Transcript AGEING AND FINANCIAL STABILITY

AGEING AND FINANCIAL
STABILITY
Course on Financial Instability at the Estonian Central Bank,
9-11 December 2009 – Lecture 11
E Philip Davis
NIESR and Brunel University
West London
[email protected]
www.ephilipdavis.com
groups.yahoo.com/group/financial_stability
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
United Kingdom
United States
Germany
Japan
Canada
France
Italy
1970–1975
72
73
71
74
73
72
72
1980–1985
74
75
73
77
76
75
75
1990–1995
76
77
76
79
78
78
78
2000
78
77
77
81
79
79
79
TABLE 2
FERTILITY RATES
Number of Children per Female
United Kingdom
United States
Germany
Japan
Canada
France
Italy
1970–1975
1.8
1.8
1.5
1.9
1.8
1.9
2.2
1980–1985
1.8
1.8
1.4
1.8
1.7
1.8
1.4
1990–1995
1.8
2.0
1.2
1.5
1.9
1.7
1.3
2000
1.7
2.1
1.4
1.4
1.6
1.7
1.2
TABLE 3
PROJECTIONS OF ELDERLY DEPENDENCY RATIO TO 2030
Population 65 and
over as a Percentage
of Population Aged
15–65
United Kingdom
United States
Germany
Japan
Canada
France
Italy
Memo:
E.U. average
1960
1990
2010
2030
17.9
15.4
16.0
9.5
13.0
18.8
13.3
24.0
19.1
21.7
17.1
16.7
20.8
21.6
25.8
20.4
30.3
33.0
20.4
24.6
31.2
38.7
36.8
49.2
44.5
39.1
39.1
48.3
16.5E
21.4
25.9
40.3
TABLE 4
PROJECTIONS OF PENSION COSTS (OECD ESTIMATES)
Pension
expenditure/
GDP
United Kingdom
United States
Germany
Japan
Canada
France
Italy
1995
2000
2010
2020
2030
2040
4.5
4.1
11.1
6.6
5.2
10.6
13.3
4.5
4.2
11.5
7.5
5.0
9.8
12.6
5.2
4.5
11.8
9.6
5.3
9.7
13.2
5.1
5.2
12.3
12.4
6.9
11.6
15.3
5.5
6.6
16.5
13.4
9.0
13.5
20.3
5.0
7.1
18.4
14.9
9.1
14.3
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 savinginvestment 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
Constant
AGE20
AGE40
DYHP
DDIFY
RLR
VOL
DY (-1)
2
R
RSS
SE of regression
F-statistic (7,50)
Wald test for
exclusion of AGE40
R-bar-squared
Serial correlation (2)
Normality
Heteroscedasticity
Stability (RESET)
Stability (Chow
forecast)
Unit root test
Log difference of US
real stock prices
-2.97 (0.64)**
-0.0024 (0.0098)
0.108 (0.02)**
-3.4 (6.5)
-1.28 (0.97)
0.03 (0.009)**
-1.19 (0.62)*
0.092 (0.026)**
Independent variables
Constant
AGE20
AGE40
DSR
TS(-1)
DLCPI(-1)
DDLCPI
DYHP
DDIFY
US real bond yields
0.54
0.58
0.12
6.0 (0.0)**
15.2 (0.0)**
12.3 (4.0)**
0.266 (0.052)**
-0.239 (0.084)**
0.628 (0.1)**
-0.73 (0.125)**
-109.1 (9.7)**
-142.6 (10.0)**
-197.3 (58.9)**
-5.8 (6.4)
0.98
4.9
0.4
102.9 (0.0)**
16.2 (0.0)**
0.45
1.1 (0.36)
1.53 (0.28)
0.53 (0.47)
2.4 (0.09)*
0.81 (0.62)
0.97
1.8 (0.19)
0.045 (0.97)
0.06 (0.81)
1.98 (0.14)
0.74 (0.67)
-5.9
-3.7
Projected US asset prices without
AGE65
Change in real equity prices
Real bond yields
1.6
10
8
1.2
6
0.8
4
0.4
2
0
0.0
-2
-0.4
-4
-0.8
1950 1960 1970 1980 1990
-6
2000 2010
USDLRSPF
2020
1970
1980
1990
2000
USRLRF
2010
2020
Projected US asset prices with
AGE65
Change in real equity prices
Real bond yields
1.2
15
0.8
10
0.4
5
0.0
0
-0.4
-0.8
1950 1960
-5
1970
1980
1990
2000
USDLRSPF
2010
2020
1970
1980
1990
2000
USRLRF
2010
2020
Re-evaluation of theories and
indicators
• Public finance will play a crucial role in pay-asyou-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