Archive for July 17th, 2007

Demographics could explain world imbalances

July 17, 2007

I came across a speech from David Poole (President, St Louis Fed) where he says part of the trade imbalances in USA could also be explained via changing demographics. I have lately been very interested in changing demography and the changes it would bring about in economies.

We all know US has huge trade deficits (and current account deficits) and it is financed by capital flows from mostly Asian countries. The current account deficit exists as US investments are higher than savings. I have summarised the entire story here.

Poole says the demographic transition (in which fraction of retired persons to total population is rising) could be responsible. (He presents his theory but is not very sure, as more research is needed on the subject). Look at some facts of possible demographic transition here.

It clearly shows developed countries would have higher median ages by 2050 (Japan, Italy in 50s, China’s median age increases from 33 to 45!!). Another interesting part is than % of people above 80 years in total population is projected to increase from 1.3% in 2005 to 4.4% in 2050, a four fold jump!! Read more facts in the speech.

I was more interested in the impact:

The connection between demographic changes and international capital flows follows directly from the life-cycle theory of consumption and saving developed by Franco Modigliani and Richard Brumberg in their 1954 paper (1980). The argument is straightforward. Young households save relatively little, because of the expense of child rearing. Middle aged households save a lot, in anticipation of retirement. Elderly households, no longer working, draw down assets to pay for their consumption. These ideas are easily extended to the entire economy.

When a population can be characterized as middle aged, then the economy should tend to have a higher saving rate than when it can be characterized as elderly. Thus, as the population of a country moves from middle aged to elderly, it is reasonable to expect a country’s saving rate to decrease. Unless the country’s investment rate moves identically, foreign capital flows and current account balances will be affected. Exactly how depends on the change in investment.

The decline in the number of workers associated with an aging population tends to depress investment demand relative to a case of no decline in workers. The reason is simple. A country with a declining work force need not replace all its depreciating capital to maintain its capital stock per worker. In contrast, a country with a growing work force must replace depreciating capital and add to its capital stock to prevent the stock per worker from falling.

Thus, the tendency for saving to outrun investment in many countries with slowly growing or declining work forces is perfectly sensible and not a sign of imbalance. But with saving outrunning investment, capital flows abroad, especially to the United States.

Eventually, for a country with an aging population, the decline in saving will exceed the decline in investment, which will cause the country’s current account to decrease. However, it is not obvious whether aging would immediately cause investment to fall more or less than saving. It is possible that domestic investment falls more than saving initially because of persistence in saving habits. The key point is that the saving-investment balances of individual countries can evolve in complex ways.

The problem becomes more complicated as every country is different and the impact may vary across countries.

So, what should we be seeing ahead? Developed countries (including US) should have current account surpluses (as savings would be higher than investments) and would be exporting capital to still young countries in emerging and developing markets.

Therefore, we have another way of thinking about this global imbalance. Poole has pointed some nice references on the subject. Let me read them and get back to you. I would be posting some more findings on changing demographics.

Assorted Links

July 17, 2007

1. IFC Blog points out that there is a company in Brazil that provides carwash without any water. It uses indigeneous wax. Wow! That is some innovation. The company getting some good offers from countries worldwise for co-operation. Here is a list of some innovative products being developed in emerging markets.

2. The latest Economic Advisory Council Report is out. It says India is slated to grow at 9% for 2007-08 (higher than RBI estimates of 8-8.5%). It has given measures to control rupee appreciation and is critical of India’s public finances. The Newspaper summaries: ET, BS, FE.

As usual we do not have the report on EAC’s website till now. So I can’t post my review. The review for previous year’s is available here.

3. Rajrishi Singhal in ET, explains the rationale for sudden rush of setting holding companies by Indian corporates.

4. Ravi Sardana has written an article in ET on the importance of having the right name. It is funny.

5. ET analyses Deepak Parekh Committee report (on Infrastructure Financing) which says India’s Fin System could derail infra spending. Why? We don’t have basic instruments like debt markets which could intermediate savings to infrastructure sector. So, this means we would need foreign savings…again we would have to balance currency appreication with capital inflows. Why haven’t they put the report in public yet?

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