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Tuesday, July 31, 2007

Credit Rating Agencies, Pensions, Ageing and Debt

In a recent post on Italian Economy Watch I drew attention to the issues which were being raised by the impending changes in Italy's minimum retirement age legislation. In fact agreement among the "social parties" has now been reached on this topic, with Prodi finally winning the support of Italy's labour unions for a much more gradual pace of increase in Italy's pension and retirement age. The agreement, it should be noted, is simply that, an agreement between parties, and it is not yet law. As such measures will now need to be brought before the Italian parliament, and presumeably this will take place in the context of the 2008 budget proposals.

The new agreement is bsed on a staggered increase in the minimum retirement age, which is currently set at 57. The change in fact involves supplanting a previously agreed reform law - one which would have boosted the retirement age to 60 as early as next year - and an effective slowing down of the reform process. The law which it is proposed to put aside was in fact agreed to in 2004, by one of Silvio Berlusconi's governments, and the decision then was to raise the minimum retirement age—from 57 to 60 - as of January 2008. Since that date is now fast approaching, pressure has evidently been mounting to repeal this part of the reform.

One direct consequence of the new agreement - according to Labour Minister Cesare Damiano - will be the loss of some 10 billion euros in savings which would have been achieved under the existing legislation.

Under the new plan the retirement age will now rise by one year, to 58, in 2008. In July 2009 the retirement age will again go up, this time to 60 for those with 35 years of contributions, or remain the same for those workers who can muster 36 years of pension payments. From 2011, the retirement age for everyone will rise to 60, and then to 61 by 2013.

This decision, apart from being an astonishing one for outside observers, raises a number of important issues, especially since the ageing population problem is one which affects Italy in a very important way. Life expectancy in Italy has now risen to almost 80, and is among the highest in the EU. At the same time Italy currently has the third-lowest birth rate in the EU. Without raising the retirement age, contributions simply won't keep pace with pension payments over the coming years, even assuming there is no ageing impact on the overall economic growth rate, which is far from clear (and here).

The stark reality is that the combined level of both pension spending (about 15% of GDP) and public debt (107% of GDP in 2006) in Italy is the highest in the European Union, and the connection between the two is certainly not an incidental one.

The Economist had a useful leader on the declining populations problem only this week, and they made the following pretty significant point:

If the world's population does not look like rising or shrinking to unmanageable levels, surely governments can watch its progress with equanimity? Not quite. Adjusting to decline poses problems, which three areas of the world—central and eastern Europe, from Germany to Russia; the northern Mediterranean; and parts of East Asia, including Japan and South Korea—are already facing.

Think of twentysomethings as a single workforce, the best educated there is. In Japan (see article), that workforce will shrink by a fifth in the next decade—a considerable loss of knowledge and skills. At the other end of the age spectrum, state pensions systems face difficulties now, when there are four people of working age to each retired person. By 2030, Japan and Italy will have only two per retiree; by 2050, the ratio will be three to two. An ageing, shrinking population poses problems in other, surprising ways. The Russian army has had to tighten up conscription because there are not enough young men around. In Japan, rural areas have borne the brunt of population decline, which is so bad that one village wants to give up and turn itself into an industrial-waste dump.

The necessary response to all of this, as the Economist points out is a battery of measures, including, of course, the systematic raising of retirement ages:

The best way to ease the transition towards a smaller population would be to encourage people to work for longer, and remove the barriers that prevent them from doing so. State pension ages need raising. Mandatory retirement ages need to go. They're bad not just for society, which has to pay the pensions of perfectly capable people who have been put out to grass, but also for companies, which would do better to use performance, rather than age, as a criterion for employing people. Rigid salary structures in which pay rises with seniority (as in Japan) should also be replaced with more flexible ones. More immigration would ease labour shortages, though it would not stop the ageing of societies because the numbers required would be too vast. Policies to encourage women into the workplace, through better provisions for child care and parental leave, can also help redress the balance between workers and retirees.

And of course all of this is just one more area where Italy is falling badly behind in its response.

After the full implementation of this law Italians will still be able to retire before, say, either the French or the Germans. France's retirement age is currently 60, provided you have 40 years of contributions, but this is already programmed to rise to 41 contribution years in 2012, which compares with the 35 (or 36, depending) years of contributions currently required in Italy. Now Germany is arguably much more comparable to Italy in this area, since France is about 20 years behind (in a favourable sense) both these countries in the ageing game, and won't reach the levels of ageing (dependency ratios, median age etc) which currently exist in Germany or Italy till the mid 2020s at the earliest, but Germany is currently in the process of lifting the minimum retirement age to 67 from 65 in 2012.

The point is, can Italy, with its well known low economic growth problem, afford all (or any) of this, and if she can't what may be the consequences?

