Financial Times

How China Can Defuse Its Looming Demographic Crisis

One of the most notorious facets of Chinese life may be about to change: it has been reported that Beijing is considering much broader exemptions from the “one-child” policy, which limits most urban families to one child. This change cannot come soon enough: the country is heading into severe demographic problems.

The share of the population that is of working age (19 to 59 years old) relative to the country’s total population peaked three years ago, and is declining rapidly. Under current conditions, the proportion of the population that is aged 65 or older is projected to double by the early 2030s. By 2050, without significant reforms, there will be fewer than 1.6 workers for every retired person in China.

Allowing every family to have two children would increase the number of workers supporting each retired person, and limit the number of forced abortions. Yet it would not automatically lead to a fertility rate of 2.1 per household, the rate necessary to hold China’s population level. In industrialized Asian nations without population control laws, as people move from the land to cities and more women join the workforce, fertility rates have been dropping below 1.5 children per family.

The ratio of workers to retired people can be further improved by making the retirement age for women the same as for men – today, it is either 50 or 55 for women and 60 for men. Moreover, the normal age of retirement should be moved above 60 as life expectancy rises. China has used the age of 60 for retirement since the 1960s, although life expectancy has risen from below 60 then to almost 74 at present.

At the same time, China should reform its pension system, which is now run by each city or comparable unit of local government – all with different rules. Such fragmented administration, together with a minimum vesting period of 15 years, is a barrier to permanent labor mobility. If workers move to a new city or province without obtaining a new hukou (residency permit), they are likely to lose a share of their accrued pension benefits.

Such decentralized management also creates opportunities for corrupt practices. For example, a few years ago Chen Liangyu, the Shanghai Communist party chief, was jailed for diverting pension funds to other uses. Most local governments do not have the resources to meet their obligations to pay the retirement benefits promised in the “iron rice bowl” phase of the Maoist era. State-owned enterprises during that period pledged benefits with few, if any, pension contributions from workers.

To pay these legacy benefits, local governments have been using most of the current pension contributions from urban employers (20 per cent of wages) and even “borrowing” employee contributions (8 per cent of wages) to individual accounts. As a result, the system is mainly pay-as-you-go with little advance funding.

To the extent that contributions are invested, they have low returns because of government restrictions. The assets in individual pension accounts may be invested only in domestic bank deposits or government bonds, both of which pay interest below China’s rate of inflation. More broadly, pension contributions may not, in general, be invested in securities overseas.

So why not undertake a “Big Swap” for the pension system in the next decade? Beijing would take over legacy benefits from local governments and establish a centralized pension system. In return, local governments would give up their roles as collectors of pension contributions and payers of retirement benefits.

This Big Swap would have several crucial advantages. Beijing has the resources to pay legacy benefits without relying heavily on current pension contributions. And if a centralized pension system were established, workers could move permanently to locations with the most attractive jobs – without the threat of losing part of their accrued pension rights. If the pension system were rationalized, most contributions could be invested in diversified portfolios with higher returns.

Of course, a two-child policy, the Big Swap and related changes would take years to implement in a sensible fashion. But China should start soon on these pension reforms since the clock is already ticking on its demographic time bomb.