July --
September 1996
Volume 7, Number 3
World capital markets will be tight in the years ahead. But a severe global capital squeeze and a sharp rise in world real interest rates are not inevitable..
That is the conclusion of Zia Qureshi in his recent Global Capital Supply and Demand: Is There Enough to Go Around? (Directions in Development, Washington, DC: World Bank, 1996).
Much will depend on whether industrial countries continue to reduce their fiscal deficits. If they can, rising global demand for capital can be accommodated by likely increases in supply—and world long-term real interest rates should not rise above the recent average of about 4 percent a year. Those rates could even decline if deficit cuts are strong enough.
Much is at stake here. If deficits are not reduced, world real interest rates could rise well above their already historically high levels, hurting both industrial and developing countries.
Central to cutting deficits in industrial countries—and with favorable implications for private saving—is the reform of social security systems. But the timing is crucial. Acting early will help improve fiscal positions before the share of the elderly in industrial country populations begins to rise rapidly.
Developing country demand for foreign capital will rise, but is unlikely to put much pressure on world real interest rates. Greater investment spending by these countries will for the most part be financed from increases in domestic savings. Moreover, net capital flows from industrial to developing countries are small compared with budget deficits in industrial countries. In 1995 a one-fifth reduction in industrial country budget deficits would have financed all net capital flows to developing countries.
Saving in developing countries will not rise automatically to support the higher investment. Domestic economic environments, policies, and institutions conducive to higher saving will be needed. This means ensuring macroeconomic stability (to underpin strong and sustainable growth) and fiscal discipline. It also means reforms in pricing and the tax and social security systems (to remove disincentives to saving). And it means improving the functioning of financial markets. These improved conditions have the salutary benefits of promoting investment and attracting foreign capital.
As East Asia shows, higher investment can call forth higher saving. Foreign capital also flows more steadily (and sustainably) to countries with high domestic investment and saving—and therefore high economic growth.
The greatest influence on world capital markets will be the savings in industrial countries, which account for about three-quarters of the world's total annual savings. Unfortunately, the average gross savings rate in OECD countries has fallen by about 5 percentage points of GDP since the early 1970s, with the drop concentrated in the public sector. On average, public saving fell from almost 4 percent of GDP during the 1960s and early 1970s to near zero today.
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Much will depend on whether industrial countries continue to reduce their fiscal deficits |
If the decline in industrial country savings continues, global long-term real interest rates could rise even higher than the 4.0-4.5 percent average since the mid-1980s. But this is unlikely, at least for a while, as the baby boom generation enters middle age. People between 40 and 64 years old—the prime earning and saving years—are expected to rise from 40 percent of the population today to 45 percent by 2010. And those aged 20-39 years—typically a time of net borrowing—will drop from 42 to 34 percent. This shift is expected to more than offset the negative effect on savings of a continuing rise in the share in population of those over age 65—who usually save little or dissave—from 18 to 21 percent.
Over the next 10 years these factors could increase net household financial savings in real terms by about $5 trillion, on top of a trend increase of about $7 trillion, yielding a total of $12 trillion. This demographic shift is expected to be especially pronounced in the United States, potentially raising its net savings rate from 4.9 percent of GDP in 1992 to 6.2 percent by 2010.
Net private investment in industrial countries financed through capital markets could account for up to $5 trillion of increased net household financial savings over the next 10 years or so. After allowing for net capital flows to developing countries of $1.5-2.0 trillion, that would leave roughly another $5 trillion for financing industrial country government deficits.
Can government borrowing in industrial countries be kept within that $5 trillion? Only if things change. Past trends and current spending programs suggest that the aggregate borrowing requirement of governments in industrial countries will greatly exceed $5 trillion over the next 10 years. That would squeeze the available capital both for private investment in industrial countries and for flows to developing countries, putting upward pressure on interest rates.
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Most developing countries will finance their increased investment from their own savings, projected to rise |
A major area of fiscal adjustment will be the reform of social security systems. The present value of unfunded public pension liabilities in most major industrial countries ranges from 100 to 250 percent of GDP. That means that the implicit social security debt is a multiple of an already large explicit public debt. (The gross public debt averages more than 70 percent of GDP in industrial countries, up from about 40 percent just 15 years ago.)
The boost to private savings in industrial countries from a rising proportion of middle-aged savers, though significant, will be temporary. Around 2010 the share in industrial country populations of people over 65 will start to rise rapidly, while the share of those aged 40-64 will fall, tending to depress private savings rates once again (figure 1). The rising proportion of retirees will also add to public pension liabilities, which at that point could rise exponentially unless pension systems are reformed. Along with those reforms, temporary increases in savings over the next 10 years or so must be invested as profitably as possible to generate high returns to support the growing ranks of pensioners. Limiting government deficits in industrial countries and so allowing more capital to flow to profitable investments in developing countries would benefit both groups of countries.