Well, as I have been noting on this blog, Italy already has an outstanding issue with the Credit Rating Agencies. Last summer two of the major agencies (Standard and Poor's and Fitch) cut Italy's credit rating, and at some point all of this will come up for review again. Italy needs to be very careful, 2007 may not be as simple as 2006, and people really shouldn't be taking these sort of risks, not when there are whole societies at stake they shouldn't.

In fact the ratings agencies are coming under increasing pressure these days, especially following the US sub-prime derivatives debacle, and as Buttonwood recently observed in the Economist, their responses are not exactly linear and consistent:

As central banks lose authority, might credit-rating agencies play the watchdog role? By acting swiftly to downgrade debt, they would constrain companies (and countries) from borrowing too much. But the agencies tend to lean with the wind, rather than against it. They upgrade debt when the economy is booming and downgrade it when recession strikes. If the central banks do eventually slam on the brakes, therefore, the rating agencies will only exacerbate the downturn. As asset ratings fall, investors will be forced to sell their holdings and credit will be withdrawn from the system. Thanks to the financial markets, central banks now struggle to police the economy. But this may imply that the bust, when it comes, is as hard to control as the boom that preceded it.

The ECB has already effectively handed over the buck here, since they decided back in 2005 that they will not in future accept government paper (bonds) from any country which has not maintained at least an A- rating from one or more of the principal debt assesment agencies.

But as Buttonwood recently observed in the Economist:

the questions being asked of the agencies are important because banks around the world have been filling their vaults with AAA-rated structured products ahead of international implementation of the Basel 2 regulations on bank capital. Under this new accord, a bank holding triple-A assets is allowed to keep less capital, enabling it to lend more. So banks have stocked up, especially on CDOs. If they were forced to sell securities that had been downgraded, liquidity could dry up.

No one knows for sure what would happen to the value of the triple-A tranches in such a scenario. In this week's ratings downgrades, the highest-quality tranches of CDOs were unaffected.

But the agencies are caught in a dilemma. They know that if the cherished triple-A rating is seen as devalued, it would undermine their credibility. Yet they earn so much revenue from CDOs that working with the banks and funds that structure them has proved irresistible.

So we may see an under-reaction, followed by a subsequent over-reaction, and it is just this which may make events difficult to control.

And then, if we go back to just last month, we may remember that the Italian government announced it was raising its deficit forecast for this year to 2.5 percent of GDP from 2.3 percent, in part in order to spend money to raise minimum pensions. The government also said it may need until 2011 to balance its budget, falling behind in the process on an EU-wide goal of doing this by 2010.

So all of this now constitutes a slippery slope, and Italy is sliding. I can't hep feeling that if one day we reach some sort of post-mortem type "benefit of hindsight" evaluation of what it was that actually went wrong in Italy, then this recent retreat on the pensions front may come to be be seen as one of the last nails in the coffin. I hope I am wrong, but this is the feeling I have. Basically, you can't simply let one comparatively good year (and I would stress the word comparatively here) deflect you from what you know has to be done, and if you do, well really you can't exactly complain if people eventually assess what you say not on the basis of your declared intentions but rather on the basis of your past actions.

Postcript: while in essence I am not a political animal, I will certainly ride with Radical Party minister Emma Bonino in some of the things she is saying and doing at the moment. In the first place she did threaten to resign over the pension negotiations (although perhaps the issue was important enough to have actually delivered on the resignation threat) and then she waded in to the great Sovereign Wealth Funds debate, by declaring her opposition to the idea of establishing European government-controlled “golden shares” of companies considered of national or strategic interest as being “unacceptable in principle, and moreover impracticable”, adding in for good measure that she didn't care who the hell bought Alitalia "it can be the Chinese, or the Eskimos for that matter, as long as they turn it around.”

Good for you Emma. Keep it up! Sock it to them baby!

Climatic Change, Bioethanol and Food Prices

This article in Portfolio Hungary caught my attention:

A likely damage in crop volumes induced by extremely hot weather and drought in Hungary will probably aggravate the situation in the food industry now that price hikes also seem to be hanging in the air. The rise of food prices, together with rising petrol prices, may cause some serious inflation pressure, Societe General has warned on Friday.

