Mario Catalán

Recent IMF research examines the global macroeconomic challenges posed by population aging, including analyses of large and persistent shifts in capital flows, substantial fiscal challenges, and risks of increasing poverty among the elderly. IMF studies show that the stakes are high and instill a sense of urgency, and that prompt reforms can mitigate future risks.

The world’s population will age substantially in coming decades, posing severe macroeconomic and fiscal challenges for advanced and developing economies. Recent IMF papers addressing these challenges can be grouped into four topic clusters focused on (1) aging and international capital flows; (2) fiscal challenges arising from aging; (3) pension reforms in advanced economies; and (4) pension reforms in developing economies.

The pace and timing of aging will vary across countries and regions. Aging is well advanced in Japan, Europe, and North America, but it lags behind by more than two decades in much of Asia and Latin America.

Brooks (2003, 2005) and Batini, Callen, and McKibbin (2006) show that nonsyncronized demographic movements will cause large shifts in international capital flows. In the next decade, advanced economies will observe a surge in saving as large cohorts of workers prepare to retire, while investment will fall as workforces shrink. This will result in lower levels of growth, capital outflows to developing countries, and falling world real interest rates. Beyond 2020, current accounts in industrial countries will decline as baby boomers dissave in retirement. But world interest rates will continue to fall as population aging intensifies in Asia—particularly China. Policies that increase productivity growth can offset the demographic impact on world output, and improved capital market access for developing countries could facilitate global adjustment and mitigate the decline in world interest rates.

Fiscal challenges posed by population aging are also a major concern. How will the decline in world interest rates—associated with global aging—affect small and open economies whose populations are also aging? Catalán, Guajardo, and Hoffmaister (2008) show that aging-related fiscal pressures in small and open economies will be exacerbated as declines in world interest rates boost capital-labor ratios, and hence, wages and pension benefits. The pass-through effect of lower interest rates into pension benefits will be stronger if pensions are indexed to nominal wages rather than prices. And pension reforms, particularly those that shift indexation from wages to prices, can provide macro-insurance against long-run declines in world interest rates.

Widely used projections often involve extrapolating past macroeconomic trends in light of demographic movements. In this approach—followed notably by the European Commission’s Aging Working Group—individual behavior is taken as independent of the changes in incentives associated with aging, pension reforms, and tax reforms needed to finance aging-related spending. All approaches have limitations, but only a general equilibrium analysis can account for important feedback effects, including the (endogenous) response of output, labor, capital accumulation, and the current account to aging and policy changes. Catalán, Guajardo, and Hoffmaister (2007) assess the impact of aging in the Spanish economy using an overlapping-generations model and find that aging-related fiscal pressures could be twice as large as those projected by the European Commission’s working group. Also in a general equilibrium setting, Botman and Kumar (2007) evaluate the effects of prefunding aging-related spending in large and open economies. Prefunding has an adverse short-term growth effect, but reduces future tax increases and world real interest rates. Although individual economies benefit from delaying tax or spending adjustments and free-riding on fiscal consolidation elsewhere, all economies are worse off in a non-cooperative outcome. Hence, there is scope for improving global welfare through international cooperation.

Regarding pension reforms in advanced economies with mature pay-as-you-go systems, Turner (2006) argues that the principle of proportionally rising retirement ages—to keep stable the proportion of a person’s adult life spent working and in retirement—should be a central feature of reform to cope with increasing longevity. Declining fertility rates, however, require retirement ages that rise more than proportionally with rising life expectancy, large-scale immigration, higher levels of taxes and pension contributions, or significant falls in pensions relative to earnings.

“The pace and timing of aging will vary across countries and regions. Aging is well advanced in Japan, Europe, and North America, but it lags behind by more than two decades in much of Asia and Latin America.”

Catalán, Guajardo, and Hoffmaister (2007) examine the effects of reducing the Spanish system’s replacement ratio by extending the averaging period used to compute pension benefits. They show that this reform limits the increase in pension expenditure at the peak of the demographic transition as much as increasing the retirement age in line with life expectancy. Heller and Hauner (2005) argue that there is narrow scope for most governments to cut nonage-related spending or to increase taxes; hence, the focus must be on implementing structural pension and health care reforms.

IMF staff have also studied pension reforms in developing countries, with a focus on financial market development and coverage. Roldos (2007) shows that Latin American pension reforms from pay-as-you-go to fully funded systems based on individual accounts have contributed to the development of government bond markets, but regulatory investment limits have at times distorted the prices of domestic securities. Results are also somewhat disappointing in terms of coverage ratios, which remain far from levels of member countries of the Organization for Economic Cooperation and Development. Other areas of concern are the high administrative costs—account and management fees—and the low replacement rates associated with the new systems. Catalán (2004) criticizes the Latin American capital markets development strategy based on pension reforms combined with tight capital controls restricting the international diversification of pension fund assets.¹ This strategy can be called, paradoxically, “financial repression-for-financial development” because future pensioners are financially repressed while corporations, the government, and banks have access to a low-cost and captive source of funds that spurs the development of local bond and stock markets. The drawbacks of this strategy could be avoided by (gradual) elimination of pension-fund-specific capital controls. Also, one could ask why workers should pay for the cost of local capital markets development. Even if market failures would justify the imposition of capital controls, these controls should be broad-based.

Large emerging market economies, including China and India, have also introduced pension reforms in recent years. India launched reforms in 2004 shifting central government employees from a noncontributory defined benefit scheme to a defined contribution plan, and allowing voluntary participation of nongovernment workers. Poirson (2007) asks whether these reforms could stimulate financial market development. She argues that financial development may be thwarted by the absence of minimum pension guarantees—participants may opt for highly conservative asset allocations—and the optional participation of nongovernment workers, which may prevent the achievement of critical mass needed to exploit economies of scale in the financial system.

In aging China, the risk of a widespread increase in old-age poverty is higher than in aging developed countries because of China’s lower income per capita. Dunaway and Arora (2007) call for further and faster pension reforms. A reform initiated in 1997 to provide coverage to the entire urban population is ongoing, but progress has so far been slow: less than half of urban workers and only 12 percent of rural workers have pension coverage. The need to expand coverage and increase the retirement age is pressing, but the transition costs associated with the old regime have distracted attention from these objectives. Also, geographical discrepancies in key pension parameters have emerged from the decentralized approach to reform, and Dunaway and Arora recommend steps toward nationwide consolidation.

Heller (2006) shows that similar risks loom for other Asian economies. In contrast to industrial countries, where elderly dependency ratios will start rising sharply around 2010, in Asian countries they will do so only after 2030. By the time these ratios start rising in Malaysia and the Philippines, income per capita will be less than two-thirds of the current EU-6 level; in China and India, income per capita will be about 40 and 20 percent of the current EU-6 level, respectively. This implies that Asian countries will get old before they get rich. Sustaining strong growth will not be sufficient to avert the risk of increasing old-age poverty, and younger generations will need to support the elderly. Facing this challenge would mean expanding the coverage of pension systems and improving health care so that individuals can work longer. Also, financial sector reform would allow greater productivity to be achieved on savings accumulated for retirement.