Ageing populations create repayment risk for government bonds

New Old Top 10 Apr14Government bonds in the larger, wealthy countries of the West have traditionally been regarded as being “risk-free”.  Most countries have failed to pay their debts at some time in the past, but it hasn’t happened in the post-War period for the major economies, and so investors have forgotten this can happen.

This situation may well change in the future, however, as the population ages.  The reason for this risk is that governments keep on piling up large amounts of debt, whilst economic growth remains slow.  And whilst the problem will not appear next week, pension funds have to think long-term, looking ahead up to 50 years.

Quite a lot could change over this period, as the blog highlights in a new analysis for Allianz Bank’s ‘Project M’ (click here for free download).  The key issue is that the proportion of New Old 55+ in the adult population is rising rapidly, due to the combination of increasing life expectancy and falling fertility rates:

  • Policy-makers continuing to believe they can somehow kick-start growth by adding yet more debt
  • Yet rising proportions of New Old inevitably create a deflationary rather than inflationary environment
  • This combination, if policymakers don’t change course, will eventually mean the debt cannot be repaid

As the chart above highlights, the ageing BabyBoomers are all now becoming New Olders.  In Japan, the New Old are nearly half of the adult population today, whilst they are 43% in Germany and Italy.

The example of Cyprus, and its default last year, is a small, but extremely important indication that it could be dangerous to be too complacent over this type of issue.

Just a year ago, Cyprus defaulted on its debt, causing major losses for domestic and foreign borrowers.  Cyprus is and was an EU member and a member of the Eurozone.  So it was supposed to be protected by the European Central Bank (ECB) – the second most important central bank in the world.  But this made no difference.

The result of the default was that Cyprus then had to impost capital controls, to stop remaining money flooding out of the country.  This was totally contrary to all the EU rules, but still took place.  It was said at the time that these controls would merely be temporary, perhaps lasting for just a week or two.  But the blog was more cautious, arguing:

“The eurozone’s bungled rescue of Cyprus’ banks last week has led to capital controls being introduced on the island.  These are meant to be temporary, whilst things ‘normalise’.  But ‘temporary’ can mean different things to different people.  The UK, for example, introduced “temporary capital controls” as World War 2 began in 1939.  They were only abolished in 1979.”

Unsurprisingly, the blog’s analysis has proved correct.  Every few months, there have been ‘promises’ that the controls will be lifted in a week or two.  But now the Foreign Minister has admitted they will remain for at least the rest of this year, as the economy is forecast to decline 4.8% this year, after a 6% fall in 2013.

The blog will therefore stick to its original forecast, that the controls could easily last for a decade or more.

The critical point is that it is foolish to rely on the promises of policymakers, when the policies that should support the promises are bound to fail:

  • As suggested back in September, if one EU member can introduce capital controls, then so can others
  • And if policies can fail in a small economy like Cyprus,  then they can also fail to work in larger countries
  • Cyprus demonstrates that promises made by the ECB, IMF  and EU have not proved deliverable

The EU now has a growing geopolitical crisis on its doorstep with the Ukraine issue.  Whilst next month may also see major gains by the anti-EU parties in next month’s European Parliament elections.  Reuters, for example, reports there are now “some projections suggesting around a quarter of the 751 seats in the parliament could go to non-mainstream parties“.

The EU have made promises to Ukraine which it clearly cannot keep.  And with anti-EU politicians becoming more numerous, who knows what promises will be next to be broken.

None of this will be new to those who lived through the Cold War, and other geopolitical crises, before the Boomer-led SuperCycle led to the illusion that constant growth was now inevitable.  ‘Trust but verify’ was then the best advice for ordinary citizens and companies, as well as governments.

Those not around in those days now need to go up the learning curve on these issues as fast as possible.  Otherwise they will find out, like the citizens of Cyprus, that policymakers’ wishful thinking has a habit of disappearing into thin air when faced with hard reality.

