Britain faces the prospect of an ageing population with a consequent rise in its dependency ratio, and an economy in decline relative to the rest of the world, says Joseph Mariathasan.
Globally, GDP growth is increasingly dependent on emerging markets, most of which still have younger populations. Britain’s problems are not unique in the developed world, although Europe faces a structurally deeper problem than the US. Higher immigration in the US means that it continually replenishes its ageing population with an influx of younger, often highly qualified, workers. At some stage, the immigration debate within developed countries may switch as they realise that as their populations age, the shrinking proportion of young skilled workers will lead to key skill shortages. It will become clearer that long-term economic prosperity will be enhanced by competing more effectively with other developed nations (the US in particular) to attract the best young workers from emerging markets. But the problem of rising dependency ratios is unlikely to disappear, and could also strike at the heart of the inter-generational contract that exists in the provision of state pension schemes.
John Kay, writing in the Financial Times in September, pointed out: “If one generation asserts for itself a higher relative standard of living than it offers to those before or after it, the social contract between generations is threatened. If life expectancy rises, that social contract can be sustained only if working lives and the length of retirement move in parallel.” Clearly, that has not happened, and in a depressed economic environment encouraging older workers to work longer will be seen to happen at the expense of younger workers who will be unable to begin their careers. In London, for example, youth unemployment is 25%. While it is quite realistic for skilled professionals to continue their careers indefinitely as long as they are mentally fit, few employers are looking to hire 66-year-old labourers on building sites. The government, therefore, faces the dilemma that an ageing population will need increasing pension payments but that the rising dependency ratio is leading to fewer active workers to support retirees.
A pay-as-you-go pension scheme will ultimately give rise to intolerable burdens if dependency ratios keep rising. It is the ultimate Ponzi scheme that is only sustainable during periods of population expansion, which has been the case for most government-sponsored pensions. The solution that many countries have realised, of course, is that a sovereign wealth fund that invests a proportion of savings can greatly alleviate the burden on future tax payers. Moreover, in countries with ageing populations, there is a fundamental economic rationale in investing in emerging markets with younger populations and higher growth rates.
While the arguments for a funded sovereign wealth scheme are strong, the UK arguably missed an opportunity during the 1970s and 1980s when North Sea oil boosted Britain’s income. It should have used its oil revenues during the 1980s to fund a sovereign wealth fund of its own for the benefit of future generations, rather than using the revenues to finance current expenditure. Some might argue that the wealth was used, through a lowering of taxes, to effectively remake the UK into a free-market economy. But it did have the effect of turning sterling into a petro-currency, which led to a mild version of the ‘Dutch disease’ – a commodity-driven appreciation of the currency leading to a decline in the competitiveness of the domestic manufacturing sector.
Could Britain afford to set up a sovereign wealth fund today? The immediate answer for many would be that it could not. Where would the money come from and how could it be justified? Yet current market conditions are truly extraordinary and give rise to strategies that would be impossible under normal market conditions. In particular, there is an opportunity for Britain to create a fund for future pensions that is based on the labour of the younger population, while simultaneously satisfying the current demand by pension funds for adequate long-dated government bonds.
Today’s economy is characterised by the term ‘financial repression’. Government bond yields across the developed markets do not in any sense reflect fundamentals, and 30-year UK government bond yields hover around 3%, while 10-year yields are around 1.7%. It is difficult to see any positive return above inflation on either of these, except in a calamitous deflationary environment. A 2% GDP growth rate in the developed world is seen as nirvana. But even putting aside China, Brazil and India, a host of other emerging and frontier markets, such as Indonesia, Nigeria, Vietnam, Kenya and Sri Lanka, are showing annual GDP growth rates approaching 5% or more, growth driven by young populations moving rapidly towards greater urbanisation underpinned by healthier balance sheets, positive demographics, a rapidly growing middle class and rising urbanisation.
There is a way to take advantage of current economic conditions. The UK should set up a sovereign wealth fund, as a separate legal entity, that would issue $50bn (€23.1bn) or more of 30-year bonds, backed by the government, at current yields of 3% or slightly higher. These bonds would be sold to UK domestic institutions who are desperate for long-dated gilts to match their long-term liabilities. The proceeds would be invested in a range of emerging market assets covering equities, bonds, private equity and property. While the yield on all the assets may not be 3%, there are plenty of emerging market listed equity funds today that yield more. The Aberdeen Asian Income fund, for instance, yielded 3.3% at end-September, while the Henderson Far East Income fund yielded 5%. Over a period of 30 years it would be expected that emerging market assets would return more than 3% per annum.
This structure is effectively a government sponsored hedge fund but with one huge benefit over hedge funds – namely that it can never go bankrupt for the simple reason that the government can effectively print more money to pay off the debt if the assets are insufficient. The risk for the country is that issuing debt by printing money would very likely be the precursor to higher inflation – but that would only have to take place if the assets did not achieve a 3% return. Over 30 years, it would seem reasonable that emerging market assets could achieve above a 3% nominal return. Moreover, any global inflation would only increase the NAV of the fund as its assets would be highly correlated to inflation, while its liabilities would be fixed.
Critics of the idea would, of course, immediately point to the work of economists Carmen Reinhart and Ken Rogoff, whose key finding is that economic growth slows once the ratio of debt-to-GDP exceeds 90%. But there is a crucial distinction between debt raised to finance current consumption, and debt used to finance investment, particularly long-term debt used to finance long-term financial investments in good quality assets, albeit in faster growing economies. Reinhart and Rogoff themselves caveat their findings. They differentiate between a debt level seen at around 90% when growth slows and another unspecified intolerance level when bond markets force debt yields to unsustainable levels. But Japan, which has a debt-GDP of over 200%, clearly illustrates that markets can support low bond yields way past any 90% threshold. The debt issued by the sovereign wealth fund would be backed both by the government guarantee and also by the assets.
Over 30 years and beyond, the result would be to produce a fund that would generate a positive NAV, as well as a positive dividend stream. Future generations of the retired would effectively be living off the wages of younger populations elsewhere in the world. For Britain, a well-structured fund could also be used to incorporate the investment activities of entities such as the department for international development and the CDC development fund, while simultaneously addressing a need for its own population, a need that is not going to disappear.