Pension Reform, Financial Market Development, and Economic Growth: Preliminary Evidence from Chile
Author: Mr. Robert Holzmann1
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Contributor Notes

* Robert Holzmann is Professor of Economics and Managing Director of the Economics Department of the European Institute at the University of Saarland. He is currently on leave and Director of the Social Protection Team of the Human Development Department of the World Bank. The first version of this paper was prepared while he was a guest professor at the Instituto de Economía, Pontiticia Universidad Católieade Chile in March-April 1995, and a revised version was prepared while he was a visiting scholar at the Fiscal Affairs Department of the IMF in June–August 1995. The author thanks both institutions for their encouragement and support, and the possibility to present the results at their research seminars, where he received many valuable comments. Special thanks for helpful comments and support go to Friedrich Breyer, Peter Diamond, Philip Gerson, Ross Levine, Sandy Mackenzie, and Salvador Valdés-Prieto. All errors and omissions are, of course, his own doing.

Publication Date:
01 Jan 1997
eISBN:
9781451947243
Language:
English
Keywords:
SP; paper number; priority mail delivery; state; Visa credit cards; series name; inflation expectation; Pension spending; Pension reform; Unemployment rate; Inflation; Central and Eastern Europe; Africa; Asia and Pacific; growth theory; indicator effect; market participation; stock market exchange; investment rate; Financial sector development; Total factor productivity; Private savings
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The reform of the public retirement scheme is a standing agenda in essentially all countries throughout the world (see Holzmann (1988) and World Bank (1994)). It is of particular importance for the emerging economies of Latin America and Central and Eastern Europe as their current schemes constitute an important drain on the public budget, reducing national saving, capital formation, and growth. Also, these schemes are held responsible for the main distortions in the labor market. Thus the experience of the Chilean pension reform of 1981 has special attraction for other emerging economies, as this reform was thought to have contributed to the country’s excellent economic performance after the shocks of the foreign debt and domestic banking crises of 1981-83 had been absorbed (see Table 1). Very recently, various countries in Latin America, such as Argentina, Peru, Colombia, and Mexico, have begun to imitate to some extent the Chilean approach, and some former centrally planned economies, such as Hungary, Latvia, and Poland, are taking preparatory steps in this direction.1

Abstract

The reform of the public retirement scheme is a standing agenda in essentially all countries throughout the world (see Holzmann (1988) and World Bank (1994)). It is of particular importance for the emerging economies of Latin America and Central and Eastern Europe as their current schemes constitute an important drain on the public budget, reducing national saving, capital formation, and growth. Also, these schemes are held responsible for the main distortions in the labor market. Thus the experience of the Chilean pension reform of 1981 has special attraction for other emerging economies, as this reform was thought to have contributed to the country’s excellent economic performance after the shocks of the foreign debt and domestic banking crises of 1981-83 had been absorbed (see Table 1). Very recently, various countries in Latin America, such as Argentina, Peru, Colombia, and Mexico, have begun to imitate to some extent the Chilean approach, and some former centrally planned economies, such as Hungary, Latvia, and Poland, are taking preparatory steps in this direction.1

The reform of the public retirement scheme is a standing agenda in essentially all countries throughout the world (see Holzmann (1988) and World Bank (1994)). It is of particular importance for the emerging economies of Latin America and Central and Eastern Europe as their current schemes constitute an important drain on the public budget, reducing national saving, capital formation, and growth. Also, these schemes are held responsible for the main distortions in the labor market. Thus the experience of the Chilean pension reform of 1981 has special attraction for other emerging economies, as this reform was thought to have contributed to the country’s excellent economic performance after the shocks of the foreign debt and domestic banking crises of 1981-83 had been absorbed (see Table 1). Very recently, various countries in Latin America, such as Argentina, Peru, Colombia, and Mexico, have begun to imitate to some extent the Chilean approach, and some former centrally planned economies, such as Hungary, Latvia, and Poland, are taking preparatory steps in this direction.1

Table 1.

Macroeconomic Indicators and Pension Fund Performance

(In percent, unless otherwise indicated)

article image
Sources: Central Bank of Chile, Monthly Bulletin; and Superintendency of Pension Fund Administration, Statistical Bulletin.

Based on consumer price index: 12 months ended December.

Based on October-December data.

An increase indicates a real depreciation of the domestic currency.

Private saving in percent of GDP.

In a nutshell, the Chilean reform consisted of (1) a shift from a conventional unfunded and defined-benefit plan to a funded, defined-contribution plan. (2) the replacement of public administration of the program with private administration by competing pension funds, and (3) the separation of the social assistance element from the mandated saving element of retirement provisions. The government is still involved with supervising and regulating the new mandatory but funded scheme, guaranteeing minimum benefits, and financing the transition; otherwise, the market is allowed to play its role.2

Various advantages for the reform approach are claimed by domestic and foreign observers. At the political level, three effects stand out. First, the approach provides a break in the deadlock of traditional reform attempts since it suggests a time-consistent and, hence, credible reform (Holzmann, 1994). Second, the approach isolates retirement provisions to a large extent from political interference and risk (Diamond, 1997; and Godoy-Arcaya and Valdés-Prieto, 1997). Last but not least, it sensitizes workers to financial issues and enterprise performance, thus reducing the dichotomy between capital and labor (Piñera, 1991).

At the economic level, three main reform effects are claimed. First, the reform establishes a close link between contributions and benefits, thus reducing the labor market distortions with which traditional unfunded programs are considered to be fraught (World Bank, 1994). Second, the reform approach furthers and accelerates financial market developments and thus efficiency of resource allocation. Last but not least, the reform affects positively national saving and capital accumulation and. hence, contributes to economic growth (IMF, 1995).

