The world outside the capital markets tends to view all within as dreadfully short-termist, while those in the know point an accusing finger at the fixed income community (who in turn ‘tut tut’ in disapproval of the foreign exchange community’s urges for instant trade gratification). So trying to attract attention to an issue – even one that could have profound implications for every government bond market, whose time horizon stretches to 2025 and beyond – is not easy.
The issue in this case is the financial implications of ageing in Western Europe. A fascinating study by Standard & Poor’s*, paints a stark picture of what might happen if governments fail to make changes. As the populations age, tax bases will diminish and public social security obligations will rise through mature ‘pay-as-you-go’ (PAYG) schemes (especially for health and pensions).
“Left unchecked the debt levels of some countries would exceed 200% of GDP by 2050, bringing about double-digit deficits. This hypothetical fiscal outcome would be inconsistent with the current high level of sovereign credit ratings in the EU-15… a collective slide down the ratings scale would commence early in the next decade,” argues S&P. “It would continue until the mid-2030s by which time the vast majority of EU-15 sovereigns would display fiscal characteristics that are today associated with non-investment-grade sovereigns.”
Dramatic reading indeed. “We must emphasise here that these are not predictions: we are categorically not implying that it is unavoidable that European governments will be downgraded so dramatically in the coming decades. We do not believe that they would allow debt and deficit burdens to spiral out of control,” stresses one of the authors of the research, Moritz Kraemer of S&P’s rating group. “It is a back of the envelope calculation, extrapolating into the future. Today’s profile does exist and must be changed. I don’t like this expression ‘a demographic time bomb’ that I hear being used. Nothing is going to suddenly go off. What we wanted to show was that the issues must be addressed sooner or later.”
Kraemer and his team used computed data from the OECD and the European Commission to compile the report. “If things were to stay the same then implicit or explicit promises made by politicians to their citizens might have to be broken. The temptation will always be to postpone necessary adjustment until the political environment is more conducive to change. In the past governments have inflated their way out of debt problems. Today with an independent regional central bank how could they do this?’
As Kraemer comments, their analysis does not unearth startlingly novel conclusions, the rising cost of funding an ageing population is a well-aired topic amongst the economic soothsayers and bond market analysts. He does point out that the concept of the majority of EU governments with below investment-grade credit, which is the outcome of one scenario he has analysed, might cause some angst. S&P suggests experience has shown that running extended fiscal surpluses is politically unsustainable, and that eventually the money is returned to the electorate in the form of tax cuts or used to step up public spending. Couple this scenario with no attempt at structural reform of pensions for example and the path of credit deterioration is quite shocking (see figure).
So should the market be pricing in additional risk premia, and sending government bond yields higher?
“This is one of those eternal questions,” admits Roberto Plaja, head of fixed income at SanPaoloIMI. “Should bond investors be worried? Yes, when the time comes. It is many years in advance and we know that governments have a tendency to react only when the crisis is upon them. They don’t seem to be able to plan in advance. But yes they will start to react eventually. If for argument’s sake pension reforms go the way of the UK, then yes bond issuance will have to be greatly increased and yes sovereign creditworthiness will be worsened.”
S&P indicates that European governments need to generate budget surpluses as large as possible and as soon as possible or undertake comprehensive reforms of the social security systems. Kraemer adds, “The window of opportunity has been closing – Europe needs to seize its chances now.”
* Western Europe Past Its Prime – Sovereign Rating Perspectives in the Context of Ageing Populations by Moritz Kraemer and Luc Marchand, Standard & Poor’s
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