While reducing fiscal deficits is a priority, the low private saving in industrial countries calls for correcting the incentive distortions that depress the private propensity to save. Some analysts consider generous, unfunded public social security systems to be the main factor in the decline of private saving in industrial countries. As Chile's success with the privatization of pension plans shows, social security reform can do much to raise saving.
The World Bank expects real gross domestic investment in developing countries to rise by about 7 percent a year during 1996-2005, boosting investment from the 25 percent of GDP that it averaged during 1986-95 to 27 percent in 1996-2005. Investment in developing countries could average $1.4-1.5 trillion a year over the next decade (in 1987 dollars), an increase of almost 50 percent from its 1995 level (figure 2).
Investment ratios are expected to rise in all developing regions—by different margins.
Most developing countries will finance their increased investment from their own savings, which are projected to rise as a result of stronger growth, favorable demographic developments, and declines in government deficits. Average central government deficits in developing countries fell from 5-6 percent of GDP in the second half of the 1980s to about 3 percent in the early 1990s.
The World Bank expects average gross national saving in developing countries to rise from 24 percent of GDP in the past decade to about 26 percent in the next, roughly matching the projected rise in their investment rate. Assuming continuing economic reforms and buoyant world trade, average growth in developing countries is projected to rise from 2.1 percent a year in the past 10 years to 5.3 percent in the next (excluding the transition economies, the projected increase is from 4.2 percent to 5.4 percent).
Savings in developing countries should also increase because of demographic developments. Because of a falling share in the population of those below working age, the average dependency ratio in developing countries is expected to decline continuously for at least the next 20-25 years.
As with investment, the largest rise in saving is expected in East Asia. Over the past 10 years gross national saving in the region averaged 34 percent of GDP, and in the next 10 it is likely to reach 36-37 percent of GDP, supported by declining youth dependency ratios and the virtuous circle of high investment, high growth, and high saving.
A shift in investment toward the private sector should also promote increased domestic financing of investment. East Asian countries formerly relied heavily on public sector and foreign funding, but in infrastructure they are increasingly switching to private sector and domestic financing. Of all private investment in East Asia over the next 10 years, only about 4 percent is expected to be financed by foreign investors.
Developing countries make a net claim on industrial countries' savings roughly equal to their current account deficit plus the net change in their external reserves. Experience shows that, in general, current account deficits in developing countries are unlikely to remain well above 2-3 percent of GDP for long. If large, persistent imbalances are not corrected by domestic adjustment, international financial markets could force the necessary adjustment by ceasing to finance the deficit, as happened recently in Mexico.
World Bank projections show an average current account deficit for developing countries of about 1.4 percent of GDP over the next 10 years, roughly the same as in the past decade. Allowing for increases in reserves to maintain adequate import cover, this translates into cumulative net capital flows of $1.4-2.0 trillion over the next decade. Foreign capital will finance about 7 percent of all investment in developing countries over this period. Relative to industrial countries' total savings, the net capital flows to developing countries over the next 10 years would remain small—about 4 percent on average.
Because these claims are so small, developing countries are unlikely to face a shortage in international capital markets. Individual developing countries' access to capital markets will depend mainly on investors' perceptions of country policies and prospects. Foreign investors' attraction to stable, growth-supporting environments is reflected in the surge in private capital flows to developing countries during the 1990s. Between 1991 and 1995 only a dozen countries, most of them in East Asia and Latin America, accounted for more than 80 percent of private capital flows to developing countries. Countries with a record of sound policies and strong economic prospects are likely to be able to continue raising capital without much difficulty on international capital markets.
Major recipients of private capital flows have been mostly middle-income countries, with the notable exception of two big low-income countries—China and India. Most low-income countries remain heavily dependent on official flows for foreign capital needs. Sub-Saharan Africa, for example, which received a paltry 2 percent of private flows to developing countries over the past five years, continues to receive nearly 90 percent of its long-term capital inflows from official sources, compared with a developing country average of 30 percent.
Although the demand from low-income countries for official capital will remain high, the supply is likely to be increasingly limited. Net official capital flows have leveled off in the 1990s and have declined in real terms. So if a shortage does develop, it will be in the supply of official capital, a particular concern for the Sub-Saharan countries. These countries not only rely predominantly on official finance but are more dependent on external financing than other developing regions. Even in 1995, when commodity prices helped boost export earnings, Africa's external current account deficit (excluding grants) was about 3 percent of GDP, compared with about 2 percent for all developing countries. The probable scarcity of official capital emphasizes the urgency for countries in the region to strengthen domestic resource mobilization and step up economic reforms to improve their prospects for attracting private investment.