Madhusudan S. Joshi
The household sector is the largest contributor to the financing of investment in developing as well as in developed countries. Yet our knowledge of the variables which determine both the level of household savings and its utilization is meager. Quite often, private savings are treated as a simple function of income, and attempts to increase national savings emphasize public, especially budgetary, savings. Furthermore, inadequate attention has been given to the uses to which household savings are put. In many countries, the undeveloped financial structure of the economy fails to channel savings to the most productive long-term uses. Improvement of the financial structure requires specific policy measures to develop both financial institutions and financial instruments.
Financial policy is an integral part of the government’s economic policies related to mobilization and allocation of resources. Financial policy variables consist of two broad categories, those concerned with public savings and investment and those influencing private savings and investment. The former includes fiscal measures, such as tax increases and expenditure curbs, which lead to increases in public savings. The most important financial policy variable affecting private savings and investments is the interest rate policy. Other factors include creation of financial institutions, such as insurance companies, pension funds, and investment trusts, which provide financial instruments satisfactory to both savers and investors in terms of safety, profitability, and liquidity. This article briefly examines the role which contractual savings can play in developing the financial structure.
What Are Contractual Savings?
Total household financial savings can be divided into discretionary savings and contractual savings. Discretionary savings are held in the form of financial assets of differing degrees of liquidity; they include claims on the banking system (currency and deposits), claims on the government sector (government securities), and claims on the private business sector (stocks and bonds). On the other hand, contractual savings are long-term savings involving a definite, continuous commitment on the part of the savers. These savings may take the form of insurance premiums, provident fund and pension fund contributions, and principal payments on mortgage debt.
Contractual saving occupies a crucial position in household budgeting directed toward long-term goals: acquisition of a house and major consumer durable goods, protection against emergencies, and provision for a comfortable retirement. The components of contractual savings have certain distinguishing characteristics that appeal to different types of savers. For example, insurance protects against casualty, whereas mortgage or installment debt payments enable the consumer to enjoy the benefits of certain goods before fully owning them. Many people prefer the discipline of being forced to set aside certain amounts on a regular basis; in addition, pension funds and other forms of payroll savings often benefit from employer’s contributions.
Institutional arrangements involved in contractual savings also assume a stable rate of household saving in the economy. Saving is thus considered as not merely a residual of unspent income but as a regular feature of positive action. Moreover, institutionalization of the saving-investment process in this form improves the financial market mechanism. These institutional investors benefit from large-scale operations as well as centralized and professional management. The role of contractual saving institutions in the security market or the markets for long-term industry and housing loans has become increasingly important in many developed countries.
Importance of Contractual Savings
The importance of the level of total savings for investment is generally recognized and the “act of saving” is considered enough to finance investment, but the significance of variations in the composition of savings on the magnitude, direction, and nature of investment is often overlooked. This is primarily because all forms of savings are considered to be close substitutes; thus an increase in one form of savings is sometimes believed to be at the cost of another rather than at the cost of consumption. The available evidence1 suggests, however, that contractual savings are made primarily at the cost of consumption and thus provide a net additional source of funds for the capital market. They inculcate household saving habits and create a continuous supply of longer-term savings in the economy. Financial intermediaries through which these savings are channeled, such as insurance companies and pension funds, have acquired a central place in the financial systems of developed countries. They perform a dual role, increasing longer-term savings on the one hand and lending longer-term funds or buying negotiable securities on the other.
Determinants of Total Savings and Its Components
Economic theory suggests that total savings of an economic unit depend mainly on income, wealth, interest rates, and tastes; normally, the same variables also influence the individual components of savings. However, explanations of variations in the composition of savings usually emphasize the structure as well as the level of interest rates, the stocks of related components of wealth, and the relative yields and costs of different forms of assets and liabilities.
The most important financial variable determining saving is the structure of interest rates, although prices, valuation and liquidity of assets, noninterest terms of credit, and other financial variables are bound to have an influence on the components of savings. The demand for a particular type of financial asset or component of saving relative to the total is likely to depend primarily on its comparative yield. The comparative yield would refer to the current value as well as the expected future values of this variable.
The optimum structure of individuals’ assets depends not only on the variables explaining total assets and savings but also on the relative rates of return and risks of each type of asset and liability. Interest rates do have a marked impact on the composition of saving. Obviously, savers prefer assets with higher yields and lower costs. Changes in interest rates are also likely to affect the composition of savings indirectly via their influence on the distribution of income among groups with different preferences.
