Demographics affect not just the outlook for economic growth – with population size (and hence labour force) a key building block of the economy – but they also have implications for savers and borrowers (households, firms and governments) via an influence on interest rates.

Indeed, while growth is a major influence on the EM investment landscape (stronger economic and corporate earnings growth lift equities), interest rates on debt determine the price of a range of other assets too. Lower rates raise the value of firms’ revenue generation and vice versa.

It is therefore important to form a view on how demographics will affect both growth and interest rates.

Emerging market demographics ‘in focus’ – implications for equilibrium real interest rates is the second of three research papers that seek to examine the nature and consequences of demographic change in major emerging markets. This second paper hones in on the impact that demographic trends may have on real equilibrium interest rates – a crucial, but unobservable, economic variable.

Government bond yields – falling since the 1980s

Taking a step back from the current market volatility and concerns about high inflation, government bond yields in developed and emerging markets have been in long-term decline since the 1980s.

Sliding developed market and EM yields over this period partly reflect success in bringing down inflation, but they also reflect falling real — inflation adjusted – yields.

A large body of academic literature points to an underlying downward trend in equilibrium real interest rates (r*, pronounced ‘r star’) as the reason.

Many papers have concluded that secular trends – including demographics – explain much of the fall in real yields, with the global financial system potentially creating a global phenomenon as markets link savings and investment across borders.

This raises a crucial question for investors: if demographic trends are turning, will interest rates be pushed higher?

R* as theory

The equilibrium interest rate is a hard-to-measure theoretical concept. It’s closely related to economic growth and is also the interest rate that balances an economy’s supply of savings with the demand for investment.

Some commentators have concluded that demographics will push up r* as shrinking pools of labour reduce the supply of savings.

However, demographics operate via two channels which can work in opposite directions: fewer workers may reduce the number of savers, but they also push down on potential economic growth and therefore investment.

R* gazing

Our research suggests that over the next five years, demographic composition will typically push up on r* – primarily due to rising dependency ratios as the number of non-workers outpaces workers. But shrinking labour forces are almost always exerting greater downwards pressure.

Moreover, other factors influencing potential growth are likely to push equilibrium interest rates in different directions across EMs. On a net basis, roughly half of major EMs may see equilibrium rates pushed down by these forces, while half may see them rise.

Over a longer time horizon – say 30 years – the impact of shifting demographic composition potentially creates more meaningful upwards pressure. But even then the outlook varies.

For example, China faces a well-known demographic challenge as the result of its now scrapped ‘One Child’ policy. But even here, falling long-term growth will likely offset the impact on the balance of savings and investments from an ageing society.

Demographics aren’t destiny for growth, interest rates

Demographics are just one (albeit very important) influence on interest rates over the longer term. The Covid-19-shock, income inequality and technological change are all important drivers too, along with policy choices.

Indeed, the fracturing of EM-developed market real yields – which had moved in near lockstep until 2013 – implies that domestic policy choices may have become increasingly important.

Ageing by itself won’t drive interest rates higher, compounding the Covid-19 shock. While demographic trends are becoming more adverse as populations age, the impact on real equilibrium rates continues to be offset in many countries by downwards pressure from slower growth in working-age populations.

Additionally, the balance of risks from economic scarring, inequality and technology gives further weight to our research which suggests that few economies will suffer major upwards pressure on r*.