AGEING AND FINANCIAL STABILITY

AGEING AND FINANCIAL STABILITY

E Philip Davis

NIESR and Brunel University

West London

[email protected]

www.ephilipdavis.com

groups.yahoo.com/group/financial_stability

Course on Financial Instability at the Estonian Central Bank,9-11 December 2009 – Lecture 11

Introduction• Focus on pitfalls for financial stability arising

from ageing• Draw on extant theoretical and empirical work on

these two areas• Focus is on “systemic risk” leading to heightened

risk of a financial crisis, impairing provision of payments services and credit allocation

• Link to retirement income security for individuals

Structure

1. Indicators of financial instability

2. The ageing problem

3. Consequences of ageing for the macroeconomy and pension systems

4. Financial market effects of savings patterns

5. Effects on systemic risks

Indicators of financial instability• Selective synthesis required of different theories

– Financial fragility– Monetarist– Uncertainty– Disaster myopia– Asymmetric information and agency costs– Bank runs– Herding– Industrial

– Inadequacies in regulation– International aspects of financial instability

• Development of macroprudential indicators– Regime shifts, first to laxity, later to rigour– Entry conditions to financial markets– Debt accumulation and asset booms– Innovation, risk concentration and lower capital

adequacy

• Econometric work on indicators of banking crises– Often accompany currency crises (Kaminsky and

Reinhart)

– Highlight indicators such as GDP growth, interest rates, inflation, fiscal deficits, ratio of broad money to Foreign Exchange reserves, credit to the private sector/GDP ratio, lagged credit growth, GDP per capita, deposit insurance, financial liberalisation (Demirguc Kunt and Detragiache 2005)

– Or in OECD countries, bank capital, bank liquidity and property prices (Barrell, Davis, Karim, Liadze 2009)

The ageing problem

• Increase in life expectancy….

• ….decline in the birth rate….

• ….giving rise to an ageing population…

• ….and financial difficulties for generous pay-as-you-go systems

TABLE 1 LIFE EXPECTANCY AT BIRTH Years 1970–1975 1980–1985 1990–1995 2000 United Kingdom 72 74 76 78 United States 73 75 77 77 Germany 71 73 76 77 Japan 74 77 79 81 Canada 73 76 78 79 France 72 75 78 79 Italy 72 75 78 79

TABLE 2 FERTILITY RATES Number of Children per Female 1970–1975 1980–1985 1990–1995 2000 United Kingdom 1.8 1.8 1.8 1.7 United States 1.8 1.8 2.0 2.1 Germany 1.5 1.4 1.2 1.4 Japan 1.9 1.8 1.5 1.4 Canada 1.8 1.7 1.9 1.6 France 1.9 1.8 1.7 1.7 Italy 2.2 1.4 1.3 1.2

TABLE 3 PROJECTIONS OF ELDERLY DEPENDENCY RATIO TO 2030 Population 65 and over as a Percentage of Population Aged 15–65

1960 1990 2010 2030

United Kingdom 17.9 24.0 25.8 38.7 United States 15.4 19.1 20.4 36.8 Germany 16.0 21.7 30.3 49.2 Japan 9.5 17.1 33.0 44.5 Canada 13.0 16.7 20.4 39.1 France 18.8 20.8 24.6 39.1 Italy 13.3 21.6 31.2 48.3 Memo: E.U. average 16.5E 21.4 25.9 40.3

TABLE 4 PROJECTIONS OF PENSION COSTS (OECD ESTIMATES) Pension expenditure/ GDP

1995 2000 2010 2020 2030 2040

United Kingdom 4.5 4.5 5.2 5.1 5.5 5.0 United States 4.1 4.2 4.5 5.2 6.6 7.1 Germany 11.1 11.5 11.8 12.3 16.5 18.4 Japan 6.6 7.5 9.6 12.4 13.4 14.9 Canada 5.2 5.0 5.3 6.9 9.0 9.1 France 10.6 9.8 9.7 11.6 13.5 14.3 Italy 13.3 12.6 13.2 15.3 20.3 21.4