Various components of savings have different degrees of substitutability among themselves. Currency and demand deposits appear to be nearly perfect substitutes, while currency and pension funds seem to be the least substitutable forms of savings. In general, discretionary savings and contractual savings are not close substitutes; they possess quite different characteristics, and the motivations of savers are different. Empirical evidence2 suggests that three important variables determining variations in contractual savings are as follows: disposable income as a measure of the ability to save contractually; marriage and the presence of children as a measure of the need for contractual saving; and education as a measure of the perception of need.
Empirical Evidence from the United States
Shifts in the main components of financial assets of the household sector over a long period could be examined only in the United States; data for the period 1909–64 are shown in Table 1. These figures reveal a very large reduction in securities—from over 40 per cent of total household financial assets at the beginning of this century to barely 2 per cent in the 1960s. The share of contractual saving, in contrast, doubled during the same period; it amounted to nearly 45 per cent of household financial assets in the 1960s.
|Deposits (including currency)||32.9||27.3||36.9||41.2||54.5|
Life insurance is the most common method of contractual savings. In the United States about 75 per cent of all family units own life insurance; in the United Kingdom, 70 per cent of all income units pay life insurance premiums. Almost all families in the United States with incomes over $3,000 save contractually. In fact, contractual savings have become an integral part of the budgets of most U. S. families, and the layman does not consider repaying mortgage or installment debt, paying life insurance premiums, or contributing to a pension fund as “saving.” The trend of contractual saving as a proportion of total savings had been upward in the United States; in 1949, contractual saving was almost as large as total saving since discretionary dissaving largely offset positive discretionary saving.
In the United States, there has been a marked shift from saving through life insurance companies, which was predominant through the 1920s, to saving through private and government retirement funds. During the 1950s, private pension funds accounted for more than one half of total “insurance” saving, government retirement funds for about one fourth, and life insurance companies (excluding the private pension funds they administer) about one fifth. Contractual saving in the form of retirement plans and pension funds, practically unknown until the early 1930s, accounted for about one third of the total accumulation of financial assets by individuals in the early 1960s.
Several empirical studies find a high degree of substitution between securities and cash and deposits and almost negligible substitutability between deposits and insurance premiums. These studies suggest that households with contractual savings seem to have at least as much saving in other forms as similar households with no contractual saving. In general, the evidence suggests that contractual savings are made primarily at the cost of consumption, particularly in low-income groups. The empirical evidence3 also refutes the proposition that contractual saving is static and inflexible and suggests that many families respond to income increases by stepping up their contractual saving—apart from automatic adjustments like those of pension funds—and not by merely adding to their liquid resources.
… and From Other Countries
Data for some of the developed countries covering the early 1960s are presented in Table 2. For developing countries there is a dearth of data on the structure of household sector’s financial assets. Table 2 includes data based on a study made by the Economic Commission for Asia and the Far East (ECAFE), which also utilizes the results of a series of direct estimates of saving made in a few ECAFE countries. These figures must be considered with caution: they relate to the 1950s, and the methodology followed in estimation is likely to vary among countries. Nevertheless, some tentative observations can be made.
|Germany, Fed. Rep. of |
|United Kingdom |
|United States |
|Sri Lanka (Ceylon) |
Contractual savings appear to be the most important form of saving in the United Kingdom. There are tax advantages to investing in equities through insurance and pension funds rather than in direct investment; households have thus liquidated, on net, their directly owned securities. Contractual savings are also important in Belgium and Germany. Insurance is the chief form of contractual savings in Belgium; in Germany, deposits at building and loan associations have also played an important role. The French data are somewhat misleading because the figures refer only to private life insurance: the more extensive public insurance schemes are not included. In Italy and Japan, time and savings deposits occupy a much more dominant position; contractual savings play a steady but modest role. Contractual savings are the least important form of financial savings in Greece: life insurance companies play a marginal role in the underdeveloped financial system, and there are not many facilities for other forms of contractual saving.
