European Demographics & Fiscal Sustainability

Transcription

1 17 January 213 Global Demographics and Pensions Research European Demographics & Fiscal Sustainability Global Demographics and Pensions Research Research Analysts Amlan Roy amlan.roy@credit-suisse.com Sonali Punhani sonali.punhani@credit-suisse.com Angela Hsieh angela.hsieh@credit-suisse.com Growth is sustainable in the long run if it is based on a variety of pillars, one of which is fiscal stability. Mario Draghi, ECB President (3 May 212) Europe s fiscal problems have dominated global economic news over recent years. This report assesses European fiscal sustainability strains in the face of ageing and changing demographics with detailed analysis for six countries (France, Germany, Italy, Greece, Portugal and Spain). It builds on our reports Spotlighting the European Union s Demographics (211) and A Demographic Perspective of Fiscal Sustainability: Not Just the Immediate- Term Matters (21). The 8+ age group is the fastest growing population group in the EU (5%) but accounts for a disproportionately higher share of public expenditure. The old-age dependency ratio (people aged 65+ versus those aged 15-64) is strongly positively correlated to government indebtedness. In 21, the EU27 spent 76% of total benefits on old age, health care and disability. EU27 s age-related expenditure on public pensions, health care and long-term care are projected to rise from 2.3% of GDP (21) to 24.5% (26). The vast demographic heterogeneity of European countries suggests that the one-size-fits-all policy approach will not work in the future. In 211, the ratio of highest/lowest GDP per capita across the EU27 members was times in contrast to 2.23 times across the states within the US an example of the EU s vast heterogeneity. We present three indicators (S, S1 and S2) developed by the European Commission to measure and assess fiscal sustainability. S measures the risk of immediate fiscal stress, S1 and S2 measure fiscal sustainability over medium- and long-term horizons. Spain (relative to France, Germany and Italy) appears to be the fiscally most vulnerable with an S level of.44 (at risk), S1 level of 5.3 (high risk) and S2 level of 4.8 (medium risk). We also discuss alternative approaches to fiscal sustainability by the IMF and the OECD. We re-emphasize and discuss four policy prescriptions for the fiscally challenged ageing European countries abolish mandatory retirement and adopt flexible enabled retirement, raise labour productivity, increase female labour participation rate and adopt selective immigration. Holistic policy reform across labour, taxes, pensions, migration, health and education is essential to mitigate the current fiscal strains that loom over the growth prospects of Europe. Current and future frameworks for a reconstituted EU need to acknowledge and incorporate proactively the demographic and economic differences across member states. ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES ARE IN THE DISCLOSURE APPENDIX. FOR OTHER IMPORTANT DISCLOSURES, PLEASE REFER TO CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION Client-Driven Solutions, Insights, and Access

2 General government gross debt (% of GDP) 17 January 213 Analyzing prospective government debt developments and risks to fiscal sustainability is crucial at the current juncture for euro-area countries and the EU as a whole to be able to formulate appropriate policy responses and restore credibility and confidence. The deterioration in fiscal positions and increases in government debt since 28 together with the projected demographic transition, with an ageing population, compound each other and make fiscal sustainability an acute policy challenge. European Commission (December 212) The current state of demographics and debt are acutely affecting the ability of European governments to maintain a strong fiscal position in the future. Fiscal sustainability is the ability to continue now and in the future current policies without causing debt to rise as a share of GDP. Our perspective of demographics is based on people characteristics. The two important characteristics of people are that they are consumers and workers. The ongoing demographic trends of low fertility rates and increased life expectancy (at birth and older ages too) are expected to increase significantly age-related government expenditure on the elderly. Exhibit 1 shows there is a strong correlation between the old-age dependency ratio (ratio of population aged 65+ per 1 people aged 15-64) and government gross debt for selected EU countries. The old-age dependency ratio and the share of the old (6+ years or 8+ years for example) are summary measures of ageing. European countries allocate a large share of their benefit expenditure on old age, health care and disability. In 21, the EU27 spent 76% of total benefits on old age, health care and disability. Exhibit 1: Old-age dependency ratio and government debt, Ireland Luxembourg Netherlands Belgium UK Spain France Denmark Portugal Austria Greece Finland Germany Sweden Source: UN, IMF, Credit Suisse Old-age dependency ratio (ratio of population aged 65+ per 1 population 15-64) In this report, we examine the dynamics of demographics and debt in Europe, highlighting the projected effects of an ageing population on government budgets. In section 1, we present EU27-wide demographic and economic data while conducting detailed demographic and ageing analysis for six selected countries France, Germany, Italy, Greece, Portugal and Spain. Section 2 presents the patterns of household consumption, savings and debt. In section 3 we discuss projected age-related government expenditure and its impact on fiscal sustainability. Section 4 advocates four policy prescriptions for ageing European countries, focusing on retirement age, labour productivity, female labour force participation and immigration. We relate the discussion to the state of policies and data in the selected countries. Our conclusions are noted in Section 5. European Demographics & Fiscal Sustainability 2

