THERE is more to Europe’s current challenges than debt, stagnation and unemployment. There is an elephant in the room that could become the biggest issue of all: an ageing population.
Europe’s baby boom started in the 1950s and the proportion of retirees relative to the working population, therefore, is beginning to rise. This will inevitably lead to societal changes, including rising pension and healthcare costs and their resulting economic burden. But the influence of pensioners goes further: they are making investment decisions that will increasingly affect the wider economy.
Baby boomers’ attitudes change as they stop work and sell off assets – especially risky ones – to finance their retirement. An ageing population also leads to relative scarcity of labour, dampening productivity and returns on capital, thus reducing asset values.
And Europe’s top heavy population structure will only exacerbate existing economic problems, which already steer investors towards what they perceive to be secure investment solutions. New regulations like Basel III are even accelerating this trend – they force banks, pension funds and insurers to invest mainly in low-risk assets. The outcome is an asymmetric investment pattern that overlooks the private sector in favour of government bonds.
This trend is already apparent on an institutional level. Insurers and pension funds are mostly invested in fixed income instruments, with small equity allocations. This pushes down returns from low-risk assets, thus preventing investors from achieving their targets.
This economic environment could induce a credit crunch. If the private sector lacks funds to invest, economic activity will become sluggish. A credit crunch also causes central banks to lower interest rates to inject life back into the economy. This does have its benefits, as it encourages investment and keeps mortgage repayments and refinancing costs down. But it can prove problematic over the long term, as market forces are not necessarily reflected in prices, potentially leading to investment bubbles. We have already seen this scenario play out in Europe, in the form of a property boom and bust in the UK, Ireland and Spain.
This state of affairs has a precedent. Japan began to experience an ageing population in a low interest rate environment following its success in the 1980s. Prosperity was followed by a financial crisis, when property and equity market bubbles burst at the start of the 1990s. Annual GDP growth fell from 4.6 per cent in the 20 years before 1990 to 0.9 per cent over the next 20 years. In 1990, Japan’s proportion of pensioners to the working population also reached its lowest point. By 2010, its working population was more than 5 per cent smaller than 1990, while the number of pensioners more than doubled from 17m to 37m.
The population structure within Europe may change just as much, or even more. The combined impact of demographics and regulatory requirements is threatening to lead Europe down the slippery path towards the malaise affecting Japan.
It’s a bleak scenario, but is it avoidable? Demographically speaking – obviously not. But on the investment front, superior growth prospects in emerging markets could be the tonic Europe needs. The requirement of tomorrow’s retirees for high investment returns, and hunger for capital in emerging nations, could be satisfied through the developed world’s pension assets. Emerging economies could also counter the demographic deficit – they’re still relatively young.
But this is far from simple. Firstly, emerging markets need to relax capital controls. Secondly, pension fund regulators currently prevent them from taking big stakes in global diversification. It’s also important not to place all your eggs in one basket, as it could cause emerging markets to overheat, given a potentially massive inflow of funds.
Ultimately, the impact of ageing on growth is too big to ignore. Some changes are, at least, already happening. Countries are introducing labour market reforms to reflect growing life expectancy. In 2010, European labour force participation by those aged 55-64 was close to 50 per cent and Switzerland had substantially over 80 per cent. Retirement ages have also risen in reaction to widening gaps in financing pension schemes.
But an ageing population affects the markets in a way that is not conducive to economic growth. Cursory adjustments offer no long-term solution. Fundamental changes are needed.
Bruno Pfister is chief executive of Swiss Life Group. This is an extract of an article for The Geneva Association, which can be found at http://bit.ly/BrunoPfister