Debt and demographics might be among the most important and least discussed factors influencing long-term movements in foreign exchange rates. From mid-2019 to mid-2024, the currencies of countries with an older population underperformed those that are younger and less heavily indebted.If this relationship continues into the second half of the decade, debt and demographic trends might give us insight into the future direction of foreign exchange rates.
The influence of debt and demographics on currency market returns is especially relevant given the significant, but uneven, increases in debt-to-GDP ratios and the of the world’s population. Since 2000, debt ratios have increased for every major economy in the world. That said, the total level of credit to the non-financial sector varies considerably, for example, from 80% of GDP in Mexico to 400% in Japan (Figure 1).
Figure 1: Public and private sector debt has grown faster than GDP in almost every country
The increase in debt levels has happened in conjunction with the of the global population. Not only has the average age increased considerably during the past few decades, but the ratio of the retired population (65 years and up) to the working age (23-64) has increased even more quickly. Here, too, there is considerable variation among countries (Figures 2 and 3).
Figure 2: The world’s population is greying with the average age rising in every major economy
Figure 3: The ratio of retirees to workers has soared unevenly around the world
In younger countries like Mexico, India and Brazil, the retirement age population is around 15% of the working age population, implying that there are around seven workers supporting every retiree. By contrast, the retired population in Japan is around 58% the size of the working age population, implying around four retirees for every seven workers.
These trends raise the question: how can public and private sector entities service increasing debt burdens and finance their retirement systems with working age populations that are, in many cases, shrinking? The currency market’s answer to this question is that the debts and retirement benefits might be paid off with currencies that are progressively worth less and less.
We calculate the returns of 15 currencies versus the U.S. dollar (USD) from futures markets with the futures contracts rolled to the next contract 10 days prior to expiry. The return of a currency futures contract equals the spot return plus the interest rate differential between the two currencies in question. The return closely resembles what one would earn investing in a short-term deposit in one country relative to the return of a T-bill or other risk-free security in U.S. dollars (USD).
From July 1, 2019 to June 30, 2024, the correlation coefficient between the old age dependency ratio and the reinvested (rolled) return of currency futures on our 15 currencies was -0.65. The older the population, the lower the average return of a currency versus USD and the younger the population the better the currency’s performance, on average (Figure 4).
Figure 4: The greater the retiree-to-working population ratio, the weaker the currency, on average
The relationship between currency futures returns and debt levels is even stronger. Using data from the Bank for International Settlements (BIS), we calculated the total debt of each country (public sector, household and non-financial corporate debt) as a percentage of GDP. The correlation between the total debt-to-GDP ratios and the reinvested (rolled) returns of our currency futures was -0.75 (Figure 5) over the five years from July 1, 2019 to June 30, 2024.
Figure 5: The higher the total debt-to-GDP ratio, the weaker, on average, a currency has been
What mattered was the overall level of debt, not whether it was public or private. Taken separately, public debt ratios and private debt ratios had a weaker correlation to currency returns than total debt levels. The correlation of public debt/GDP versus currency returns over the five-year period was -0.48; for private sector debt (household + non-financial corporate debt)/GDP, it was -0.52 compared to -0.75 for total public + private debt to GDP. The fact that the overall debt ratio had a stronger influence on currency returns than public or private sector debt ratios taken in isolation appears to confirm the notion that all debt is public sector debt. To be sure, households take out mortgage, credit card, auto and student loans while businesses can borrow from banks and bondholders, but in a crisis, much of that debt can be nationalized in one of two ways:
- Directly: nationalizing banks or other financial and bringing their debt onto the public books or forgiving loans to households and businesses.
- Indirectly: running large budget deficits where tax revenues fall well short of allows a gradual transfer of household and corporate debt onto the public balance sheet.
Both approaches were used in the U.S. and Europe during the global financial crisis and in Japan during long period of economic stagnation following the bursting of its real estate and equity bubbles in the early 1990s.
A country by country look beginning with the extremes: Japan and Mexico
At the extreme ends of the distribution are Mexico and Japan. Mexico has low levels of debt and a classic age pyramid with far more young people than old (Figure 6). Japan offers a striking contrast, with the largest portion of its population between the ages of 40 and 80 (Figure 7). So, on the one hand, Mexico has an abundance of young workers to finance a relatively small amount of debt. By contrast, Japan is having fewer and fewer young people available to finance not only a large population of retirees but also the world’s highest debt-to-GDP ratio.
Figure 6: Mexico has an abundance of young workers supporting a small retired population
Figure 7: Japan has large numbers of retirees and a shrinking working age population
Given Japan’s demographics, how can such a debt burden be financed? One way is through currency devaluation: reimburse the debt with currency that is worth less and less. This would explain why the Bank of Japan (BoJ) is one of only two central banks that has not substantially raised rates over the past two years (Figure 8). It would also explain the BoJ’s outsized balance sheet expansion over the past decade due in large part to a quantitative easing program that has dwarfed those of other central banks (Figure 9). As the BoJ’s balance sheet has expanded relative to the Fed, JPY has fallen precipitously versus the USD.
Figure 8: The BoJ is one of the few central banks that has not raised rates substantially
Figure 9: The BoJ balance sheet grew more than other central banks’ and it hasn’t shrunk since
By contrast, Mexico has pursued a tight monetary policy, with the central bank keeping its policy rate around 6% the Fed’s (Figure 10). MXN’s +6% interest rate carry versus USD contrasts sharply with the -5% carry on JPY versus USD. In Japan’s case, high levels of indebtedness more or less require rates to remain low: it’s the only way to finance the debt burden. ountries with rapidly populations don’t need to attract a lot of capital to finance new investments. Overall, JPY futures contracts have plunged in value while MXN contracts have soared (Figure 11).
Figure 10: Mexico raised rates faster and higher than the Fed and it isn’t cutting quickly
Figure 11: The value of the reinvested peso future has soared as the yen has declined
Bottom Line
Most countries fall between the two extremes of Japan and Mexico. Among some of these countries the nations that comprise the Eurozone, and South Korea are set to experience a rapid rise in their dependency ratios in the coming decades. China and South Korea, in particular, have seen rapid rises in debt levels in recent years and have seen some currency weakness as their economies slow. Meanwhile, other countries like the U.S., U.K. and especially Brazil, India and South Africa have different demographic profiles. In the second part of our paper, we will explore how developments in these countries might influence currency returns in coming decades.
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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
