The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival

by Charles Goodhart

if capital is not free to flow in and out of China, then the exchange rate can remain fixed and the PBoC can set interest rates to suit the needs of the domestic growth strategy. And it did.

Besides strict capital controls on financial flows both in and out of the country, the PBoC intervened heavily in foreign exchange markets to prevent the inflows of investment funds from raising the value of the Renminbi. Over 2001–2015, the PBoC intervened regularly in foreign exchange markets, the intervention peaking at nearly 18% of GDP in 2007 according to official estimates, resulting in a massive accumulation of central bank reserves. Such a sustained intervention allowed the exchange rate to remain steady at a level that delivered China’s exports a considerable advantage. As a result, the trade balance (the difference between exports and imports) grew rapidly

China’s interest rate market was effectively insulated from the rest of the world, thanks to the restrictions on capital controls. Within China, the PBoC dictated the rate at which banks (dominated by government-owned banks) could borrow and lend, and it controls the flow of credit in the economy even today.

Interest rates were set well below the rate of growth and the rate of inflation. While the economy grew on average by around 10% over 1990–2010, the inflation-adjusted deposit rate over the same period averaged −3.3% (for a 1.4% average for the nominal deposit rate versus an average annual inflation rate of 4.75%). Let alone receiving protection against inflation on their deposits in the banking sector, the inability to participate in China’s growth through financial investment at home or abroad was a double-digit, inflation-adjusted penalty on households. Households had very few means of protecting themselves financially; buying houses was the investment of choice. Household leverage rose as a result.

In other words, low interest rates were effectively a tax on households. As household savings were collected by banks and redirected towards SOEs, the tax on households effectively became...

But why did households continue to put their money in banks rather than in other financial assets? The choices for households to protect their savings were designed to be, and remain, extremely limited. Buying foreign assets remains an option for an extremely small and wealthy segment of the population, and equity ownership too remains limited among the population. China...

Nabar (2011, IMF) finds a negative correlation between urban savings and the decline in real deposit rates. When banks fail to protect household savings, households tend to save more, not less, in order to achieve a ‘target’, whether that is for education or the purchase of a home. China’s household savings have also been linked to the lack of a social safety net, and import...

Third, as we have argued earlier, global capital was partly directed towards, and in part attracted to, investing in physical rather than financial assets. Subsidised land and infrastructure, cheap labour, an extremely competitive exchange rate and access to advanced economy markets (particularly afte...

The flow of physical capital, particularly in manufacturing, brought along with it the newer vintages of technology to China. Additionally, multinationals brought along with them state-of-the-art methods to combine labour, capital and the technology embedded in that capital.

China’s regulations allow foreign firms to operate in certain key sectors in China only if they form joint ventures with Chinese firms.

physical capital was encouraged to enter China. The transfer of technology and access to credit allowed China’s SOEs as well as the private sector to grow rapidly.

All of that should have resulted in a huge current account deficit for China, which would have reflected the surge in investment. Except that China’s savings were even larger—the financial repression encouraged high household savings, high enough to finance domestic investment and push national savings higher than investment and create a current account surplus.

The capital that entered China was met by the PBoC in the foreign exchange markets through a massive sterilisation effort to prevent the Renminbi from appreciating. The PBoC purchased US dollars in the foreign exchange market equivalent to 18% of GDP by 2007. As a result of these purchases, China’s FX reserves grew dramatically, as mentioned earlier, to just below USD 4 trillion. These hard currency reserves were assets and needed to be invested. Under the stewardship of the State Administration of Foreign Exchange, China’s official agency for managing reserves, hard currency reserves were invested almost entirely in the deep and liquid asset markets in the advanced economies. The bulk of that investment was in US Treasury securities. Global capital thus flowed ‘uphill’, from China (and most of North Asia) to the advanced economies, helping create what the Federal Reserve’s ex-Chair Ben Bernanke termed the ‘global savings glut’. The excess of desired savings ...

The US consumer, fabled for needing no encouragement to spend, got some help nevertheless. Falling interest rates raised the value of asset prices, including housing. The sharp decline in manufacturing employment in the 2000s, mentioned earlier, went largely unnoticed at the time because construction employment growth was rampant. The surge in consumption during the 2000s added fuel to the fire as imports grew strongly, and the bilateral current account balance between the USA and China widened substantially before the crisis. Central banks misinterpreted these global, demographic trends for the success of their inflation targeting regimes which were introduced from 1990. The over-confidence of...