“Disaster is still some way off” for Cyprus, as Germany prepares to vote

Cyprus Sept13Back in April, the blog suggested that capital controls might remain for rather longer in Cyprus than the “few days or weeks” suggested by the central bank.  And a month later, the bank was still unrealistically claiming they would be lifted “as soon as possible”.

Today, the blog’s own view that they could be in place “for a decade or more” is looking more and more likely.

As the chart from the Wall Street Journal shows, the decline in GDP is accelerating, contrary to all the official forecasts.  GDP fell 4.8% in Q1 and 5.4% in Q2.  As the Journal notes:

“Christopher Pissarides, a Nobel laureate and head of the government’s council of economic advisers, acknowledges that the economy is sinking faster than expected.”

Credit has basically stopped on the island, with most transactions now in cash.  And the economy’s downward spiral is likely to intensify.  Unemployment was 17.3% in June, well above the forecast of 15.5%.

Basic industries are suffering badly.  Cement sales are only 25% of those in 2008.  And as Mr Pissarides added in an unguarded moment ”disaster is still some way off. But times are getting tougher.”

Clearly this is very bad news for Cypriots.  But it is equally ominous for the Eurozone for 3 key reasons:

  • Cyprus is in the Eurozone.  Its use of capital controls means they could happen in other member countries
  • Its bailout was the first one where depositors suffered major losses, also setting a precedent for the future
  • The policy prescription has now had 6 months to work, and has clearly failed

This would not matter if the rest of the Eurozone was healthy.  But it isn’t.  Germany’s finance minister has said Greece may another bailout of perhaps €10bn.

Click here to view the embedded video.

And then there is Portugal, whose economy is also getting worse, not better, as this Financial Times video shows.

So what will happen with Greece and Portugal?  Will the German taxpayer be asked to pay the bill all on their own?  Or will investors instead be forced to take another ‘haircut’ – to use the phrase popularised with Cyprus?

Neither option looks good.  As the blog noted in its 4 Butterflies post last month, we all know that these issues cannot be discussed before the German election on 22 September, for fear of frightening voters.  Markets clearly expect Germany to then pick up the bill on 23 September.   But the blog is not so sure.

Investors are complacent today, but they are not stupid.  If Germany forces them to take a haircut or suffer capital controls in Portugal or Greece, they will immediately worry about what might happen next in Spain and Italy?  Both will likely need outside help before too long.  Spain is not a small island like Cyprus, but the 13th largest economy in the world.  And Italy is not a minor country like Greece, but the world’s 9th largest economy.  Combined, their economies are the same size as Germany’s.

Most large companies have some exposure to both Spain and Italy either directly or indirectly.  Any CFO who hasn’t already developed a contingency plan for the period after 22 September, clearly has a few sleepless nights ahead.

"A word means just what I choose it to mean"

Humpty Dumpty.png‘When I use a word,’ Humpty Dumpty said, in rather a scornful tone, ‘it means just what I choose it to mean — neither more nor less.’

This quotation from Lewis Carroll’s great novel ‘Through the Looking-Glass‘ rather seems to sum up policymakers’ current approach to financial markets. Two recent examples highlight the issue:

Cyprus. Last month, we were assured that the capital controls introduced in Cyprus were only ‘temporary’ and would be lifted within days, or maybe a few weeks. But last week, the Governor of the central bank changed his mind. Instead, they will be lifted “as soon as possible“. And the criteria for lifting is he needs to “make sure that trust in the banks has recovered sufficiently“. That rather sounds, to the blog at least, as though it could be a decade or more before people are allowed to move their euros around freely again. As Reuters notes, the ‘temporary’ controls imposed by Argentina and Iceland are still in place years later.
Japan. Also last month, the G20 Finance ministers issued a statement noting that “Japan’s recent policy actions are intended to stop deflation and support domestic demand“. Nothing about devaluation in order to boost exports. But after pausing in its downward spiral whilst the meeting took place, the currency has resumed its fall and has now passed the $1: ¥100 level. This is already a 27% devaluation since the Abe government arrived.

The blog will continue to keep a close eye on developments, particularly with regard to the Japanese yen. Its link to a potential bursting of the oil price bubble is too important to ignore.