China's Aging Problem: Limited Options, Ominous Risk

By Lo, Chi | The International Economy, Fall 2006 | Go to article overview

China's Aging Problem: Limited Options, Ominous Risk


Lo, Chi, The International Economy


Demographics are becoming a big challenge to China's future growth dynamics. The graying population will have far reaching implications for the country's economic policy, structural reform and investment return. The cause-effect sequence runs as follows: An aging population leads to a shrinking labor force, which reduces the marginal product of and hence the return on capital. Investment will thus fall due to lower returns. This means a vicious chain effect--when labor falls, investment falls so that output and living standard fall too.

The only way to keep or raise the living standard on the back of aging population is to raise productivity. This needs deeper structural reform. It also needs more capital formation. But capital formation will not rise unless capital return rises, and this highlights an important policy implication. To raise the return on capital in the face of a shrinking labor force, China has to keep a loose monetary policy bias in the long-term, as low interest rates are needed to stimulate investment. The government will also need to give tax incentives and improve technology to help enhance the return on capital in the long-term.

These implications also apply to Europe whose population is likewise aging. But they have even greater relevance to Japan, whose population has started to fall this year. Behind the Bank of Japan's pledge to keep interest rates very low after it ended quantitative easing and zero interest rate policy recently is this tight demographic constraint on monetary policy. Meanwhile, Japan's acceleration of structural reforms since 2001 has indeed reflected its vision to put in place long-term solutions to tackle the demographic challenge. The lesson for China is that with the proper response, it can still enjoy sustainable growth even in the face of adverse demographics.

COMPARATIVE DEMOGRAPHICS

The falling demographic trend in China (and Europe and Japan) contrasts with growth in the United States, which benefits from a fertility rate close to the replacement rate and high level of immigration. Europe's net immigration is not enough to offset its low birth rate and Japan has no net immigration. The major economies in Asia are facing a similar trend, as economic liberalization, rapid development, better education, and changing values are prompting later marriage and fewer children. Hence, birth rates fall, the workforce shrinks, and the share of the graying population rises.

Asia's four biggest economies--Australia, China, Japan, and South Korea--are all affected by the aging phenomenon. According to the United Nations Population Division estimates, 30 percent of the populations of China and Australia will be older than sixty by 2050, while South Korea's figure is 36.9 percent. Japan's aging phenomenon is the most serious, where 42.4 percent of its population is expected to be aged sixty or older by 2050. On the other hand, only 25.5 percent of the U.S. population will be over sixty years old by 2050.

THE DEMOGRAPHIC CONSTRAINT

The impact on the economy, investment, and living standard of an aging population can be seen in the neoclassical production function, which states that output is a function of capital and labor inputs and technological changes. The first point to note is that as the population ages, the returns to different factors of production--land, labor, and capital--will change. This is because the factors' relative scarcities will change. Second, the return on any factor of production is its marginal product, or the increment to output from an extra unit of that factor being added, holding the amount of all other production factors constant. The extra revenue added by an extra unit of capital is the return on capital.

The neoclassical school of economics argues that an aging population should depress the return on capital. This is because according to the structure of the classical production function, changes in the factors of production being used have feedback effect on each other. …

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