China’s greatest contribution to global growth and globalisation is past us. The current account surplus peaked in 2007 and it will now move into a deficit over time. Nominal GDP growth topped out in 2012 at around 18% and fell very sharply to just over 5% in 2015 before recovering somewhat. Investment growth and the property sector mirrored this fall but have remained in a much more subdued, post-crisis-type state since then. Its stock of hard currency reserves still stands at USD 3 trillion but could fall further as the current account moves into deficit territory.

The internal migration that had provided a seemingly endless supply of labour to the industrial zones has reached the ‘Lewis turning point’, a point at which the surplus rural labour supply no longer provides a net economic benefit through migration

Globally, China’s demographic reversal comes at a time when the social tide has turned against globalisation. That means global incentives are not aligned towards continued physical inflows of capital into China.

With labour and capital flows both constrained, China has now turned to upgrading technology as a means of sustaining growth and compensating for the contracting supply of labour.

Innovation naturally requires highly educated and trained workers. That is the kind of labour that already resides in the developed, coastal regions of China, not the type of labour supply that is available in the underdeveloped, interior regions of China.

Could the capital account lead to a change in the direction of the current account? Should the capital account move into a persistent deficit, then the current account would be pushed back into surplus. However, it is not clear what direction the capital account will take. On the one hand, China’s households hold too much of their wealth at home and have been trying to hold more foreign assets. At the same time, the flows associated with the investments in the ‘One Belt One Road’ drive should also mean persistent outflows. On the other hand, opening up the financial sector and access to China’s financial markets will provide incentives to global investors to allocate funds to China’s assets. How strong these trends will be is open to question.

Agarwal et al. (2019) argue that just 10% of China’s bank deposits moving to buy foreign assets would mean USD 2 trillion of funds flowing to markets offshore. The history of capital account liberalisation, however, shows that freeing up household flows is the least predictable and hardest to control part of capital flows. As a result, such a move is usually one of the last changes in the process of capital account liberalisation.

The change in China’s economic fortunes was accompanied by a radical change in its growth strategy. Around a decade ago, the growth strategy in China switched from a centralised one of promoting growth to one of decentralisation of economic decisions.

Three clear changes define the strategy of decentralisation: (i) the whole-hearted pursuit of a consumption-based model of growth, (ii) a greater role for the private sector aided by deregulation and (iii) a change in the role of SOEs pursuing a cut in excess capacity and excess leverage with the aim of raising productivity.

What will China’s new growth profile look like? Consumption, investment and debt.

China’s corporate debt carries a much lower risk of default than many believe, but its resolution does not bode well for the consumption-led model of growth.

Consumption-led growth will be a disappointment but the investment side of the economy will perform better than many think. Debt will be a drag as it is digested (as we explain further below), but it is unlikely to bring about a crisis now, or in the future. Like Japan, China’s transition to consumption-led growth is likely to be a mathematical, not economic, rebalancing.

Consolidation in the manufacturing sector, particularly among SOEs.

Large-scale layoffs, however, were not a valid option for SOEs because of social considerations and the risk of political damage. The 1989 Tiananmen Square protest was not to be repeated, which meant the labour market could not bear the brunt of the adjustment.

Even if banks could be recapitalised by the government, SOEs that wrote down substantial loans would not receive any further funding, and would probably have to lay off a substantial part of the workforce. Instead, banks ‘evergreened’ the loans granted to SOEs and allowed them to stay operational. The presence of ‘zombie’ firms in China is therefore at least partly a function of societal and political constraints.

With capacity already having been cut, the slow release of labour from the manufacturing sector will actually raise the capital/labour ratio in the manufacturing sector and hence productivity.

Consumption, however, is likely to remain subdued.

Household savings are likely to fall, with consumption directed to ageing- and health-related services, in the absence of a full and proper social safety net. This may happen either directly, or indirectly via the government. The social contract, that the Communist Party must abide by, may...

In this case, the upside risks to inflation may come from higher wages to offset the resultant tax on workers, or through the higher inflation that may be needed to reduce t...

The kind of sustainable increases in wage growth that would have led to a robust consumption cycle do not appear to be available. The sharp decline in manufacturing investment is likely to lead to subdued productivity growth that rises only very slowly. As workers move from the manufacturing to the services sector, they will be moving to a sector that usually is more labour-intensive but has lower productivity growth, as has been the case in AEs elsewhere. Both dynamics will keep real wage growth under pressure.

the PBoC’s campaign against shadow banking started in 2017, but continued right through 2018 and 2019, even though President Trump’s trade war was launched and intensified. Despite the worsening economic situation in China in late 2019, the PBoC continued to constrain the flow of funds from the shadow banking sector to the housing sector. In essence, the PBoC appears to be strongly committed to the process of deleveraging, stepping back from this aggressive stance only when economic conditions have deteriorated too much and warrant some accommodation.