Based on the available data, Malaysia, the Philippines, and Sri Lanka (Ceylon) held a substantial proportion of their households’ financial saving in contractual form. Life insurance is the major form of contractual saving in these countries, followed by provident funds and social security schemes. There are indications that contractual savings are becoming increasingly important in household portfolios in these countries. Korea is the chief exception; a substantial portion of the financial savings of the household sector seems to be in the form of bank deposits which earn a very high tax-free interest return.
Indian data for the last 15 years indicate a distinct preference for contractual saving rather than for securities. The conclusions of a 1963 study on contractual saving made by the National Council of Applied Economic Research (NCAER) in India may be relevant for other developing countries. These data indicate the possibility of increasing total saving by extending the coverage of contractual savers and by increasing the amounts saved in contractual form, especially since people who save in contractual forms seem to have a higher total saving-income ratio than people in a similar situation who do not save contractually.
Practical Significance and Policy Implications
Apart from the act of saving, it is the “form” of saving, which is specifically significant for the process of “financing” in an economy. The advantageous position that “contractual savings” hold in this process has been already discussed in the earlier sections. A crucial question for policymakers in the developing countries is whether they should encourage direct participation by ultimate investors in the process of financing or whether they should give priority to indirect financing through financial institutions. Specifically, whether they should make conscientious efforts to establish and promote the growth of contractual saving institutions? Or, alternatively, whether they should give priority to development of the stock market? Evidences from both theoretical as well as empirical literature suggest a preference for a policy that puts a strong emphasis on growth of contractual saving in developing countries.
Development of stock markets with an emphasis on equity-type securities is a fairly complex process and essentially a long-term solution; business firms and individual investors in these countries can be expected to adjust only slowly to the complex operations of a stock market. Although family type businesses are slowly expanding their operations in these countries, they are still unwilling to meet the requirements of listing on the stock exchanges, especially for fear of disclosures and losing control. Moreover, the potential class of rational investors prepared to partake in the unfamiliar as well as the risk-bearing activities of the stock market would emerge only gradually.
It might therefore be preferable to start by fostering contractual saving institutions which would induce the household sector to increase its indirect savings. Creation of institutional and professional investors would also help to develop the environment suitable for the growth of stock markets. The priority for indirect personal saving through financial institutions is more evident in developing countries today, than it was in developed countries during their early phases of development, especially because of different socioeconomic structures. The emphasis on mobilization of small savings, clearly indicated by policies of many of the developing countries, also suggests a preference for indirect saving through financial institutions. Governments might be willing to foster the growth of social security institutions, which are often used as a kind of tax device. This would also help meet the demands of the blue collar workers and trade unions, which have been acquiring increasing importance in developing countries in recent years.
Another reason for emphasizing growth of contractual saving institutions is that they are an important type of “saver-oriented” institutions. These institutions specialize in creating financial instruments which meet the needs of different savers in terms of safety, liquidity, and profitability. Activities in many developing countries seem to concentrate more on “investor-oriented” institutions such as development banks, which appear to be mainly concerned with the allocation of funds made available to them mostly by governments and international institutions. Policymakers in developing countries that are trying to mobilize private domestic savings might do well to adopt a more concerted effort to foster “saver-oriented” contractual saving institutions.
the stand-by arrangements of the international monetary fund
by Joseph Gold
A commentary on their formal, legal, and financial aspects
(or equivalent in most other currencies)
This is the first comprehensive examination of the formal, legal, and financial characteristics of stand-by arrangements. It describes the relation of this novel technique to the law and policies governing the use by members of the Fund’s financial resources. Illustrative stand-by documents, consisting of the stand-by arrangement itself and the member’s letter of intent which is annexed to it, are provided and analyzed paragraph by paragraph in detail.
The book concludes with much reference material relating to stand-by arrangements and the use of the Fund’s resources.
The author is General Counsel of the Fund and Director of the Legal Department.
Available in English only.
The Secretary, International Monetary Fund
19th and H Streets, N. W., Washington, D. C., U. S. A.
Phillip Cagan, “The Effect of Pension Plans on Aggregate Saving,” National bureau of Economic Research, New York, 1965.
Reher, William C, “A Multivariate Analysis of Contractual Saving,” The Review of Economics and Statistics (Cambridge, Mass., February 1966), pp. 61-68.
Katona, George, Private Pensions and Individual Saving, The University of Michigan, 1965, and Roger F. Murray, Economic Aspects of Pensions—A Summary Report, National bureau of Economic Research (New York), 1968.