Abstract
According to the demographic projections described in section 1, the coming decades will witness large differences, at the individual country level, in both the timing and extent of the ageing phenomenon. On the basis of a no-policy change assumption, these demographic differences have the potential to result in slower rates of GDP and investment growth, lower public and private savings and large shifts in the respective shares of world output held by developed and developing countries. With such fundamental changes in the relative positions of countries in terms of savings / investment balances, this book predicts that the world will increasingly witness both protracted swings in current account and net foreign asset positions over the coming decades as well as big changes in real interest rates and exchange rates. While section 4 will provide the models central predictions for the evolution of these “financial” market variables over the coming decades, the focus of the present section is mainly historical, with its primary purpose being to lay out the empirical evidence justifying the assumptions adopted for the simulations in the subsequent sections with regard to:
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firstly, the degree and nature of global capital market integration and especially whether an assumption of limited, as opposed to full, worldwide capital market integration35 is appropriate or not (section 3.1); and
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secondly, whether the evidence supports this book’s central assertion that demographics is becoming a significant driver in terms of both the volume of external capital movements and in explaining the trend evolution of changes in the foreign wealth/debt positions of countries over the last 30 years (section 3.2) and in the future (section 3.3).
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Capital market integration is defined in terms of an absence of crowding out of domestic investment by domestic savings patterns i.e. a low degree of correlation between domestic savings and investment trends. This definition also encompasses the concept of financial market openness which is measured using gross stocks of foreign assets and liabilities as a % of GDP for the respective countries.
Argentina, Australia, Canada, Denmark, France, Germany, Italy, Japan, Norway, Sweden, UK, US.
For example, Lucas (1990) estimated, using a simple production function approach, that the implied marginal product of capital in India was about 58 times that of the US. Despite such large productivity differentials, Lucas stressed, that apart from international capital market failures, that differences in labour productivity, linked to higher levels of human capital investment in developed economies, could be a possible explanation for the paucity of resource flows in the face of such apparent profit opportunities. In fact he went on to emphasise that “correcting for human capital differentials reduces the predicted return ratios between very rich and very poor countries from about 58 to at least about 5, and possibly, if knowledge spillovers (i.e. the external effects of human capital) are local enough, to unity”. This line of research by Lucas is also a feature of the work of Clark (1987) and Lal (1991).
This analysis of the gross stocks (and at the net level in 3.1.3) draws heavily on the “External Wealth of Nations” dataset created by Lane and Milesi-Ferretti (2001). This dataset is used for a large number of the graphs in section 3 (graphs which draw on complementary data sources are indicated in the text). This dataset covers the period 1970–1998 and classifies the external assets and liabilities of 66 industrial and developing countries into three main categories, foreign direct investment (FDI), portfolio equity and debt instruments. This dataset relies mainly on stock data, supplemented by cumulative flows data and with the portfolio equity and FDI flows data introduced with appropriate valuation adjustments. In order to split the non-FDI stocks into assets and liabilities, data for the international investment positions of the respective countries was used. It should be stressed that the overall financial flows and stocks data is somewhat problematic, with large discrepancies in the global current account position being a feature of developments for some decades now. For example, the annual discrepancy in the net external asset position at the worldwide level over the period 1970 to the late 1990’s ranges from +1% to —8% of world GDP.
Net flows of foreign capital into or out of a country imply a savings / investment imbalance in the respective country, with net outflows implying that domestic savings exceed domestic investment and with net inflows implying the opposite. These net flows between countries are summarised in the current account of the balance of payments, with current account deficits indicating the share of domestic investment which is financed by foreign savings and vice versa for current account surpluses. With the Feldstein-Horioka puzzle (1980) implying that there is a strong empirical correlation between domestic savings and domestic investment trends, at least up until the 1980’s (which implies of course that domestic not foreign sources of savings are the primary financing method for domestic investment), the conventional view is that prolonged current account imbalances (i.e. a trend towards persistent net inflows or net outflows of foreign capital) are unlikely to endure over long periods of time, especially amongst large developed economies with similar economic structures (unless of course one is predicting a higher long run growth rate for one of the developed countries in question, eg the US). Large current account imbalances can however persist, as this section shows, between developed and developing countries (with such flows justified by the potentially larger rates of return to be earned on investments in catching-up countries) and also to a lesser extent in the case of smaller developed economies. As argued later on in this section, the persistence of large current account deficits in the US and surpluses in Japan would appear to contradict or at least to call into question the Feldstein-Horioka view that savings and investment are normally highly correlated, with the analysis suggesting that ageing could provide a highly plausible explanation for such persistent trends. Ageing in fact is already leading to fundamental changes in the savings-investment balances of a small, but growing, number of rapidly ageing countries, with Japan the most notable example thus far.
