Contractual Savings and Financial Markets Alberto R. Musalem, Gregorio Impavido and Thierry Tressel Financial Sector Development Department Financial Sector Vice Presidency The World Bank

2 Definition and Importance of Contractual Savings n Funded pensions plans: accumulation period n Annuities: pensions pay out n Life insurance n Funded unemployment benefits, gratuity, end of service indemnity n Other contingencies - down payment for a house, education, weddings, funerals n Supply long term savings

3 Financial assets of contractual savings, selected countries

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

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

6 Financial Market Effects n Increase demand for shares and bonds, market capitalization and volume traded: increase depth and liquidity n Increase demand for long term bonds n Increase supply of long term loans n Improve regulations and transparency n Foster financial innovation, competition and efficiency n Improve corporate governance

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

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

9 Causality n In countries with developed capital markets, direction of causality between contractual savings and either market capitalization or value traded is not clear. n In countries with underdeveloped capital markets, either contractual savings causes market capitalization and value traded, or causality runs both ways. n In developing countries, pension funds cause market capitalization while life and non-life insurance cause value traded. n In Malaysia and Singapore there is no causality in either way between institutions and mkt capitalization or value traded.

10 Market Capitalization n Estimator: Error Components 2 Stage Least Square (EC2SLS), N=281, 26 unbalanced panels (21 OECD and 5 non-OECD countries, ) n Positive impact: contractual savings, non-life ins., value traded, real return on stocks n Negative Impact: real return on money, real interest rate, book reserves, stock price index volatility n Step dummy: developing countries with positive coefficient n Endogenous variables: asset returns n Exogenous variables: all other n Diagnostics: various specification tests passed

11 Value Traded n Estimator: EC2SLS, N=233, 26 unbalanced panels (21 OECD and 5 non-OECD countries, ) n Positive impact: contractual savings share portfolio, non- life insurance share portfolio, real return on money n Negative impact: real interest rate n Step dummy: developing countries with positive coefficient n Diagnostics: various specification tests passed

12 National Saving Effects n Mandatory plan and credit constraints increase household saving but watch welfare effects n Non-captive funding for public sector promotes its saving n Significant shift to funding promotes saving n Transition cost financed by cutting the non-pension public sector deficit increases Government saving n System coverage and retirement ages are increased n Uncertain effect from voluntary plan (tax incentive)

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

14 Social and Financial Risk Mitigation Effects n Beneficiaries improve management of longevity, death and other risks n Reduce debtors refinancing risks, including governments, by lengthening the maturity of debts n Reduce pressure on banks to engage in excessive term transformation risks n Reduce enterprise vulnerability to interest rate and demand shocks due to improved financial structure (higher equity/debt ratio) n Reduce capital markets volatility

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

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

17 Leverage (TDTE) vs Contractual Savings: Conditional Correlation - Market-based Financial Structure Residual = * (CS Fin. Assets, % Sec. Market) (t-stat = -2.47) Pooled reg., 82 obs.

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.

19 Debt Maturity vs Contractual Savings: Conditional Correlation - Market-based Financial Structure Residual = * (CS Fin. Assets, % Sec Mkt) (t-stat = -3.84) Pooled regression, 82 obs.

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.

21 Development of Contractual Savings Institution n Reform pension systems to increase funding u Mandatory: privately or publicly managed u Voluntary u Regulation and supervision of pension funds: allow banks and life insurance companies to market pension plans u Tax treatment n Developing life insurance u Regulation and supervision: allow banks to market insurance u Tax treatment

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

Portfolios Composition

24 Pension funds portfolio composition Source: OECD Yearbook of institutional investors and WB database

25 Pension funds portfolio composition (Common Law) Source: OECD Yearbook of institutional investors and WB database

26 Pension funds portfolio composition (non-Common Law) Source: OECD Yearbook of institutional investors and WB database

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: EPFSingapore: CPF /1

28 Share of long-term bonds in bonds portfolio Source: OECD Yearbook of institutional investors and WB database

29 Share of foreign bills and bonds in bills and bonds portfolio Source: OECD Yearbook of institutional investors and WB database

30 Share of foreign stocks in stocks portfolio Source: OECD Yearbook of institutional investors and WB database

31 Country List