3 17 January Core demographic indicators In Exhibit 2, we present demographic indicators 1 such as population, the population growth rate, the fertility rate, life expectancy, dependency ratios (child and old-age) and the median age across 27 countries in the EU as well as economic indicators such as GDP and GDP per capita. As is evident, these EU27 countries display vast heterogeneity in terms of size of their population and economy. The population and economic size range from.4 million people and 8 billion USD (Malta) to 82. million people and 3.4 trillion USD (Germany) in 212. Exhibit 2: Core economic and demographic indicators Population (millions) Population growth (rate per annum) Total fertility (children per woman) Life expectancy at birth (years) Child dependency ratio (pop. aged - 14 per 1 pop ) Old dependency ratio (pop. aged 65+ per 1 pop ) Median age (years) GDP (current USD billion) GDP per capita (current USD) Austria ,33 Belgium ,175 Bulgaria ,974 Cyprus ,629 Czech Republic ,337 Denmark ,448 Estonia ,987 Finland ,545 France ,58 4,69 Germany ,367 41,168 Greece ,757 Hungary ,934 Ireland ,781 Italy ,98 32,522 Latvia ,316 Lithuania ,873 Luxembourg ,72 Malta ,74 Netherlands ,942 Poland ,32 Portugal ,768 Romania ,29 Slovakia ,726 Slovenia ,461 Spain ,34 28,976 Sweden ,879 United Kingdom ,434 38,591 EU15 2 average ,9 44,42 EU27 average ,541 Source: UN, IMF, Credit Suisse 1 We conduct detailed demographic analysis of consumers and workers in European countries in Credit Suisse Demographics Research, European Demographics at the Core - Consumers and Workers (February 21). 2 Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden and the United Kingdom. European Demographics & Fiscal Sustainability 3

4 17 January 213 Among all the EU27 countries, Bulgaria, Estonia, Germany, Hungary, Latvia, Lithuania and Romania are currently experiencing negative population growth, i.e., a decreasing population size. Ireland is the only country with a fertility rate equaling the replacement level of 2.1 in Life expectancy at birth (21-15) is projected to range from 72.8 years (Lithuania) to 82. years (Italy). Italy also had the highest old-age dependency ratio of 32.1 whereas Cyprus had the lowest of 17 in 212. A further split of the EU27 s old-age population above 6 into 6-69, 7-79 and 8+ age groups is presented in the Appendix as Exhibit 53. In terms of GDP per capita, Luxembourg was the richest (15,72 current USD) and Bulgaria had the lowest GDP per capita (6,974 current USD) in 212. The ratio of GDP per capita in the richest (Luxembourg) to the poorest country (Bulgaria) in EU27 in 211 was nearly 16 times whereas for the US the ratio of the richest (Delaware) to the poorest (Mississippi) state was 2.23 times. This exemplifies the vast heterogeneity across EU member states. We next focus on a more detailed examination of the six selected countries France, Germany, Italy, Greece, Portugal and Spain 3. As shown in Exhibit 3, population growth rates are projected to fall significantly for all the six countries. The population growth rate is projected to be negative for all the countries (except France) in and for Germany, Italy and Portugal in While population growth rates relate to the number of consumers, labour force growth rates relate to the potential pool of workers. As in Exhibit 4, labour force growth rates have been falling since 199 and are projected to continue to fall in the future, turning negative for Germany and Italy by Exhibit 3: Population growth rates Rate per annum Exhibit 4: Labour force growth Rate per annum % 1.4% 1.%.6%.2% -.2% %.3%.4%.3%.2% % -1.% -.3% Source: UN, Credit Suisse Source: ILO, Credit Suisse Exhibit 5 displays fertility rates of these countries, where we note that in , total fertility rates decreased, especially in Greece, Portugal and Spain. Fertility rates are currently below the replacement fertility rate of 2.1 children per woman. In France, however, fertility rates have been increasing and are projected to increase closer to the replacement fertility rate. Exhibit 6 shows a significant increase in the old-age dependency ratios (the number of people aged 65+ per 1 people of working age) across all the countries. This trend is projected to continue in the future. In Portugal and Spain, the old-age dependency ratio is projected to rise over 21-6 and reach 64 and 6 respectively. In 23, Germany is projected to have the highest old-age dependency ratio of 48 amongst all the six countries. In fact four of the five countries with the oldest populations in the world, discussed in detail 3 Detailed coverage of the demographic indicators for all the EU15 countries was presented in our previous report: Credit Suisse Demographics Research, Spotlighting the European Union's Demographics (December 211). European Demographics & Fiscal Sustainability 4