The investigation of these economic effects and first attempts at empirical testing are the core of this paper. If confirmed, the positive effects of such a pension reform approach would go far beyond the successful restructuring of a major public expenditure program, as it would allow the economy of a reforming country to be put permanently on a higher growth path than would otherwise be possible. Placing the reform effects within the framework of endogenous growth theory would also allow, in principle, traditional arguments against a shift from an unfunded to a funded scheme to be overcome since the transition generation would not necessarily be burdened twice. Yet even transitory growth effects of relevant size may substantially reduce or even eliminate the transition costs.

To analyze these hypotheses, the paper has been structured as follows. Section I presents the theoretical underpinnings of the claimed welfare economics effects of the pension reform approach, stressing the importance of externalities and putting the approach within the framework of modern endogenous growth theory and a specific, testable model. Section II outlines the research strategy and discusses the problems of empirical testing posed by the short time span of pension reform and the multiple economic reforms. Section III presents empirical data and preliminary econometric testing of the effects claimed for Chile on total factor productivity, capital formation, and saving. The empirical results are, in general, consistent with most but not all hypotheses and underscore the importance of a sound fiscal policy to support such a reform. Some tentative conclusions are drawn in Section IV.

I. Theoretical Background

Shifting from an unfunded to a funded scheme raises the issue of the repayment of the implicit debt of the existing pension scheme and the burdening of the transition generation. For this reason, countries have generally rejected this reform option.3 However, the welfare economics issue of a “Pareto—improving transition”—which makes at least one generation better and no other worse offreceives a different assessment once the economic externalities of the reform are taken into account, and the case for reform can be strengthened if these effects are embedded in the theory of endogenous growth. This section outlines these considerations.

Pareto-Improving Transition and Economic Externalities

In the conventional world of neoclassical economics, an unfunded pension scheme is Pareto efficient even when the interest rate permanently exceeds the natural growth rate if the scheme does not create economic distortions; for example, if it is financed via lump-sum taxes and provides lump-sum transfers. Although only the first generation gains and all later generations are worse off, there exists no mechanism to reverse the situation without the welfare position of at least one generation deteriorating (Breyer, 1989). The result is intuitively and immediately understandable, as it amounts to an application of the second basic theorem of welfare economics: any lump-sum redistribution of income entails an allocation that is different but also Pareto efficient (Homburg, 1990).

Consequently, a Pareto-improving transition requires either that the fully-funded scheme exhibit fewer distortions than the unfunded scheme—for example, if negative externalities are reduced—or that the fully funded scheme introduce positive externalities, such as a shifting outside the intertemporal budget constraint of the economy. These externalities may result from special growth effects.

The Case of Lower Negative Externalities

Lower negative externalities can be motivated by eliminating the many distortions that an unfunded scheme may exert on intertemporal consumption or on labor supply decisions, resulting in an excess burden. By shifting from an unfunded to a funded scheme, the reduction or elimination of the excess burden may be used to repay the implicit debt of an unfunded scheme within finite time (Homburg, 1990). Because public pension schemes and the way that they are financed entail numerous distortions, a change in the funding mechanism may thus actually improve welfare and, further on, may diminish the impact of population aging.

The conclusion rests, however, on the assumption that the funded scheme is less distortionary for individual saving decisions and labor supply than the unfunded one. Nevertheless, such a result is not necessarily linked with the funding procedure; under the assumption of elastic labor supply, it is typically related to the inadequate link between contributions and benefits in unfunded schemes. Public and earnings-related pension schemes traditionally have a distributional and annuity component, and it is the mingling of both components and the lack of a clear link between contributions and benefits that is claimed to be responsible for the distortions (Schmidt-Hebbel, 1993; and World Bank, 1994). These distortions may also be reduced in an unfunded scheme by separating both components more clearly. For example, a two-tier scheme can be set up in which a basic tax-financed, flat-rate scheme takes care of distributional and poverty considerations. while a fully earnings-related one, financed by earmarked contributions only, takes care of income replacement considerations. However, it remains unclear at the theoretical level whether such a separation always creates fewer distortions than a well-conceived, traditional social insurance scheme. The basic poverty-oriented component will exist in any alternative scheme, and the incurred distortions are the inevitable consequence of introducing distributional activities. The remaining distortions in the fully earnings-related scheme are reduced to the effects of the funding mechanism. These effects may exist because a nondistortionary pension scheme requires actuarial neutrality, which can be achieved in an unfunded scheme only if the implicit rate of return (the natural rate of growth) equals the rate of interest (that is, if the golden rule of growth holds (Breyer and Straub, 1993)). Put differently, an unfunded pension system will always entail a net tax on labor if the system’s implicit rate of return is below market, and the implicit tax burden may be sizable (Valdés-Prieto, 1997).

Even if the funded scheme were nondistortionary compared with the unfunded one, new distortions may be introduced through the transition and the financing of the now explicit social security debt. To keep the ratio of debt to GDP constant, the interest rate-economic growth rate differential of this debt has to be financed via taxes, and a new excess burden may emerge. However, as the higher rate of return allows a lower contribution rate to pay the same benefit, a new wage tax may be introduced to keep the take-home pay constant and limit the new explicit debt.

Finally, the decision to shift from an unfunded to a funded scheme is also a question of the scope of the expected welfare gains. Simulation studies with overlapping generation models à la Auerbach and Kotlikoff (1987) suggest that the welfare gains resulting from the elimination of labor market distortions are comparatively small. A model calibrated on the German pension system exhibits long-term welfare gains of some 9 percent of lifetime resources of future generations if the transition generation is not compensated. With compensation, the long-term welfare gains are reduced to some 1.5-2 percent of lifetime resources of future generations (Raffelhuschen, 1993). Simulations by Kotlikoff (1996) provide larger welfare gains to future generations of 4.5 percent (while compensating the transition generation) when it is assumed that the tax-benefits linkage is weak, that the initial tax structure features a progressive income tax, and that consumption tax is used to finance the transition. However, when the initial tax structure is a proportionate income tax, the tax-benefits linkage is strong, and income taxes are raised to finance the transition, there is a 3.1 percent welfare loss to future generations. Other studies exhibit similar small and distant welfare gains. Long-term welfare effects of some 1.5-4.5 percent under a potential Pareto-improving transition are likely to be too small to convince politicians to undertake a transition technically and politically difficult when potential gains emerge only in the distant future.