The conventional wisdom about China’s debt is misguided. First, simply cancelling debt doesn’t work in most places, but it does in China.

Cancelling debt helps the debtor but shocks the wealth and future income of the creditor. In the aftermath, debtors don’t ramp up lending, chastened by their experience, but creditors curb spending aggressively. The result is a sharp negative shock to overall spending, which is why debt cancellation isn’t costless by any means

Japan’s government debt cannot be cancelled even if it is domestically held. Why? Because the ‘leakage’ via households is too big. The enormous stock of government debt is held almost entirely domestically, with a huge chunk held by pension funds.

In China, both sides of leverage are on the same balance sheet (i.e. the government’s) since so much of the corporate debt in question was issued by state-owned banks to SOEs.

Second, debt-equity swaps are ongoing, but will take some time to make a dent in debt levels. Debt-equity swaps are our preferred solution to leverage

Third, the price for accruing a large stock of debt will be paid via a shortage of credit for consumption and for businesses in the services sector. Even though debt-equity swaps allow for a much smoother deleveraging, they will eat up bank capital as the value of swapped equity is slowly written down to match the realised value of the non-performing assets that had been financed by the debt in the first place. While bank capital is being eaten away, and while real wage growth finds lower support from capital accumulation, the ability and willingness of banks to lend will be lower. Thus, even though consumers and the private sector account for an increasingly larger share of the economy, they will not be able to draw upon future earnings to consume or grow faster today.

For China, the implications of everything we have discussed are threefold. First, China will no longer be a global disinflationary force. If anything, demographic pressures and the Lewis turning point imply that inflationary pressures, with which the economy has never had to deal until now, could materialise and catch us off-guard. Second, falling savings related to the ageing population and to the end of financial repression will push the current account into deficit. The capital account, as we discussed earlier, could push the current account back into surplus, but it is not clear how the contrasting flows in household wealth, financing of the Belt and Road Initiative and foreign investment within China will play out in net terms. Without the persistent ‘uphill’ flows of capital that China’s earlier current account surplus had engendered, USA and global bond yields (and in turn asset prices) will see a reversal of the support from this source they had in the past. Third, China’s ability to introduce labour-saving and productivity-enhancing technology depends on the not-inconsiderable innovations that can be generated at home. Without the help of foreign firms transferring technology, and with political sensitivities around the acquisition of foreign technology firms by Chinese firms, an organic improvement in technology will be more difficult.

As a result, dependency ratios are set to rise sharply in the AEs, and even more sharply in some EMEs in North Asia and Eastern Europe.

Home to the elderly: Where in the world is the population greying the fastest? Between 2015 and 2030, the number of elderly over 60 is expected to grow by 71% in Latin America and the Caribbean, followed by Asia (66%), Africa (64%), Oceania (47%), Northern America (41%) and Europe (23%). In terms of levels, the ageing process is most advanced in high-income countries. Japan is home to the world’s most aged population, as 33% were aged 60 years or over in 2015, followed by Germany (28%), Italy (28%) and Finland (27%).

Most worryingly, it is not just the share of global GDP that the ageing economies dominate, they also account for the lion’s share of global growth over the last 15 years. If we extend that timeline over the last 35 years, the picture does not change appreciably. The danger facing the global economy is precisely that the economies that have dominated global growth are facing the biggest demographic challenges. And that means even if the world as a whole still faces substantial population growth going forward, the economies that shaped global growth for the last 35 years are the ones which bear the brunt of the demographic headwinds . Put differently, if demography is to leave only a scar on the global economy, then the economies that have done very little for global growth in the past few decades are the ones that must do much, much more in the future. Seen from this perspective, it should be clear that the disruption from technology that many fear so much in the advanced economies is actually an imperative without which the damage to global growth could well be far worse.

effective retirement ages have only just recently begun to rise, and still grudgingly, usually by less than the rise in life expectancy,

Even Putin, whose command over the political system in Russia has been formidable, was forced to backtrack on his plans to make pension arrangements less favourable

note the difficulties that Macron faced in reforming French retirement and pension arrangements in France in late 2019.

So, if we are to maintain, let alone to increase, growth rates from present, somewhat disappointing, trends, what would be needed would be a significant increase in the rates of growth of productivity per worker.

the rate of growth of productivity per worker in Japan, where the workforce has already been declining for a decade, has been better in recent years than in most other advanced countries.