For consistency with the net stocks data presented later on, these current account flows are also taken from the Lane databank and consequently only go up to 1998. If one looks at the data for the intervening period 1998–2002, one sees that the trends up to 1998 for the EU and Japan have broadly persisted in recent years, with the trend towards deficits in the US being further reinforced. In fact, the average US current account deficit over the period 1999–2002 was nearly 4% of GDP which was more than double the average of the period 1995–1998.
Assuming that these Japanese assets are yielding normal rates of return, Japanese consumption patterns are now been partially insulated from the poor domestic output performance of the Japanese economy over the last decade.
For the fast ageing group, changes in net foreign assets have been very volatile, rising from -13% of GDP in 1970 to —23% in 1985 before recovering to —7% in 1998. The changes over time in the case of the slow ageing countries have also been volatile and the level of overall indebtedness has stayed high at between —15% to -20% of GDP.
This process was historically initiated in, and is still predominantly a feature of, a range of manufacturing sectors. However, more recently, FDI flows are starting to extend into an expanding number of, low-skilled, service sectors such as data processing and “call centres”, with the economics of such investments being made possible by the technological advancements and cost reductions emanating from the ICT revolution.
As predicted by standard life cycle models the current account balance of countries which are ageing relatively faster compared to the world average are likely to be in surplus, since the savings rate in these countries falls less rapidly than the domestic investment requirements. Given the fact that divergent demographic trends tend also to be rather prolonged one would therefore expect to see a build-up of foreign assets over extended periods of time. There are of course other possible factors explaining capital exports from Japan and more recently Europe to the US, such as, for example, sustained differences in labour force participation rates, with strong increases in the US participation rate compared with rather stable trends in Japan and Europe. However, other influences, especially the process of technological convergence (assuming that this process has not, as some commentators have suggested, come to an end in the second half of the 1990’s) and divergent fiscal developments between Europe, Japan and the US (at least in the case of Japan), point in the opposite direction. The analysis in this section, on the basis of the net stocks of wealth / debt for the 5 areas tries to evaluate the relative importance of the different factors, especially the demographic determinants, and come to some conclusions regarding the likely evolution of net foreign assets over the coming decades.
Taylor (1994), Higgins (1998), Herbertsson and Zoega (1999) and Lane and MilesiFerretti (2001).
Common, as opposed to relative, movements of the latter variables should not however impact on net foreign asset positions and would instead be expected to be reflected in movements in global real interest rates.
The growing trend, per capita, growth rate differential shown in Graph 28 in favour of the US compared with the EU and Japan is a source of concern to policy makers in the latter countries since this more recent pattern casts doubt on the continuance of the post-World War II process of catching-up with the US. In addition, while technological convergence was the standard paradigm in empirical international growth research, the IT revolution which occurred in the US in the 1990s casts some doubt on the convergence hypothesis, especially since the acceleration in total factor productivity (TFP) growth in the US was accompanied by negative TFP growth in Japan. As discussed later on in this section, expected technological divergence between the US and the rest of the world could be another reason justifying a sustained US current account imbalance. Finally, as section 4 will show, these worries are compounded by ageing which is expected to widen the existing GDP per capita growth rate differentials even further. Policy makers can take some residual comfort from the fact that in GNP per capita terms (i.e. income as opposed to output) the relative deterioration in living standards will not be as severe given that EU and Japanese citizens will earn higher rates of return on their foreign investments than they would have done if this investment had taken place domestically and consequently the deterioration in welfare terms (i.e. consumption per capita) will not be as severe as for output.
In other words, domestic investment becomes progressively less profitable as capital productivity tends to decline as economies grow wealthier.
