Longevity: The second fiscal crisis
Unchallenged, the projected costs of ageing in Europe are truly terrifying. But Douglas Renwick and Eugene Chiam point to potentially significant long-term mitigation that can – and has – come from reforms
Most advanced economies are still struggling to adjust their public finances to lower growth and permanent output loss after the global financial crisis of 2008-09. Therefore, the successful resolution of the current fiscal crisis represents the most pressing risk for many advanced-economy sovereign ratings. However, without further reform to address the impact of long-term ageing, these economies face a second, longer-term fiscal shock.
In advanced economies, the elderly are expected to make up a rapidly rising proportion of their populations over the next 30-40 years. On average, the elderly dependency ratio (over-65s as a share of working age population) will rise from 14.2% in 2012 to 34% by 2050. This will put severe pressure on public spending for many countries.
The ageing population problem in Japan is already widely documented and is the most severe, according to UN projections of elderly dependency ratios for 2010, 2025 and 2050.
The Japanese government has estimated that ageing adds about 0.2% of GDP to the social security bill each year. This intensifies the already daunting fiscal challenge facing the Japanese sovereign a nd contributes to our negative outlook on the sovereign’s A+ ratings. Yet the problem is forecast to be much more severe for EU countries in the medium term, as they will comprise the worst 15 countries (besides Japan) by 2025.
To put this into a sovereign credit context, Fitch is not currently downgrading ratings on the basis of future ageing costs. Few countries face an imminent problem and there is still significant scope to neutralise the costs through reform. However, without reforms or consolidation in other parts of the budget, demographic trends will lead to substantially higher pressure on budgets in the long term, as declining potential GDP growth exacerbates the fiscal challenge. We would expect to take negative rating action over the next decade for countries facing the most severe and/or urgent ageing pressures in the absence of reforms, whereas countries with a good track record of passing reforms would be accorded more leeway.
Fitch recently produced a study on framing the impact of ageing populations on sovereign credit ratings. According to our analysis of EU and OECD countries, the median country is projected to see its annual budget worsen by 0.6% of GDP by 2020, and 4.9% of GDP by 2050. Consequently, many of these countries would experience ballooning government debt-to-GDP ratios if no action were to be taken, with the average EU27 debt-to-GDP ratio projected by Fitch to rise 6.9 percentage points by 2020 and 119.4 percentage points by 2050.
In the study, for illustration purposes we used our sovereign rating model – one of a range of qualitative and quantitative inputs into the rating process – to frame the ratings impact under a no-policy-response scenario. It predicted a 1.5-notch downgrade by 2030 for countries with the worst ageing problem, and a five-notch downgrade by 2050. According to the model, Japan, Ireland and Cyprus face the largest jump in ageing costs over the next decade, while Luxembourg, Belgium, Malta and Slovenia face the most severe impact over the very long term.
Despite the fiscal challenge currently facing some periphery euro-zone countries, their recent experience also shows the power of reforms in transforming long-term projections. Here, accelerated reforms in Portugal, Italy and Greece to shore up confidence in long-term fiscal sustainability have effectively neutralised the long-term impact of ageing on public finances.
Greek ageing costs are projected to rise by just 3.2% of GDP by 2050, while the figure for Italy rises by just 1.2%. In Portugal, the size of the projected increase in expenditure from 2010 to 2050 was 9.7% of GDP when estimated in 2003, and is now just 0.2% of GDP, by latest estimates. Fitch calculates that this change would reduce the impact on Portugal’s public debt by 2050 from 240% of GDP to a negative 40% of GDP.
However, it is still important to remember that such reforms are politically challenging, which increases the risk that they will be deferred. Even when passed into legislation, they are not cast in stone, and are subject to the risk of policy U-turns if there is high social pressure, notably in countries with a long history of generous entitlements, or those with growing ‘austerity fatigue’ as a result of the euro-zone crisis. As most legislated reforms will result in state pensions becoming less generous over time, there could be a further risk to their political sustainability in the face of a greying electorate.
In conclusion, when considering the impact of ageing populations the largest uncertainties relate to the scope for policy reforms. There are also other uncertainties about the underlying economic assumptions used in long-term fiscal projections. However, despite this, there are broad trends that can be identified with some certainty.
For example, life expectancy (and the median age of the population) is most likely to continue to increase. But variables such as net immigration and productivity are much harder to pinpoint. As an example, this year the EC has revised down long-term productivity assumptions for the euro-zone by 0.2 percantage points compared with that of 2009. Trend growth in advanced economies has also declined over past decades, which underlines the importance of structural reform in the coming years to raise potential output and thereby improve fiscal sustainability. In this respect, the crisis has not gone to waste – the pace of reform in Europe has accelerated in the past few years. Nordic countries, in particular, set a good benchmark, illustrating how much scope there is to increase labour force participation in advanced economies, especially among the 55-64 age bracket.
Douglas Renwick and Eugene Chiam are research analysts at Fitch Ratings