Now this article, which is basically about how food price inflation may interfere with the National Bank of Hungary's plans for monetary easing, put me in mind of two points I had recently come across elsewhere, and which are of much more general application:

In the first place Daniel Antal had been complaining about the heat in Budapest. So I began to ask myself, are we alreadt seeing an on-cost to global warming? Certainly Serhan Cevik over at Morgan Stanley seems to think so. In an article on inflation in the Turkish economy, entitled appropriately enough "heat wave",and wriiten back in June he made the following point:

Weather anomalies present a threat as challenging as liquidity-driven capital flows
. Nothing seems to bring an end to the Istan-bull’s breathtaking run, pushing the Turkish lira to its strongest level in years, thanks to the lure of carry trades and strong economic fundamentals. In turn, the lira’s strength may have accelerated disinflation, even against strong inertia in certain sectors. On our estimates, consumer price inflation will decline from 9.2% in May to 8.8% at the end of this month. However, with higher energy quotes, weather anomalies present a challenge through the volatility of food prices. Surface temperatures in Turkey have already been 4˚C above the seasonal pattern, while average rainfall is running about 60% below the long-term mean. These dramatic changes in climatic conditions are not just specific to Turkey, but reflect a global phenomenon.

He then went on to explain how he felt all of this was having an impact on the Turkish economy and the inflation problem they have there:

Global warming is not just about warmer weather, but also — more importantly — leads to unpredictable changes in variability patterns. One of the immediate consequences of extreme weather conditions is droughts with greater severity that cause agricultural supply shocks and higher volatility in food prices (see Stay Tuned to the Weather Channel, August 4, 2006). And we may now be observing such an event on a global scale, as the ratio of stocks to consumption dropped to its lowest reading on record, leading to a sustained increase in food prices. Indeed, virtually every country around the world has experienced a surge in food prices and consequently pressures on headline inflation rates. This is a significant risk, especially for developing countries where food has a greater weight in consumer price indices. In Turkey, for example, food prices account for 28.5% of the CPI and thereby can turn into a major source of volatility. Over the last couple of years, food price inflation declined from 12% at the beginning of 2004 to 4.9% at the end of 2005, but then surged to 14.6% earlier this year. Although the year-on-year rate of change in food prices eased to 10.6% last month, meteorological data still point to a volatile outlook for (unprocessed) food prices.

Then secondly, this whole argument also put me in mind of something I had seen in the Financial Times a couple of weeks ago about how the increasing demand for biofuels was consuming agricultural land rapidly, and hence driving up - indirectly - food costs (again, there would seem to be no free lunches on offer here):

Surge in biofuels pushes up food prices

A surge in the production of biofuels derived from corn, wheat and soyabeans is helping to push up food prices so sharply that the World Food Programme, the United Nation’s agency in charge of fighting famine, is finding it difficult to feed as many hungry people as it has in the past....Food commodity prices are surging because of a number of factors including rising demand from China and bad weather, but the potential consequences of the rising demand for biofuels has caught the attention of those in the business of feeding the world. Mark Spelman, head of Accenture’s global energy practice, said the biofuel industry was at risk of creating a public backlash similar to wind power generation as food inflation continues.

The BBC also had a similar story:

Several other biofuel plants are planned in the UK but biofuels are already big business in the United States, where bioethanol is seen as a greener and more sustainable alternative to traditional petrol.The downside is that land which until recently was growing crops for food is now growing crops for fuel.The United Nations says a third of the total US maize crop went for ethanol last year.The International Monetary Fund say there's no question that demand for biofuels is driving up food prices - and that it will go on doing so - though in the UK the National Farmers Union disputes that.

So back to Hungary, and food prices. According to Portfolio Hungary:

The price of wheat, bread and milk may increase significantly, up to 15-30% this year and the National Fruit and Vegetable Council expect that watermelon turnover will be reduced by 30-40%.

Daily egg production in the current heat is way smaller than usual, which may lead to even a 40% increase in egg prices. This can filter down to CPI through a number of channels.

“Maize harvest may be reduced by 40% or more from 8 million last year to 4-5 million tones until the end of 2007. The number is chilling, as 4 million is needed to feed animals alone, not to mention food production or industrial purposes," the analyst added.

Meanwhile, new bio-ethanol projects demanding hundreds of thousands of tonnes of maize are being unveiled week by week in Hungary. While only a few months ago the country was still struggling to deal with millions of tonnes of surplus maize, it is now facing a possible shortage of animal feed due to a drought.

Some experts, however, warn that the expansion of the bio-ethanol sector will be slower than expected, simply because investors will not find enough grain inputs. The draught may cause expansion-driven bio-ethanol plants to cover their input need from imports.

The announcement on new bio-ethanol projects “cannot be taken seriously", as they are “just to reserve a niche in the market", Imre Németh, state secretary at the Prime Minister's Office told Reuters earlier this week.

Hungary's bio-ethanol production capacity is expected to rise to 400,000-500,000 tonnes by the end of the decade and rise to 800,000 tonnes by about 2013, Németh added. The Agricultural Ministry said earlier this year that the 800,000-tonne output could be reached by 2009 or 2010.