The Case of Positive Externalities

The other argument for a shift toward (fully or partially) funded pensions is based on positive externalities resulting from a change in the financing mechanism.

In the framework of traditional neoclassical theory (that is, exogenous technical progress and, thus, a given intertemporal budget constraint), welfare gains can be derived from portfolio considerations. It can be argued that the internal rate of return of an unfunded scheme—the natural growth rate—is a stochastic variable that exposes each pension cohort to an income risk. The same can be claimed for the internal rate of return of a funded scheme—the interest rate. Thus, if the covariance of both returns is lower than one, a mixed financing mechanism reduces the overall income risk and provides positive welfare effects.

Potentially larger welfare effects can be achieved by changing the financing mechanism, which can shift outward the intertemporal budget constraint. Such a shift can be derived from endogenous growth considerations with regard to labor market and financial market externalities.

At the labor market level, the type of pension scheme (unfunded or funded) and the perceived link between contributions and benefits can determine the distribution of labor supply between the formal and informal sectors. If the latter is less productive, a pension reform that moves labor supply to the formal sector will enhance overall productivity and can in an endogenous growth model lead to a higher growth path (Corsetti, 1994).

At the financial market level, a shift from an unfunded to a funded scheme can promote the development of financial markets by making them deeper, more liquid, and more competitive. The resulting enhanced resource allocation may lead not only to a onetime efficiency gain but also to a permanently higher growth path (Holzmann, 1994).

Financial Market Intermediation and Endogenous Growth

The modeling of financial markets and investigation of their welfare economics and growth implications are still in their infancy. The claim that the effectiveness of financial markets and the level (or rate of growth) of real activity are closely related, however, is not new; empirical investigations have been undertaken for decades (for example, Goldsmith, 1969). Against the background of neoclassical growth theory, however, these studies could argue only for temporary efficiency effects resulting from financial market developments.

More recent developments in growth theory allow for level as well as growth-path effects, but these models concentrate on specific aspects of financial markets and their impact on real activity. In one model, for example, financial markets provide liquidity, allowing a shift from current liquid but unproductive assets toward less liquid but more productive assets (for example, Bencivenga, Smith, and Starr, 1996). In another model, financial markets promote the acquisition and the dissemination of information, thus allowing for better resource and risk allocation (for example, Greenwood and Jovanovic, 1990). In a third model, financial markets permit agents to increase specialization, shifting away from less specialized and inefficient technologies (for example, Saint-Paul, 1992). All these models cover important aspects of financial markets and their impact on real activity, providing important analytical insight on issues raised in the literature for decades. However, they all fall short of providing a comprehensive framework of the different effects of financial markets and of empirically testable relationships. Establishment of this framework still awaits future work.

To introduce potential growth effects of financial market developments into an endogenous growth model in a simple but testable manner, the following structure is proposed, borrowing from Villanucva (1993):4

dk/dt=s(k,...)Y−δK, with⁢ ∂s/∂k>0,and(1)
dT/dt=α(k,...)K/L+λT, with⁢    α>0.(2)

The saving ratio (that is, the investment ratio in a closed economy) is positively related to a variable measuring the depth, liquidity, and maturity of financial markets, summarized in the parameter K. Further variables that may influence the national saving rate are public saving behavior or tax regulations. Also, the change in technical progress, dT/dt, is dependent not only on the exogenously given rate of labor-augmenting technical change, λ, but also on an efficiency variable, α, that interacts multiplicatively with the ratio of capital to labor. α(K, . . .) depends on the financial market variable, K, and also on other variables traditionally quoted in the literature (such as the level of export orientation and the share of education expenditure in the budget). λ captures other growth effects not explicitly detailed in the model.5

In this model, the steady state growth rate of the economy depends positively on the level of K:

[(dT/dt)/Y]*=α(k,...)K*+λ+n=g*(k*),(3)

with k*, the steady state capital intensity, measured in efficiency units of labor. The model leads to the traditional result for α = 0. With α > 0, however, a higher saving rate leads not only to an increase in the optimal capital-labor ratio (as in the traditional growth models) but also to a higher steady state growth rate, which in traditional models is not influenced by the saving rate.

A further important property of the model under an optimal consumption plan (that is, ∂c*/∂s = 0) is that both the steady state growth rate and the optimal net return on capital are higher than the exogenous rates of technical progress and population growth:

∂f(k*)/∂k*−δ=g*(k*)+α(k,...)k*=λ+n+2α(k,...)k*.(4)

Hence, compensating the transition generation by the conventional rate of return of an unfunded scheme only (that is, by λ + n, assuming that a was zero prior to the shift to a funded scheme) while using part of the growth differential (up to 2α (K, . . .) k*) to finance the transition allows, in principle, for the construction of a Pareto-improving transition to a funded scheme.6 One approach could be to pay wages (and pensions) to individuals according to the old growth path until the growth differential allowed the repayment of the implicit debt. As the marginal product of each worker increases at the same rate as his efficiency, g* (k*)—n, capturing this growth differential requires the use of lump-sum taxation to ensure Pareto indifference for the transition generation until the social security debt is repaid.

II. Testing the Impact: Conceptual Considerations and Data

Establishing statistically significant links between pension reform, the financial market variable, K, the endogenous variable of technological progress, a (K, . . .), and the saving/investment rate, S(K, . . .), poses at least four main problems:

  • The multiplicity of reforms undertaken makes it difficult to separate the influence of competing explanations for growth developments, such as strengthened macroeconomic stability and enhanced export orientation.

  • It is likely that financial market development is only a necessary but not a sufficient condition for higher growth, to which pension reform may contribute via acceleration.

