Contractual savings: a lever powerful enough to move the world towards sustainable development

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By Arup Chatterjee

Although the pandemic has revealed that economies can no longer afford to return to old ways of doing things, clouding their futures, there is a silver lining in a coming of “age of sustainability” in Asia and the Pacific that can get countries growing strongly again.

However, reaching this new age will require greater use of insurance companies, pension funds, and other institutional investors to tap the region’s well-known and huge pool of savings. Asia’s savings rate is very high, at about 27.11% of gross domestic product, ranging from 40.24% in Singapore, 30.20% in India, and 24.86% in the Philippines to 14.23% in Georgia. 

The new age of sustainability calls for a more diverse range of infrastructure investments that meet environmental, social, and governance goals.

And it needs measures that can allow corporates and households to invest more widely. 

For now, high public debts, rising domestic spending, and adverse exchange and interest rates are constraining fiscal space. In addition, governments’ inability to implement countercyclical fiscal policy to respond and mitigate the adverse effects of external shocks worsens these constraints.  

Several factors contribute to high, untapped savings in the region, both among households and corporates.

Social insurance schemes such as unemployment and health insurance or sovereign insurance schemes for natural catastrophes are absent or underdeveloped, for example, causing pro-cyclical discretionary responses. And as economies in transition become market-oriented, reducing the state’s role, household-specific employment and income uncertainty rises. 

Households resort to precautionary saving to smooth income during shocks as a sort of self-insurance, which is amplified by financial frictions, including rigidities in prices and wages, borrowing constraints, or imperfect insurance. In addition, lack of diversification opportunities for financial assets restricts borrowing against future income to finance current purchases of durables, including houses.

The share of corporate savings, primarily reflected in retained earnings, also influences overall saving patterns. Corporate savings mitigate uncertainties due to cyclical and transitory factors such as money supply, interest rates, and inflation, cost of investment goods and real estate prices, and internally finance investment projects.

In addition, an incentive to reduce debt and the underfunding of company pensions encourage more significant cash holdings, which in turn add to savings.

Yet, by tapping household and corporate savings, a significant share of investments for sustainable and resilient growth could come from the private sector. 

Clearly then, this will require better social safety nets and high-quality savings run by diversified contractual savings institutions—insurance companies, pension funds, and investment trusts—encouraging greater financialization of household savings away from gold and property and other precautionary investment. In addition, these institutions can increase options for financial protection against contingencies and improve risk management.

The design of insurance and pensions systems is rarely guided just by market development considerations. Instead, they primarily reflect important social choices and differing perspectives on the appropriate role of the state – particularly the role of funded versus unfunded pay-as-you-go schemes in the case of pensions. 

Nevertheless, insurance, funded pensions, and collective investment schemes can help add to a savings pool denominated in local currency through complementary arrangements. This pool of savings can contribute vitally to a deep, liquid, and stable domestic capital market for financing private sector innovation, investment, and growth if grown over time. It can also lower dependence on foreign debt.

These institutions can also ease fiscal constraints. Since insurance companies and pension funds have long investment horizons and low leverage, they can effectively provide long-term funds in local currency and are less likely to exacerbate volatility by selling into short-term corrections.

They typically purchase bonds to back steady cash flows for their subscribers. Governments can thus finance their fiscal deficits by borrowing from the local markets without exchange rate risk by issuing such bonds.

The participation of these institutions can also help create a more steady demand for local currency debt assets and stabilize long-term government bond yields, thus enhancing signals from market interest rates for better monetary policy implementation.

And to tie this back in with sustainability goals, infrastructure debt can provide long-term, resilient, and visible cash flows, underpinned by attractive yield potential that supports environmental, social, and governance issues.

Depending on the risk-return profiles and liquidity needs, insurance companies and pensions also provide alternative funding with better pricing and longer maturities to complement bank financing. Moreover, because they can absorb less liquidity than other asset classes, institutional investors are best suited to orient their investments with sustainable development goals to the extent such investment enhances financial performance.

The diversification credentials of infrastructure debt provide an added attraction to such insurance and pension investors. A diversified domestic investor base can contribute to the trading depth and expand the range of investment options across a wide range of sectors and industries. This can help investors diversify portfolios and manage risk better by developing hedging instruments. Investors can also diversify benefits through the debt capital structure. For example, due to its illiquidity premium and low expected loss, senior debt can offer an attractive valuation. In contrast, junior debt can provide a higher absolute return while still benefiting from the same resilience infrastructure. 

Also, by funding riskier activities traditionally not served by the banking sector, insurance companies and pension funds can contribute significantly to economic innovation and help shift the focus from capital-intensive growth to intangibles-intensive investment that caters to the needs of a service-based economy. Thus, domestic firms would need to rely less on retained earnings to finance investments.

Collective investment funds, such as mutual funds, including money market funds, meanwhile, can reduce the cost of diversifying risk. By allowing retail investors to access professional fund management services easily, they facilitate the financialization of savings. Their shorter investment horizons facilitate price discovery and create liquidity. And they enhance market transparency, governance, and credit rating functions by reducing information asymmetries and help sustain the vitality of the entire financial ecosystem. 

As the markets become more sophisticated, the pool of local currency savings progressively diversifies from the banking sector into the growing nonbank institutional investor base in local currency, including cash and debt.

Institutional investors also participate as qualified investors in the spot markets and financial derivative transactions, improving a country’s overall risk allocation and financial stability. Doing so makes the market more attractive to international investors, who are comforted by the presence of a local, well-established domestic institutional investor base. 

As noted, Asia’s savings rate is very high. And the massive amounts involved mean that mobilizing contractual savings can be a “game-changer” for infrastructure. Prequin estimates that assets under management in the Asian and Pacific private market reached $1.62 trillion in 2019 and forecasts them to grow to $4.97 trillion by 2025. Thus, allocating just 5% to infrastructure projects would have a significant impact. 

And the size of institutional investors differs widely in the region. Financial hubs, such as Hong Kong and Singapore, have more than 50% of assets derived from foreign capital inflows. In countries such as the Philippines and Indonesia, the asset size of institutional investors to GDP is only about 13% and 6%. Naturally, countries with strong domestic institutional investors have more potential to tap into foreign investors for infrastructure development.

Infrastructure investment provides a strong economic stimulus with a multiplier effect that can help to rebalance growth. According to the IMF, an investment of an additional 1% of GDP increases output by 0.4% in the year that investment is made and a further 1.5% in the four years following the investment. 

By helping to raise the weight of institutional investors in intermediating savings and reducing that of the banking sector, governments can seriously boost long-term growth prospects and bridge the massive infrastructure financing gaps in critical sectors, such as housing, climate, and infrastructure. 

Since infrastructure assets have long life cycles, investment decisions must align with the Paris Agreement’s national and global targets for reducing greenhouse gas emissions. Otherwise, they are likely to generate idle assets before the end of their useful lives.

Infrastructure projects must also consider the resilience of investments to climate change, such as increases in temperature and variations in precipitation levels, to avoid unintended consequences in the form of interruption of essential services to the population or the flow of revenue collection related to such services.

Given the inherent influence of contractual savings institutions in intermediating savings, institutional investors are placed suitably as agents for change for driving sustainable development.

Therefore, governments need to seriously consider promoting contractual savings institutions and utilize their investment capabilities and risk-bearing capacity to boost their long-term growth prospects and bridge the massive infrastructure financing gaps.


The author, Arup Chatterjee is a financial sector policy and regulatory expert with a multilateral bank. The views expressed are personal.

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