Dealing with global ageing and declining world interest rates: Fiscal costs and pension reform in small open economies

Abstract

How will the worldwide decline in real interest rates associated with global ageing affect small open economies (SOEs) with ageing populations? Lower interest rates will result in higher capital-labor ratios and increased wages. Higher wages will be passed on to pension benefits, exacerbating ageing-related fiscal pressures, increasing taxation and reducing consumption and welfare. The pass-through effect will be stronger if pensions are indexed to nominal wages rather than prices. The article illustrates the interest rates transmission mechanism and its interaction with pension indexation. In addition, the article evaluates the capacity of pension reforms to mitigate the effects of long-run movements in world interest rates. It concludes that pension reforms, particularly those that change the indexation of pensions from wages to prices, protect SOEs against world interest rate changes. These results serve to strengthen policymakers case for indexation-switching pension reforms. © 2010 Macmillan Publishers Ltd.