  • Currently, there is no established methodology to differentiate between (conditional) convergence and transitory and endogenous growth effects.

  • There are data problems, including the length of usable time series. The Chilean economic data are in better shape than most other emerging markets, but this qualification is true only for the most recent data.

Against this background, a research strategy is applied that should strengthen confidence in the hypothesis advanced of the effects of pension reform on financial market development and growth, although a watertight proof may not exist. The strategy consists of three elements.

First, appropriate indicators of financial market developments are constructed to determine the impact of pension fund activities, and the relationship between those indicators and α and s (technological progress and the saving/investment rate) is empirically tested. Pension funds should contribute to deeper financial markets, higher liquidity, enhanced competition, and better risk allocation in financial markets. The financial market indicators should be able to measure these effects.

The financial interrelation ratio (FIR) compares the range of financial instruments with the net wealth of the economy (approximated by the capital stock). The financial intermediation ratio (FMR) compares the scope of financial instruments with the assets of the financial institutions. Two alternative measures of financial instruments—and thus indices—are considered. FIR-1 and FMR-1 follow an instrument concept, as used in some Chilean studies, to present the scope and structure of financial markets (De la Cuadra and Valdás-Prieto, 1992). These instruments measure only financial liabilities, enhanced by the assets (≈liabilities) of pension funds, mutual funds, and insurance companies. FIR-2 and FMR-2 follow the more traditional approach of measuring financial market instruments (as pioneered by Goldsmith, 1969). These instruments cover both the asset and liability sides of the financial market and thus deliberate double count, but they are restricted to claims to the financial and nonfinancial sectors plus equity holdings. Traditionally, both indices have been rising with economic development, leveling off only at an advanced stage of an economy (Goldsmith, 1969).

A stock market index, the average of three stock market indicators, is intended to capture the impact of that market on economic activity (Levine and Zervos, 1996). The market capitalization ratio equals the value of listed shares divided by GDP. It is assumed that the overall stock market size is positively correlated with the ability to mobilize capital and to diversify risk on an economy-wide basis. The total value-traded ratio equals the total value of shares traded on the stock market exchange divided by GDP. The turnover should reflect liquidity on an economy-wide basis. The turnover ratio equals the value of total shares divided by market capitalization. Since the market capitalization ratio may be high and the value-traded ratio low, or vice versa, the ratio of both—that is, the turnover ratio—complements the prior indicators.

Indicators for competitiveness and risk allocation may be derived by asset mispricing, which is the calculation of the systematic deviations of actual returns and those implied by reference models: the capital assets pricing model and the arbitrage pricing model (Korajczyk, 1996). The hypothesis is that rising pension fund activities should make the financial system more efficient, thus contributing to a reduction in the mismatch between the actual returns and those implied by reference models.

Second, cross-country results investigating the impact of financial market developments on economic growth, capital accumulation, and productivity improvement for 41 countries for the period 1976-93 are compared, using the stock market index approach (Levine and Zervos, 1996). Controlling for initial conditions and various economic and political factors, this relationship turns out to be statistically significant and robust; the predictive power of financial market developments in forecasting economic growth over 18 years implies that (1) financial developments do not simply follow economic activity, and (2) the strong link between both does not merely reflect positive correlation among contemporaneous shocks to financial markets, institutions, and economic activity. These results give confidence in the causality of the influence and allow for a comparison with own results with regard to the sign and magnitude of estimated parameters.

Third, the claims for this paper’s hypothesis are cross-checked using other methods and data. Given the multiplicity of the reforms in Chile and the often nonquantitative nature of the links between pension reform, financial market developments, and changes in macroeconomic variables, no full proof of the hypothesis can be expected. However, applying different methods and checking for consistency against other claims should enhance confidence in the results.

III. Preliminary Empirical Results

This section presents empirical evidence and preliminary econometric results on the conjectured link of pension reform with financial market developments and economic growth. The first link is investigated by assessing the impact of the pension fund’s activities on financial market indicators, and the second link by assessing the impact of these indicators on total factor productivity, capital formation, and saving.7 The impact of the pension reform on labor market performance was also investigated, and the results are consistent with the claim that a closer link between contributions and benefits promotes formal market participation. However, the quality of the data did not allow econometric testing, and the qualitative results are not reported for reasons of space.

Pension Reform and Financial Market Development

A central claim about the effects of the Chilean pension reform, echoed internationally, is its contribution to the development of the financial sector (IMF, 1995). The general hypothesis is that the rising investment needs of the pension funds, the instruments thereby created, and the competitive setup of the privately managed pension funds made the financial market deeper, more liquid, and more competitive. An inspection of the data and very simple empirical testing seemingly confirm the claims.

Essentially, all investigated financial market indicators moved upward strongly once the banking crisis of 1981-83 had been solved (Figures 1 and 2). The FIRs show a strongly rising tendency that well exceeds the level reported for prior decades.8 The FMRs exhibit a similar development, with FMR-2 reflecting the strong increase in bank credits to the private sector that ultimately led to the banking crisis and the consolidation afterward. The almost linear rise in the stock market index started in 1985, which was the year of the first participation of pension fund in stock market activities. Prior to this date, the investment rules permitted only the purchase of debt instruments. At the end of 1994, pension fund assets constituted almost 40 percent of all outstanding financial instruments, and the total pension fund assets at the end of 1994 amounted to 41 percent of GDP (Figure 3).

Figure 1.
Figure 1.

Financial Market Indicators

Citation: IMF Staff Papers 1997, 002; 10.5089/9781451947243.024.A001

Note: FIR-1 and FMR-1 measure financial liabilities, enhanced by the assets (≈liabilities) of pension funds, mutual funds, and insurance companies. FIR-2 and FMR-2 measure both financial assets and liabilities, but they are limited to claims to the financial and nonfinancial sectors and equity holdings.
Figure 2.
Figure 2.

