5  Capital markets

Throughout the developed world, as the baby-boomer cohorts reach retirement they will begin to draw down on investments made over their lifetime to support themselves. At the same time reductions in the size of the labour force may result in lower levels of savings[22]. Changes in the flows of saving and investment translate into changes in the current account balance. As a result we may expect changes to both domestic and international capital markets that could be reflected in fundamental changes to asset prices, interest rates, and capital flows between countries and regions[23].

5.1  Domestic markets

In considering the effects of population ageing on domestic capital markets we must bear in mind that in a small open economy such as New Zealand’s, it is difficult to sustain a distinction between domestic capital markets and international markets. The distinctions drawn on here pertain to investment in relatively immobile forms of capital, such as housing; effects ageing populations may have on domestic investment demand; and the effects that population ageing may have on New Zealand’s risk premium through changes to domestic savings rates.

Firstly, consider the possibility of changes in New Zealand’s country risk premium. This premium is dependent on a perceived level of risk that is a function, in part, of domestic savings levels and the balance in our current account. That is there is a positive relationship between a country’s current account deficit and the risk premium that it attracts: the lower national savings is, the higher the current account deficit, the higher the risk premium (Cantor and Packer 1996;O'Donovan, et al. 1996). This suggests that the future level of national savings may have an affect on the future cost of capital in New Zealand.

It is not clear whether savings will fall or increase as a result of population ageing. One argument is that, all other things being equal, a reduction in the working age population will lead to lower individual saving and thus less aggregate saving. On the other hand, increasing longevity may raise the rate at which individuals save during their lifetime (Zhang 2001), with the potential to offset a reduction in the number of savers in the economy. The former argument receives the most support in the literature but it is founded on contentious assumptions about the rate at which the elderly consume their wealth during retirement.

Bloom, Canning and Graham (2002) add both health and longevity to a standard model of life cycle savings. They find that increased longevity tends to lead to higher savings at all ages. In a stable population these extra savings are offset by the higher old age dependency ratio – there are simply relatively fewer workers to retirees. However, their model explains the high saving rates observed in Asia, where increased life expectancy has been combined with declining youth dependency to lead to abnormally high rates of saving which are expected to be reversed in future.

If individuals attempt to consume all of their wealth during their lifetime, with bequests arising only because of their inability to predict their health status and length of life, then the effect of an ageing population on savings may be large. If, on the other hand, the elderly have a strong bequest motive we may expect that this effect will be mitigated. Studies have sought to explore such retirement behaviour using neoclassical overlapping-generations models, however they have used US data and their findings are not particularly robust (Yoo 1997) (Abel 2001). For New Zealand, data from the Household Savings Survey, currently being completed, could prove very useful in helping us to gain a better picture of the behavioural dynamics at the household level.

How the elderly consume their wealth in retirement may also have interesting effects on investment demand and hence asset prices in New Zealand. There is a possibility that as the number of elderly in the New Zealand economy grows we will see more individuals drawing down on their asset wealth to obtain retirement income. If this were to be the case we may expect the supply of investment goods to increase with the potential to lower prices as a result (Siegel 1994).

Not all assets are equal and so asset prices and their determinants differ across classes of asset. Bearing this in mind, the dynamics of falling asset prices may depend on how individuals choose to store their wealth in old age. One school of thought says that as people get older they favour fixed income returns. As such, population ageing could create high demand for government bonds while the demand for equities could fall. Furthermore, an increase in demand for fixed return assets would reduce the real returns from those assets (England 2000) with net result being a dilution of the retirement stock of wealth.

In New Zealand where the lion’s share of household wealth is held in housing[24] (Claus and Scobie 2001) there is a very real prospect of wealth dilution. Over time one might expect that, as the population ages and the number of people owning their own home increases, house prices will fall[25]. In the case of other classes of assets the capital may be moved offshore or into other sectors to seek out more favourable returns. For housing assets this is not the case. Supply may well outstrip demand, with downward pressure on prices and consequently the wealth of New Zealand retirees[26].

A simplistic view of capital markets says that the prices of most all assets will fall around 2020 as the baby boomer cohorts retire en mass (Siegel 1994), but there is evidence contradicting this view. Poterba has conducted a survey of asset prices in the United States and finds that there is only a weak link between demographics and asset prices (1998 and 2000). No similar study has been conducted in New Zealand but such a study could prove very useful in understanding the implications of ageing for capital markets.

5.2  International markets

As a small open economy the movement of international interest rates and capital flows will dominate what happens in New Zealand capital markets. To obtain a clear picture of what will occur in the global economy we must consider the effects of ageing on economies throughout the world, and the different rates at which countries are ageing.

As populations age their capital to labour ratios will rise and returns to capital will fall. Assuming capital becomes relatively more abundant (relative to labour) in developed economies then there would most likely be greater capital flows into developing economies with younger populations, lower capital to labour ratios, and higher returns to capital (Borsch-Supan, et al. 2001).

The potential for movement of capital out of developed economies is also dependent on domestic savings and investment demand differentials. Other things equal we can expect that, over the next twenty years, per capita savings in New Zealand will increase due to a rise in the relative number of people in the economy between the ages of forty and sixty-four (during which time the majority of life time savings occurs (Gibson and Scobie 2001)). If this increase in domestic savings is greater than investment demand capital will move offshore with the potentially positive effect of pushing New Zealand’s current account into surplus (England 2000) (Organisation for Economic Co-operation and Development 1988). Of course this is dependent on an excess of investment demand from other countries with relatively younger populations.

Whether or not developing economies can in fact absorb large capital flows out of ageing developed countries, at existing interest rates, is unclear. If they cannot then we may expect an oversupply of capital in the global economy, driving down world interest rates. If they can readily absorb large amounts of capital then the world interest rate may even rise (Borsch Supan 1996) (Turner and Richardson 1998).

These things we may expect in the medium term (circa 2020) whilst in the long run there is a possibility of a global decline in savings rates (Heller and Symansky 1997) and a subsequent decline in world growth rates. For developed countries such as New Zealand this presages a return to high current account deficits and a reduction in our share of global output.