Aging gracefully

By Diana Farrell

Over the next 20 years, the financial wealth of Japanese households will stop growing and begin to decline, leaving them with $8 trillion less than they would have had if historical growth rates persisted, according to the McKinsey Global Institute.

Over the next 20 years, the financial wealth of Japanese households will stop growing and begin to decline, leaving them with $8 trillion less than they would have had if historical growth rates persisted, according to the McKinsey Global Institute. Wealth will decline not only in aggregate, but also on a per-household level. That means Japanese households will be no wealthier in 2024 than they were in 1997.

The heart of the problem is that Japan is getting much older. By 2024, nearly a third of the population will be over age 65, one of the highest levels in the developed world. By the same year, the median age in Japan will have increased by seven years, to 50—more than 10 years older than that of the US—and there will be more retired households than working-age ones.

In addition, as birth rates have fallen, the mortality rate has also risen, because older people are such a large part of the population. In 2006, the mortality rate will for the first time exceed the birth rate, when Japan's population will stop growing and begin shrinking, bringing about a decline in the number of savers.

The prime savers ratio, which shows the number of households in their prime saving years (30 to 50 years old) relative to the number of elderly households (aged 65 and older) has been declining in Japan since 1975, and dipped below one in the mid-1980s. This indicates that there are more elderly households saving less or actually consuming savings than middle-aged ones generating increasing new savings. This ratio is expected to remain well below one in the future.

Younger generations are also saving far less than previous generations did. Households headed by individuals born in the 1960s and 1970s have been moving into their prime saving years since 1990. These households have higher disposable incomes than earlier generations, but they also spend more money. The net effect is that this younger generation saves less. When current retirees were 35, they saved 26 percent of their disposable income. Today's 35-year-olds save just 6 percent of their income. This change in generational savings behavior will amplify the effects of a declining number of savers.

All these trends will lead a big slowdown in the flow of new savings. Average household savings will be lower because there will be fewer people in their prime saving years, prime-saver households who consume more and save less will become increasingly dominant, and many elderly households will be dissaving. The savings rate will begin a precipitous decline.

Households accumulate wealth by saving money from their income, or by the value of their savings increasing. Japanese households invest mostly in very low-yielding savings accounts, so household wealth is built primarily through new savings. This is in contrast to the US, where 28 percent of the increase in household wealth between 1975 and 2003 came from asset appreciation.

Meanwhile, Japanese household liabilities are expected to increase over the next 20 years. This is because younger generations have taken on much higher debt levels than their elders. Someone aged 35 today has accumulated debts nearly equal to what it took someone who was the same age in 1975 to accumulate by the time they were 60. Driven by these two forces of declining assets and rising liabilities, financial wealth in Japan will fall 0.2 percent annually between 2003 and 2024—in sharp contrast to the period between 1975 and 2003 when it increased by 5.5 percent a year. The result leaves Japan with nearly $8 trillion below what it would have accumulated if the 1989-2003 average annual growth rate is extrapolated.

This trend will have negative repercussions for Japanese living standards, since wealth represents the ability to finance future spending and is a broad measure of economic well-being. On a per-household basis, financial wealth can be expected to fall 0.4 percent annually over the next 20 years. This may sound like a small shift, but by 2024, household wealth will be no higher than it was in 1997.

Since 1981, Japan has produced enough savings to fund its domestic investment needs and still export savings abroad. In 2004, it sent about $170 billion in savings to other countries. But as Japan grows older and its pool of savings shrinks, it is likely to become a net borrower rather than a net lender to the world.

The US in particular could face a painful adjustment, since Japan has played an important role in financing the current massive US account deficit. As of October 2004, Japan owned more than $715 billion of US Treasury bonds—nearly 40 percent of the Treasurys held by foreigners. As Japanese funding dries up, the US will probably be forced to trim its trade deficit. This could have enormous repercussions for the global economy, since strong US demand, paid for with large amounts of foreign debt, has helped fuel economic growth in many countries—including much of Asia after the 1997 financial crisis.

There are no easy policy solutions to blunt the impact of an aging population on savings and wealth. The only way to meaningfully counteract the coming demographic pressure is to increase household savings and boost the returns earned on those savings. In Japan, as elsewhere, extending the period in which households save most by raising the retirement age is sensible, given the significant increase in average life spans over the last 50 years. Encouraging younger Japanese households to save more would also be helpful.

But the most effective change for Japan is to raise the rates of return on financial assets. Between 1975 and 2003, Japanese financial assets appreciated at a real annual rate that was 2.8 percent lower than those in the US and the United Kingdom. Raising Japanese rates of return to these levels will be difficult, but could close nearly half of the projected wealth shortfall. To do so, Japan will have to raise productivity throughout the economy and increase the efficiency of the financial system in allocating capital.

Despite a handful of world-leading industries and companies, overall productivity in Japan has lagged: labor productivity is now roughly 30 percent lower than in the US, and capital productivity is nearly 40 percent lower. Higher productivity leads not only to efficiency gains, but also stronger earnings growth and broader growth throughout the economy.

Fundamental structural reform is necessary to raise productivity growth and overall financial returns in the lackluster Japanese economy. Due primarily to its shrinking population and labor force, Japan's potential GDP growth could slow to 1.1 percent annually, down from the already anemic 1.8 percent growth that followed the 1990 crash.

Raising rates of return will also require improved financial intermediation so that savings are channeled to the most productive investments. More transparent and liquid financial systems encourage corporate managers to improve performance by exposing lower performers and denying them funding.

Japan's financial system has long been ailing, particularly its banks, which play a larger role than they do in the US or the UK Still, the consolidation and government bailouts of recent years have helped Japanese banks reduce their mountain of bad debt. To further improve financial intermediation, policy makers must increase competition and encourage innovation in the financial sector and the broader economy, enhance legal protections for investors and creditors, and end preferential lending by banks to select companies.

Japanese households also have a role to play. After being burned by the stock- and real-estate market crashes of 1990, and then seeing negative equity returns since then, the share of Japanese household financial assets devoted to equities and bonds has not surprisingly declined from its already low levels. Around half of Japanese household assets are in low-yielding deposit accounts, whereas in the US, the same figure is only 15 percent.

Japanese households may benefit from moving into riskier asset classes if productivity throughout the economy increases and raises returns. In recent years, Japanese corporations have already begun increasing their dividend payouts, albeit in response to takeover threats. A move to diversify household financial assets is an important means of increasing the efficiency of capital allocation. To promote better asset allocation, policy makers should increase the amount that can be invested in tax-deferred and tax-advantaged accounts, improve investor education, and create incentives for well-diversified portfolios.

Japan's rapidly aging population and low investment returns are driving a decline in savings and wealth that will lead to a dramatic reduction in the amount of capital available to fuel the economy. This means lower living standards and reduced growth just as Japan tries to pull itself out of its long economic malaise. But there are ways to take some of the sting out of aging, if Japan starts working on the difficult challenges now.

Diana Farrell is director of the McKinsey Global Institute, McKinsey's economics think-tank.

This article originally ran in Far Eastern Economic Review.

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