Stock Market Indices

Citation: IMF Staff Papers 1997, 002; 10.5089/9781451947243.024.A001

Figure 3.
Figure 3.

Pension Fund Assets and Financial Market Indices

Citation: IMF Staff Papers 1997, 002; 10.5089/9781451947243.024.A001

Note: For definitions of FIR-1 and FIR-2, see Figure 1.

The correlation of pension fund assets and financial market indicators, as well as of pension fund shares in total traded shares and the market capitalization ratio, is very strong, with coefficients in simple regressions close to 1 and R2 of 0.9 and above (not shown). At a monthly level, there is also a strong correlation between the turnover in asset trade (including bonds and shares) and the level of assets held by the pension funds at the end of the month (as a proxy for turnover since no such data are available), with a break occurring about the end of 1984. Before 1985, the correlation is zero or negative, except for the trade in assets with fixed return (ρ = 0.65); this was the period when pension funds were restricted to the holding of debt instruments. For the period January 1985 to June 1995, the correlation between the monthly turnover in each asset and the stock of pension fund assets at the end of the month was always above 0.9. This empirical evidence is consistent with the claim that pension funds made the financial markets deeper and more liquid.

With regard to the contribution of pension funds to enhanced competitiveness and risk allocation, the available data allow only for a very cursory investigation. The indicators of asset mispricing, based on the arbitrage, capital assets, and international assets pricing models, respectively (Korajczyk, 1996), are compared with the indicators of pension fund assets.9 If the pension fund activities improve the performance of the financial markets, the mispricing should decrease with enhanced fund activities. The correlation between the mispricing and pension fund indicators has the expected sign, is statistically significant at the 5 percent error level, and ranges between minus 0.27 and minus 0.52.

Pension fund activities are contributing to a more sophisticated financial market, as evidenced by the role of pension funds in the development of financial instruments, such as indexed annuities, the provision of funds to key sectors, such as mortgage bonds to finance housing, the importance of enterprise bonds (which are mainly held by pension funds), and the increased holding of traded shares by the pension funds. With the gradual relaxation of regulations for pension fund investments, their portfolios also have become more diversified (Table 2). Various evidence suggests that pension funds are operating efficiently and that the selected portfolios—given that the restrictions on asset investments are only gradually being lifted—are on the (restricted) efficiency frontier (Walker, 1993a and 1993b). In a competitive environment, this may constitute indirect proof of the overall efficiency of the financial system.

Table 2.

Investment Portfolios of Pension Funds

(In percent of total investments, unless otherwise indicated)

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Sources: Superintendency of AFP, Statistical Bulletin; and PrimAmérica Consultatores (1995).

Yet all this evidence does not establish watertight proof that the establishment of pension funds has been the decisive factor in the impressive development of financial markets since the mid-1980s. The empirical evidence is only consistent with the claim. The healthy growth and development of financial markets after 1983 may simply reflect changes in legislation and the lessons learned from the experiences and mistakes of the late 1970s and early 1980s.10 Since the counterfactual of the development of financial markets without pension reform cannot be established and empirical evidence from other countries with similar reforms is not at hand, it may be impossible to prove the claim. Hence, in order to increase confidence in the claim, further evidence using different approaches is required.

Total Factor Productivity and Financial Market Development

The model outlined above assumes that the change in labor productivity, dT/dt, is determined by an exogenous component λ and a component α (K, . . .) K/L that is positively dependent on the financial market indicator K. In the selected specification, we use total factor productivity, TFP,11 which in a linear approximation should exhibit a positive dependence from K:

TFPt=a0+a1D(L)kt+a2Xt+ut,(5)

with D (L) an appropriately chosen lag structure for K, since the effects can be expected to be distributed over various periods, and X representing other variables able to capture further impacts, the most important of which are cyclical effects via the use of the unemployment rate and its change.

The basic idea behind this specification of TFP—the Solow residual—is that it reflects technological shocks following (perhaps) a stationary autoregressive process (hence, the alternative inclusion of the lagged TFP). Including the unemployment rate and its change is an (imperfect) attempt to capture the cyclical development during the period under investigation, keeping in mind the high likelihood that the stock of factors (capital and labor) does not correctly represent the factor services actually provided. In the steady state, the term with the (now constant) unemployment rate collapes with the constant, and the impact of the change in the unemployment rate disappears. This simple specification (which also takes account of the limited number of observations) leads to a satisfying statistical fit for the reduced sample period (Table 3).12 In accordance with the endogenous growth model, the improvement of financial markets is specified to have a permanent level effect on total factor productivity. Indeed, adding the financial market indicators improves the overall fit, yielding for most lagged market indicator variables (with an Almon-lag-type structure)13 coefficients that are significant at the 5 percent level and below while reducing the significance of the constant. The low t-value for the stock market index may be due to high multicollinearity between the unemployment rate and the stock market index, but alternative specification and estimation techniques were not successful. The estimated parameter values prove to be robust for different specifications and time periods of estimation (not shown), and the lagged impact of financial market indicators (compared with the contemporaneous impact, which proves statistically to be totally insignificant) gives confidence in the causality.

Table 3.

Total Factor Productivity and Financial Market Developments

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Notes: OLS method is used. Endogenous variable is TFP (total factor productivity). UER is the unemployment rate, and FMI is the financial market indicator. Measures of FMI used in the equations are FIR-1, FIR-2, FMR-1, FMR-2 (defined in Section II), and SMI (stock market index). Period of estimation is 1979-94, with lagged variables for FMI estimator starting in 1975. Absolute t-values in parentheses.

Taken at face value, the results suggest that financial market developments strongly affect total factor productivity. Using the point estimates and assuming an equilibrium unemployment rate of 5 percent, the exogenous technical progress would amount to some 1 percent, to which 1+ percent of technical progress generated by financial market developments is added, yielding long-term annual total factor productivity of 2+ percent. The estimated financial market indicator effect of 1+ percent is likely to proxy other effects that may be highly correlated with financial market developments, such as reductions in exchange rate restrictions and increasing openness of the economy. Given data restrictions, the separation of these effects is not possible currently.