According to Lane and Milesi-Ferretti (2001), “The relation between net foreign assets and demographic structure also accords with the thrust of the theoretical literature : a decline in the net foreign assets occurs if there is an increase in the population shares of younger age cohorts, whereas the net foreign asset position responds positively to an increase in the share of workers nearing retirement, with a maximum effect for the 50–54 age group. It is also interesting to note that the over-65 age group exerts a negative effect, consistent with the running down of net foreign assets”.
This EU average position does not however apply to a number of individual EU member states, especially the UK and the Netherlands both of which have large privately held pension fund assets.
Restrictions on global capital mobility were introduced by imposing differential risk premia on both the fast and slow ageing countries, with the highest premia for the latter group.
It should be underlined that changes in demographic factors are not only important in terms of determining medium-to-long run balance of payments developments. They are also, via their effects on the net foreign asset positions of countries, an important long-run determinant of changes in real exchange rates. According to Lane and Milesi-Ferretti (2000), “international investment income flows associated with, nonzero, net foreign asset positions require some degree of real exchange rate adjustment in the long run”, with the key question to be answered being “whether countries that receive net payments from abroad (because they are net external creditors) tend to have more appreciated real exchange rates and, conversely, whether countries that make net payments abroad (because they are net debtors) have more depreciated real exchange rates”. On the basis of both cross-section and time series empirical evidence, Lane and Milesi-Ferretti conclude that there is a significant response of the real exchange rate to changes in the net external asset position of countries, with both variables predicted to move together over the long-run.
This is not to imply that there will not be a correction of the current US deficit position but it does suggest that once the cyclical aspects have been addressed that the underlying structural position will remain negative. This is due to the fact that even with only a proportion of the “new” economy story remaining in tact, with an absence of alternative investment locations, due to the EU and Japan facing uncertain growth prospects and with the slow ageing group essentially cut off from the world’s capital markets due to the excessive risk premia attached to investing in these countries, the US current account will not correct as much as some commentators are predicting.
Borsch-Supan, Ludwig and Winter (2001), in their analysis of the effects of fundamental pension reform on capital markets in Germany, underline the importance of international diversification to rates of return “Our simulations suggest that the decrease in the rate of return on capital, which results from secular shifts in the capital-labor ratio associated with an ageing population and retirement saving, is less about 1 percentage points by 2050 and only if all capital is invested exclusively in Germany. However, capital markets these days are anything but closed national markets and the return on capital can be improved substantially by international diversification....Moreover, the decrease in the return to capital due to a fundamental pension reform is only 0.2% points if capital is freely mobile within the countries of the EU versus 1% point if Germany is modelled as a closed economy. This suggests that closed economy overlapping-generations models overestimate the transitional burden of such a fundamental pension reform.”
The observed low volatility of net foreign assets in both the fast ageing and slow ageing countries suggests the existence of trading frictions for international financial transactions in these countries. Restrictions for international capital flows seem to be larger in the slow ageing countries, given the strong over-prediction of the model for net liabilities for the slow ageing countries. We therefore assume strong capital market imperfections for the slow ageing group and only mild frictions for fast ageing countries. Concretely, it is assumed that a worsening of the net foreign asset position of 1% leads to an increase in the risk premium of 0.4% in the slow ageing and of only 0.04% in the fast ageing countries.
These rates of return for foreign investors on US assets compare with the achievement of consistently higher rates of return for US investments abroad, with the result that the investment income balance on the US current account has surprisingly not gone into deficit despite the large deterioration in the US’s international investment position.
In terms of the breakdown between EU and Japanese firms, the EU accounts for over 80% of the total of 73% i.e. EU firms produced 59% of all FDI-produced US output in the year 2000, with Japan producing 14%. A similar % breakdown is evident for employment levels in US affiliates of EU and Japanese companies.
China in 2002 became the single largest recipient of FDI flows worldwide, pushing the US into second place.
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Mc Morrow, K., Roeger, W. (2004). Global Capital Market Developments, Current Account Imbalances and the Evidence for Age-related International Capital Flows. In: Welfens, P.J.J. (eds) The Economic and Financial Market Consequences of Global Ageing. European and Transatlantic Studies. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-540-24821-7_3
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DOI: https://doi.org/10.1007/978-3-540-24821-7_3
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