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Ageing populations create repayment risk for government bonds

Financial Events
By Paul Hodges on 25-Apr-2014

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.