The magnitude of parameter estimates for the stock market index variable in equation (4) in Table 3 invites comparison with the estimates for the cross-country study quoted above (Levine and Zervos, 1996). Their point estimate is 0.007 (with a t-value of 1.96), compared with our results of 0.004 and 0.005. While the statistical closeness of the point estimates may be spurious, the coincidence is surprising.

In summary, the tentative empirical evidence suggests a positive impact of financial market developments on total factor productivity and thus economic growth. The available data and estimates do not allow one to distinguish between permanent and transitory effects. Yet, even if the higher total factor productivity of 1 percent a year were only of a temporary nature, it would if accumulated over 20-40 years provide welfare gains for current (and all future) generations, which should permit a major compensation of the transition generation.

Capital Formation, Saving, and Financial Market Development

In economic policy discussions, both capital formation and national savings are generally claimed to be positively influenced by a deepening of the financial market induced by pension reform (IMF, 1995). In a closed economy, the overall effect should be identical but may lead to a different distribution between public and private sector investments, on the one hand, and saving balances, on the other. In an open economy, foreign saving may additionally compensate for sectoral investment or saving imbalances. The traditional wisdom is that the influence of financial market deepening on both capital formation and saving is positive. However, further theoretical considerations and international empirical evidence suggest that the effects can go in either direction or compensate to zero.

A positive relationship between financial market indicators and capital formation (as measured by the change in real capital stock) is suggested by considerations of better access to financing (that is, reduced borrowing constraints), enhanced incentives to undertake longer-term investment projects, and better risk allocation. However, a more efficient market, with reduced transaction costs and higher rates of return for all investment projects, may also lead to a redirection of the holding of wealth by economic agents in the form of existing equity claims and to less new capital investment (Bencivenga, Smith, and Starr, 1996).

Preliminary econometric testing for Chile suggests that the change in capital stock follows an adjustment process, with the lagged variable figuring very significantly. This process is also influenced by cyclical effects, or expectations about future income developments, as proxied by the unemployment rate (Table 4).14 Inserting the lagged financial market indicator variables (again with an Almon-type lag) leads to an improvement in the equation fit and to coefficients that are consistent in sign and significant at the 5 percent level and below. The exception is the stock market index variable, which leads to insignificant coefficients, possibly reflecting the same multicollinearity problems noted above.

Table 4.

Capital Formation and Financial Market Developments

article image
Notes: Endogenous variable is K Percent (change in real capital stock). For definitions of exogenous variables and other regression information, see notes to Table 3.

Again, taking the point estimates for the FIR and FMR variables at face value, the long-term growth rate in real capital stock is some 5–8 percent. This rate is reduced by an assumed long-term unemployment rate of 5 percent by some 1-2 percentage points but increased by the enhanced financial markets by about 1.5 percentage points, or by more than one-fourth of its “natural” level. This result hints at the nonnegligible effects of financial market developments on the formation of capital stock. These effects have to be considered in addition to the effects on total factor productivity in assessing the growth consequences of financial market developments.15

With regard to the relationship between financial market indicators and saving, the same theoretical qualifications about the a priori sign and strength apply. Financial market developments may induce higher (private) saving via the provision of attractive saving outlets, but they may also reduce saving for a number of reasons. First, real interest rates may be higher, and the conventional income effect may prevail over the substitution effect. Second, better risk diversification is likely to change the form of saving and may reduce the level. Third, annuities may be available (allowing for higher old-age consumption and reducing the amount of unintended bequests). Finally, access to consumer credits may be improved (allowing for better consumption smoothing).16

Preliminary econometric testing suggests that the negative effect of financial market developments on private saving prevails (Table 5). The basic specification of the private saving rate, with the constant and unemployment variables as the explanatory variables (again proxying income expectations), is generally improved if financial market variables are added. These financial market variables enter negatively, with parameters that are statistically significant at an error level of 5 percent and below (except, again, for the stock market index). This finding is consistent with international evidence on the impact of financial market liberalization and private saving behavior (IMF, 1995). Nevertheless, in view of the rising national and private saving in Chile in recent years, the result is surprising and requires a closer look at the components of, and developments in, saving.

Table 5.

Private Savings and Financial Market Developments

article image
Notes: Endogenous variable is SPR (private saving as a share of GDP). For definition of exogenous variables and other regression information, see notes to Table 3.

Pension Reform and National Saving

The structure and development of capital formation and its financing over the last 20 years exhibits a strong rise in the private saving rate since the mid-1980s, the substantial importance of public saving, and the fall in importance of foreign saving (Figure 4). Public plus private saving—that is, national saving—has reached levels not achieved since at least 1970.

Figure 4.
Figure 4.

Capital Formation and Financing

(In percent of GDP)

Citation: IMF Staff Papers 1997, 002; 10.5089/9781451947243.024.A001

To gauge the impact of pension reform on national saving, a different disaggregation, consistent with the System of National Accounts (SNA), is proposed. A balancing item is calculated that consists of two components: the private saving generated (in an accounting sense) by the new scheme, reduced by the fiscal costs (that is, public dissaving). The first component, the saving generated, consists of two flows: (1) the net contribution payments to the new scheme (essentially the 10 percent premium revenue), which in the SNA is considered as private saving; and (2) the returns on assets generated by the new scheme. These returns are not equivalent to the change in assets by the pension funds (net of contribution payments), as the asset increase comprises both capital gains and flow effects. We are interested only in the latter, which are part of private saving in the SNA. Both flows were estimated from available data.17

The second component, the financial costs (public dissaving, excluding the interest payments resulting from the larger fiscal deficit), consists also of two flows: (1) the deficit in the old scheme arising from the loss of contributors (which was approximated by the state contribution to the old scheme, excluding assistance pension financing); and (2) expenditure for recognition bonds, which compensate those who switched to the funded scheme for rights acquired under the unfunded scheme, as reported in the social security statistics.

