutional investors and WB database

31

Country ListARG Argentina FIN Finland NLD NetherlandsAUS Australia FRA France NOR NorwayAUT Austria GBR United Kingdom NZL New ZealandBEL Belgium GRC Greece PRT PortugalBRA Brazil HUN Hungary SGP SingaporeCAN Canada ISL Iceland SWE SwedenCHE Switzerland ITA Italy THA ThailandCHL Chile KOR Korea, Rep. TUR TurkeyDEU Germany LKA Sri Lanka USA United StatesDNK Denmark LUX Luxembourg ZAF South AfricaESP Spain MYS Malaysia