Photo by Aron Visuals on Unsplash
Photo by Aron Visuals on Unsplash

In aging economies, the ratio of working age to retirement age residents is on the decline. While many aging societies, such as Germany, have an excess capital supply today, they will have a high capital requirement in the future, once they are “old” societies with a high proportion of pensioners.

On the other hand, in demographically young, less developed economies, the labor force will continue to grow in the next decades and the investment requirements are high.

Could these different demographic and economic development stages be mutually beneficial? In this blog post we discuss whether foreign direct investments (FDIs) could help generate long-term economic growth and material prosperity producing demographic dividends for both sides.

There can be economic benefits in demographic transition

A population’s age structure affects key macroeconomic variables such as the labor supply, savings and consumption ratios and current account balances. Opportunities for Demographic Dividends, economic benefits arising from demographic transition, can occur at multiple stages.

The opportunity for a first demographic dividend occurs during the demographic transition process, when the child dependency ratio (ratio of population aged 0-14 per 100 population 15-64) declines faster than the old-age dependency ratio (ratio of population aged 65+ per 100 population 15-64) increases. As a result, the total dependency ratio (ratio of population aged 0-14 and 65+ per 100 population 15-64) declines and the share of the labor force in the total population grows. This can provide a strong impetus to economic growth.

The second demographic dividend opportunity results from higher old-age survival rates in aging populations. As there is a growing need for people to save more in preparation for old age, population aging will raise the ratio of capital to labor, which will make labor more productive, contribute to capital accumulation and foster economic growth.

FDI’s: a possible solution

Societies with aging populations could benefit from the second demographic dividend by increasing national income through FDI’s (Foreign Direct Investments). If the demographically “older” country generates export or current account surpluses in a demographically favorable stage, the associated income surpluses can be invested in the rest of the world. FDI’s result in capital income that increases the aggregate national income of an old population and thereby the quantity of goods available to that society. However, return of capital income or even of capital invested abroad can only be expected in the long term. As long as capital-poor developing countries generate a higher return than capital-rich industrialized countries, the capital remains in the developing countries. By investing income surpluses in developing and emerging economies with a young age structure, an aging society can benefit from the developing country’s growing or large labor force and higher economic growth potential.

Societies with younger populations could benefit from the first demographic dividend when the FDI’s from aging societies help cover the investment needs of the young, underdeveloped economies and promote economic and social development through investments in education, infrastructure, technology or the labor market. As birth rates are also already falling in most developing countries, they too will undergo a gradual demographic aging process in the coming decades. However, due to their lower life expectancy, the old-age dependency ratio will remain very low for a long period of time. This opens up a “window of opportunity” for a first demographic dividend (Fig. 1).

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The role of FDI’s

In this context, strategic development investments from aging economies can help ensure that these countries have a broader base of (highly) qualified workers in the future. In addition to job creation, FDIs by private companies enable the transfer of technology and knowledge and open up access to international markets. This can promote the modernization and expansion of economic activity in developing countries and thereby help, in the long run, reduce economically motivated mass migration toward industrialized countries.

Aging societies could, on the other hand, recruit well-trained workers from developing countries to better satisfy their demand for skilled labor without draining these economies of a large part of their skilled labor force. Skilled immigrants would, in turn, be presented with genuine access to jobs and/or a career and social inclusion in the industrialized countries. These immigrants can also positively influence the social and economic progress of their countries of origin by transferring part of their foreign-earned income back to these countries and by contributing their know-how to local environments upon their return.

To date, experience has shown that FDI’scan have positive effects on less-developed countries. Indeed, total productivity and national income increase in the target country because of the higher capital stock and the associated technology transfer. The increase in productivity is at its highest in the target country when the technological gap between the target and the source country of direct investments is relatively small. The positive effects for the target country outlined above therefore presuppose a minimum level of development, particularly with regard to education and a qualified labor force, infrastructure (transport, energy, legal security, etc.) and technological progress.

Mauro Lanati and Rainer Thiele have observed that an increase in development aid, which in addition to creating more reliable government institutions improves the non-monetary dimensions of quality of life and public services in particular, is associated with declining emigration rates. However, the increase in development aid would have to be very high.

Nevertheless, it can also be shown that certain sectors and groups in the target country can lose out as a result of FDI. In general, it can be observed that in less-developed economies in particular, the inflow of investments from abroad exacerbates income inequality. This is mainly due to the fact that these investments generally involve high technology, which boosts the demand for well-skilled workers. As a consequence, the income gap between highly skilled and low-skilled workers grows.

FDI’s as a win-win?

If the FDI’s from aging societies contribute to the economic development of today’s demographically young economies, these recipient economies could then, at a later stage in their demographic and economic development, invest their income surpluses resulting from their current account surpluses in the “old” societies that once invested in them. This is an attractive prospect for recipient economies as they age because old economies, which are characterized by a higher demand for capital and reduction in national savings, will feature rising interest rates, higher returns and capital income.

For old economies, this import surplus would, in turn, mean they do not have to reduce their own capital stock and could instead expandit even further through net investments. The capital intensity of production would increase with a positive impact on the average productivity of the old economy’s labor force and on GDP per capita. However, investors’ entitlement to income payments (interest or capital income) could nevertheless reduce the per capita disposable income in an old society and thereby the material prosperity per inhabitant.

What do we need to create a win-win situation? Our topic at Global Solution Summit 2019

According to economic theory, capital should flow from rich, developed economies to less-developed countries, as there should be a higher return on capital in developing than in industrial countries. In fact, however, the balance of FDIs is leaning (too) far towards developed economies, as many developing countries continue to lack the institutional, legal and technical infrastructures that provide investors certainty.

For example, just 2.5 percent of all direct investments worldwide go to Africa. Of the approximately €112 billion invested abroad by German companies in 2017, just0.5 percent went to Africa, mainly South Africa.
Which economic, political, institutional, legal or social requirements must be provided in order to increase international capital flows from highly developed economies into less developed economies? And what do developing economies, especially in Africa, need so that FDIs help these countries yield a first demographic dividend and foster sustainable development?

Tomorrow, Andreas Esche (Director, Megatrends Program, Bertelsmann Stiftung) will discuss these questions under various aspects in our session “Fostering Prosperity – FDIs and Demographic Transition” at the Global Solution Summit with panel:

Additional Reading:
Bertelsmann Stiftung (2010): Ageing and the German Economy. Age structure Effects Based on International Comparisons. Gütersloh.

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