Table 6 indicates that the contribution of pension reform to national saving was negative from the inception of reform in 1981 until 1988. The positive balance since 1989 is essentially due to higher returns on capital investment, while the flows from premiums in percent of GDP remain largely constant at about 2.5 percent. Also, the fiscal costs exhibit in 1990 an increase of only some 0.8 percent of GDP (owing to improved pension indexation by the new government).

Table 6.

Pension Reform and Saving Effectsa

(In percent of GDP)

article image
Sources: National statistics; PrimAmérica Consultatores (1995); and author’s calculations.

Consistent with system of national accounts.

Pension contributions to pension funds plus other increases minus commissions minus benefit payments.

Change in pension assets net of capital gains.

State contribution to social security pension funds (net of payments for social assistance).

Figure 5 disaggregates national saving according to (1) the saving balance of pension reform; (2) the private sector saving net of the pension system; and (3) the public sector saving net of (that is, plus) the fiscal costs. The striking message of this disaggregation is the parallel rise of each net saving item in the period 1984–87 and their leveling off in the period 1988-90. Since then, both private saving and public saving net of the pension system have remained largely constant at slightly above 10 percent of GDP. The positive net contribution of the new pension system to national saving began after both private and public saving net of the pension system had peaked, thereby confirming the econometric evidence that the pension reform had no direct, positive impact on private or national saving.

Figure 5.
Figure 5.

Pension Reform and National Saving

(In percent of GDP)

Citation: IMF Staff Papers 1997, 002; 10.5089/9781451947243.024.A001

a Net of pension system.

Figure 6 highlights the contribution of fiscal performance and public saving to the transition from an unfunded to a funded pension scheme, as well as the fiscal costs involved in that transition. The figure shows that restrictive fiscal policy that pays off government debt through higher taxes or lower expenditure and thus shifts resources from current to future generations encourages higher saving and capital formation.

Figure 6.
Figure 6.

Fiscal Performance

(In percent of GDP)

Citation: IMF Staff Papers 1997, 002; 10.5089/9781451947243.024.A001

Reportedly, the Chilean authorities deliberately strengthened the fiscal stance for some years before beginning the pension reform.18 This strategy led in 1980 to a positive budget balance of the general government of 4.4 percent of GDP and a public saving rate—that is, the balance of current public revenue and expenditure in percent of GDP—of 7.4 percent of GDP.

The ensuing decline in both the fiscal stance and public saving triggered by the beginning of the reform in 1981 was quickly reversed; the public saving rate became positive again in 1985, and the fiscal stance was balanced in 1988. The share of current revenue as a percent of GDP declined, owing to various tax reforms and tax rate cuts, but the fiscal stance was strengthened through program reforms and expenditure cuts (see Marshall and Schmidt-Hebbel (1994)). The new, democratic government that came into office in 1989 has stabilized the expenditure level but has done little to reverse the trend of declining revenue.

On the surface, this fiscal behavior suggests that pension reform and its transition is being fully financed by the current generation through a lower level of public consumption, in contrast to the alternative of shifting the burden to future generations via larger (explicit) public debt. However, this assessment is partly changed if the counterfactual chosen is the old growth path without reform. If, in an extreme formulation, all the growth differential of real GDP of up to 2 percent a year resulting from higher total factor productivity and capital formation were to be attributed to pension reform, the net burden for the transition generation would amount to about 3 percent a year, given fiscal costs of transition of some 5 percent a year. However, a strengthening of the fiscal stance is also required in this counter factual, as the budget captures only a fraction of the increased output level (some 20 percent) while the remainder flows to the private sector.

IV. Tentative Conclusions

Given the still incomplete state of the data and the tentative, simple econometric testing done, the conclusions reached in this paper can be seen as only very provisional. However, three main conclusions are suggested.

First, the empirical findings are seemingly consistent with the claim that financial market developments enhanced economic growth and that pension reform has contributed to this development. The links between financial market indicators and total factor productivity and capital accumulation are surprisingly robust, and a link between pension funds and financial market developments is suggested by the data with regard to the level and scope of their interaction. However, the question of how the financial market in Chile would have developed had the pension reform not taken place may never be answered.

Second, contrary to the common belief about the effects of the pension reform, the empirical findings suggest that the direct effect of financial market developments on the private saving rate was negative. These results are supported by an alternative approach that disaggregates the impact of pension reform on the national saving rate along SNA lines. The data indicate that net pension savings were negative until 1989 and small afterward. These approaches independently suggest that the conventionally assumed impact of a Chilean-type pension reform on private (and national) saving may not hold.

The suggested alternative causality is twofold: (1) economic growth owing to higher total factor productivity and capital accumulation and better labor market performance is at the heart of the higher private saving rate; and (2) the increase in the private saving rate is strengthened by higher public saving. Including the financing of the transition costs of the reform, public saving increased by some 10 percentage points of GDP, about one-half of which was used to finance the reform.

These results also temper the optimism reigning in countries in Latin America and Eastern Europe, where pension reform is seen as an easy vehicle to boost national saving, and thus capital accumulation and growth. Receiving the economic benefits of such a reform is likely to require a comprehensive and credible economic reform package and definitely requires a tight fiscal stance. Otherwise, the positive effect of financial market development on total factor productivity may not emerge, or it may be (partially) counteracted by reduced capital formation or require higher foreign saving. However, if the fiscal stance is considered weak, higher foreign saving may not materialize.

Third, the main message from the Chilean experience for the emerging economies throughout the world is, in principle, encouraging. Pension reform and a shift from an unfunded to a funded scheme may create positive externalities (on labor and financial markets), thereby accelerating the growth rate. Furthermore, these potential (endogenous or transitory) growth effects ease or perhaps even eliminate the double burden for the transition generation (if measured according to the old growth path). Finally, the potentially higher growth path may allow for some back-loading of the fiscal implications via recognition bonds and other devices.