Consequences of ageing

• Growth decelerates as ageing proceeds (lower labour supply)

• Investment unlikely to fill the gap (diminishing returns, crowding out)

• Labour force participation and higher productivity growth could help

• Private saving likely to decline, according to macro studies, possibly mitigated by pension reform…

• …also public saving falls, reflecting fiscal effects

• System of retirement income provision also impacts on:– Growth – reduced by pay-as-you go as

distortionary; funding may boost growth by improving resource allocation etc.

– Saving – unfunded social security reduces saving if confidence maintained – may boost if confidence lost (precautionary saving) – switch to funding may boost saving

• Projections of saving, growth and investment - no clear consensus but common features:– Possibly initial rise in private saving (baby

boomers), falling later– Initial balance of payments surplus, deficit later– Lower growth– Lower public saving– Flat or declining investment

• External imbalance depends on saving-investment pattern, possibly surplus initially for EU, later deficit

• Projections:– OECD (1998) GDP growth in 2030 0.25% per

annum in Japan, 1% in Europe and 1.4% in the US

– All OECD run external surpluses to 2025, thereafter deficits

– EU (2003), US deficit, EU and Japan surplus (enhanced risk of bubbles)

– Key issue absorptive capacity of slow ageing emerging market economies (EMEs)

Financial market effects of saving patterns

• Pay-as-you-go – could boost precautionary saving in life insurance and

bank deposits– Rise in supply of government bonds

• Funding – generates increased demand for securities, also relative

to deposits– Gross capital flows to EMEs, exceeding net– Eventual reduction of demand for securities– Switch from equities to bonds

Systemic risks 1 – overall macroeconomic development

• Initial rise in saving generating currency appreciation/loss of competitiveness, excess liquidity, asset price volatility, possible policy errors (as Japan)

• Later balance of payments deficit, with risks of currency crises and exchange rate volatility accompanying banking crises

• Underlines need to promote growth in EU – and slow growing EMEs…but also central bank vigilance during overall process

Systemic risks 2- pay-as-you-go• Trace extreme case of no-reform• Precautionary saving owing to uncertainty

– If directed to banks, may lead to underpricing of risk in domestic credit or international interbank markets

– Life insurers could invest in high yield bonds, property, vulnerable to credit cycle

• Case of tax finance– major economic difficulties generating credit losses and

falls in asset prices, which are unlikely to be accurately anticipated

– Ultimately “factor flight” especially if tax system distortionary

• Case of bond finance– sharp rise in long term interest rates, loss of

credit rating, crowding-out, recession– Hence major credit losses for lenders (most past

fiscal crises were with unliberalised banking systems)

– Government’s ability to recapitalise banks declines

– Ultimately fiscal-solvency crises, which could be contagious, “snowball” and temptation to monetise

– In EMU, spillovers to countries that have reformed

Systemic risks 3 – institutional investors

• Financial structure with sizeable institutional sector should have strong stabilising properties:– Accuracy of asset pricing– Liquidity– Transparency/marking to market– Distance from safety net– “Multiple avenues of intermediation”

• …but risks in transition, requiring possible intervention

– Further disintermediation, leading to risk taking by banks to maintain profitability

– Especially where banking systems have low profitability and excess capacity

• And some unfamiliar risks arise:– Extreme price volatility after a shift in

expectations and asset allocations– Protracted collapse of market liquidity and

issuance after similar portfolio shifts• Threat to EMEs, banks and non financial sector…• …and possibly to institutions themselves given

e.g. exposure to credit risk in real estate cycles

Systemic risk 4 – asset accumulation and funding

• Possible effects of institutional flows on equity market in 1990s

• Bubbles in debt and property feasible• Vulnerability of EMEs to institutional flows• Falls in asset prices during ageing:

– Lower real returns on capital– Lower saving (“baby bust”) affecting real

interest rates or risk premium– Switch from equities to bonds

Estimated demographic effects on equity prices and bond yields

Independent variables

Log difference of US real stock prices

Independent variables US real bond yields

Constant -2.97 (0.64)** Constant 12.3 (4.0)**

AGE20 -0.0024 (0.0098) AGE20 0.266 (0.052)** AGE40 0.108 (0.02)** AGE40 -0.239 (0.084)** DYHP -3.4 (6.5) DSR 0.628 (0.1)** DDIFY -1.28 (0.97) TS(-1) -0.73 (0.125)** RLR 0.03 (0.009)** DLCPI(-1) -109.1 (9.7)** VOL -1.19 (0.62)* DDLCPI -142.6 (10.0)** DY (-1) 0.092 (0.026)** DYHP -197.3 (58.9)**

DDIFY -5.8 (6.4)

R2 0.54 0.98

RSS 0.58 4.9 SE of regression 0.12 0.4 F-statistic (7,50) 6.0 (0.0)** 102.9 (0.0)** Wald test for

exclusion of AGE40 15.2 (0.0)** 16.2 (0.0)**

R-bar-squared 0.45 0.97 Serial correlation (2) 1.1 (0.36) 1.8 (0.19)

Normality 1.53 (0.28) 0.045 (0.97) Heteroscedasticity 0.53 (0.47) 0.06 (0.81) Stability (RESET) 2.4 (0.09)* 1.98 (0.14) Stability (Chow

forecast) 0.81 (0.62) 0.74 (0.67)

Unit root test -5.9 -3.7

Projected US asset prices without AGE65

Change in real equity prices Real bond yields

-0.8

-0.4

0.0

0.4

0.8

1.2

1.6

1950 1960 1970 1980 1990 2000 2010 2020

USDLRSPF

-6

-4

-2

0

2

4

6

8

10

1970 1980 1990 2000 2010 2020

USRLRF

Projected US asset prices with AGE65

Change in real equity prices Real bond yields

-0.8

-0.4

0.0

0.4

0.8

1.2

1950 1960 1970 1980 1990 2000 2010 2020

USDLRSPF

-5

0

5

10

15

1970 1980 1990 2000 2010 2020

USRLRF

Re-evaluation of theories and indicators

• Public finance will play a crucial role in pay-as-you-go…

• …financial instability will be more driven by institutional investor behaviour than that of banks…

• … but many of the theories and indicators will remain relevant, with some reinterpretation

• Examples of theory adaptation:– Agency costs in relation of investor to asset

manager– Uncertainty about impact of ageing on

economy and financial flows– Disaster myopia about effects of ageing– Herding by institutional investors– Industrial competition among asset managers

• Examples of indicator adaptation:– Focus on size and composition of retirement

saving flows– Debt accumulation by government and its side

effects come to the fore– Relevant regime shifts may include small

changes in institutional investor regulation– Exchange rate effects on the economy driven

by saving flows may also come to the fore

Conclusion

• Process of ageing seems likely to generate major shifts in financing, leading to potential financial turbulence

• Risks arising from pay-as-you-go much more serious

• Funding risks partly require adaptation to “institutionalisation” which is happening in any case

• Economy should be more robust with funding to withstand turbulence

• Policy issues include:– Reform of unsustainable pay-as-you-go– Appropriate regulation of funding and

investment for institutional investors (prudent person investment, international investment)

– Banks and their regulators need to be vigilant for side effects of ageing

References

• Davis E P (2005), "Demographic and pension-system challenges to monetary and financial stability", Geneva Papers on Risk and Insurance

• Davis E P (2002), "Ageing and financial stability", in eds H Herrmann and A Auerbach, "Ageing and Financial Markets", Springer Verlag - Deutsche Bundesbank