However, pension reform as implemented in Chile requires a comprehensive reform package covering essentially all areas of macroeconomic and microeconomic policy and institution building, supported by a tight fiscal policy. Moreover, pension reform must not be left only to social policy specialists; it should be entrusted also to economists of different backgrounds, including industrial economics, public finance, and financial markets.

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1

For a survey of the Latin American pension reform attempts and further references, see Queisser (1995); for a review of the current reform approaches in Central and Eastern Europe, see Holzmann (1997).

2

For a detailed survey and analysis of the Chilean pension reform and further references, see Diamond and Valdes-Prieto (1994).

3

Merely changing the financing mechanism of an unsustainable, unfunded retirement scheme is not sufficient to put it on a sustainable, funded basis. Any real pension reform essentially has to undertake two changes simultaneously: reduce the commitment of the given pension scheme (given target income replacement rates, essentially by increasing the retirement age) and shift the financing mechanism.

4

The other four equations of this growth model are traditional. The first specifies the output, Y, via a production function with constant returns to scale on capital, K, and labor, N (man-hours in efficiency units):

Y=F(K, N)=Nf(k).

The second equation specifies an exogenous growth rate, n, of total employment (in man-hours, L):

dL/dt = nL.

The third specifies a definition equation between N and L via the technicalchange multiplier, T:

N = TL.

The fourth equation defines the capital coefficient:

k = K/N.

d(.)ldt is the time derivative. and δ is the rate of depreciation of capital.

5

As the model features an external effect, the solution of the social planner’s problem will not necessarily coincide with the competitive equilibrium in a decentralized economy.

6

In the decentralized solution, the net rate of return with externalities is f’(k*) - δ = λ + n + α (K, . . .) k*, still leaving a growth differential of a (K, . . .) k* to compensate the transition generation.

7

The data draw from a wide range of different sources, mainly official but also private. Long-term time series in official publications are often not available and sometimes require index-type linking to overcome structural breaks.

8

No strictly comparable FIRs could be established for the pre- and post-1975 periods. However, the available data for Chile suggest a long-term decrease in FIR-2 from 63 percent (1940) to 32 percent (1950) and 29 percent (1960), with a slight increase to 39 percent (1971) prior to a major shake-up of the economy (Cerda and Zeballos, 1975).

9

These data are used in Levine and Zervos (1996), and the access granted by Ross Levine is gratefully acknowledged.

10

For an analysis of the experience and mistakes of financial market liberalization during this early period of economic reform, see De la Cuadra and Valdes-Prieto (1992).

11

To estimate TFP, a simple growth-accounting exercise is undertaken (with logarithmic approximation to account for discrete time and a constant labor share of 0.65). Admittedly, this estimation ignores its well-known limitations, such as the quality of factor inputs and the time-varying factor shares, because of data constraints.

12

For definitions of the variables used in the regressions in Tables 3-5, see notes to Table 3. All variables in Tables 3-5 have been subject to a unit root test (augmented Dickey-Fuller test), which has been passed for all endogenous and most exogenous variables at the 5 percent confidence interval. For the unemployment rate, the unit root could not be rejected. This outcome may cast doubt on the estimated parameters and their statistical significance; although the stability of the parameters under alternative measures of financial markets and the Durbin-Watson test statistics of about 2 may give confidence in the results, further investigation is certainly required.

The parameter estimates for the ΔFIR and ΔSMI variables differ slightly from previously presented estimates, owing to data revisions and the normalization of the respective sample average to one. The normalization allows for a direct parameter comparison between different financial market indicators and a straightforward interpretation of the parameter value.

13

The approach uses the data structure of the Almon lag to calculate a composite variable ΔFMI(1, s)t = 1sΔFMIt + 2sΔFMIt-1 + . . . 1sΔFMIt-1. Thus ΔFMI (2,2)t = ΔFMIt + 4ΔFMIt-1 + 9ΔFMIt-2. This approach results from economic, econometric, and data considerations. One would assume from an economic viewpoint that improvements in the financial market, as measured by changes in the level of FMI, would have little immediate impact but that the impact would grow over time. However, a direct application of the traditional Almon procedure is prevented by the small number of observations, with the increasing s under the full Almon approach reducing the degrees of freedom on a pro rata basis. In addition, AFMI (1,s) for 1 and s = 1, . . . , 3 proved to be highly correlated. Finally, unless very strict conditions are met, the Almon procedure will yield biased and inconsistent estimates.

14

In view of the weak public sector statistics for Chile, the use of the unemployment rate is preferred to the use of disposable income.

15

Our reported long-term point estimate of the effects of financial markets on capital accumulation of about 0.015 is close to the estimate in the Levine and Zervos (1996) cross-country study of 0.011 (with a t-value of 2.38).

16

See Masson, Bayoumi, and Samiei (1995) for empirical references.

17

The net contributions were calculated as premium payments plus other increases minus commissions charged minus benefit payments. The flow returns on pension fund assets were calculated using the average yearly stock and a representative interest rate of the financial market. In principle, the flows ought to be corrected for savings generated in the upstream insurance companies and for dissavings generated by benefit payouts, but these data were not at hand.

18

The source for this information is Juan Carlos Mèndez, Budget Director until 1980, quoted in Diamond and Valdéz-Prieto (1994).

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Papers
IMF Staff papers: Volume 44 No. 2
Author: International Monetary Fund. Research Dept.
Volume/Issue:
Volume 1997: Issue 002
Publisher:
International Monetary Fund
ISBN:
9781451947243
ISSN:
1020-7635
Pages:
156
DOI:
https://doi.org/10.5089/9781451947243.024

Financial Market Indicators

Stock Market Indices

Pension Fund Assets and Financial Market Indices

Capital Formation and Financing

(In percent of GDP)

Pension Reform and National Saving

(In percent of GDP)

Fiscal Performance

(In percent of GDP)