5 17 January 213 Exhibit 5: Total fertility rates in our previous report 4, are in Europe: Germany, Italy, Greece and Sweden. We reemphasize the fact that old-age dependency ratios are related to fiscal burdens of countries resulting from supporting the older non-working or partially working populations. Exhibit 6: Old-age dependency ratios Children per woman Population aged 65+ per 1 people aged Source: UN, Credit Suisse Source: UN, Credit Suisse As shown in Exhibit 7, life expectancy at birth across our selected countries has also been rapidly rising and is projected to continue to do so in the future 5 too. Conditional life expectancy, i.e., life expectancy at age 65 has also risen for the selected European countries, as shown in Exhibit 8. The increase is particularly notable for German men whose life expectancy at age 65 rose by 4.2 years between 199 and 211 and Portuguese women whose life expectancy at age 65 rose by 4.7 years between 199 and 21. Conditional life expectancy, i.e., life expectancy at age 65 is important to pay attention to for assessing the burden of the ageing population on government budgets. Exhibit 7: Life expectancy at birth Exhibit 8: Life expectancy at age 65 Years Years Male Female France 16.5 (1998) 18.9 (21) 21.2 (1998) 23.4 (21) Germany Italy (29) (29) Greece Portugal Spain Source: UN, Credit Suisse Source: Eurostat, Credit Suisse The changes in the age structure of the population can be illustrated by the population pyramids in 198, 21 and 23, shown in Exhibit 54 of the Appendix. The age pyramids rectangularize over time and show pictorially the dramatic increase first in the share of the middle-aged followed by an increase in the share of the old-aged population group. 4 Credit Suisse Demographics Research, Macro Fiscal Sustainability to Micro Economic Conditions of the Old in the Oldest Five Countries (August 211). 5 The implications of increased longevity are discussed in Credit Suisse Demographics Research, How Increasing Longevity Affects Us All?: Market, Economic & Social Implications (19 March 212) and Credit Suisse Demographics Research, Longer Lives, Changing Life Cycles: Exploring Consumer and Worker Implications (July 211). European Demographics & Fiscal Sustainability 5

6 17 January 213 The extent of ageing can be further demonstrated by the change in the share of households based on the age of the household head as shown in Exhibit 9. From 198 to 211, the share of households headed by older people (aged 6 years+) increased across the six countries. The increase was most significant in Greece where the share of households headed by an elderly person had increased by 1% over On the other hand, the share of households headed by those aged under 4 decreased. This is most significant in Spain where the share dropped by 1%. This reflects the fact that people today study more, start earning later and start families later too than they did in the past, see our detailed study, Longer Lives, Changing Life Cycles: Exploring Consumer and Worker Implications (211). We argued in that report that this has implications for sectors and the housing market too. Exhibit 9: Households by age of household head, 198 & 211 As a percentage of total 1 < Source: Euromonitor, Credit Suisse 2. Household consumption, savings and debt An examination of the age structure of households is important because the age of the household head influences the consumption expenditure patterns of a household. Exhibit 1: Household consumer expenditure by age of household head: Germany, 211 Age < Consumption Expenditure per Household, USD Total 25,949 37,716 48,61 55,84 53,772 48,223 Breakdown by Type (%) Food, Beverages and Tobacco Clothing and Footwear Housing Household Goods and Services Health Goods and Medical Services Transport Communications Leisure and Recreation Education Hotels and Catering Miscellaneous Goods and Services Source: Euromonitor, Credit Suisse European Demographics & Fiscal Sustainability 6

7 17 January 213 Exhibits 1 and 11 show the consumer expenditure by the age of the household head in Germany and Greece in 211. Households headed by 4-49 year olds tend to have the highest consumption expenditure in Germany and Greece. This accords with the Life Cycle Hypothesis too as the period between 45 and 54 years of age is typically shown to be the peak earning years of average white-collared professionals. In Germany, the households whose head is aged 6 and above spent a greater share on healthcare and medical services in 211 whereas the households with a younger head (under 2 years of age) spent a greater proportion on transport. In contrast with Germany, Greece s household consumption pattern exhibits significant differences. In Greece, younger households spent 43.7% on housing whereas households headed by people aged 6+ spent 21.8% on housing in 211. Greece s older households spent a greater share on food, beverages and tobacco (22.7%) compared to younger households (13.8%) over the same period. Exhibit 11: Household consumer expenditure by age of household head: Greece, 211 Age < Consumption Expenditure per Household, USD Total 22,386 4,522 59,194 65,845 63,488 49,76 Breakdown by Type (%) Food, Beverages and Tobacco Clothing and Footwear Housing Household Goods and Services Health Goods and Medical Services Transport Communications Leisure and Recreation Education Hotels and Catering Miscellaneous Goods and Services Source: Euromonitor, Credit Suisse As shown in Exhibit 12, Germany had the highest GDP per capita (32.31 thousand euros) and the highest gross disposable income per capita (32.44 thousand euros), the highest private final consumption per capita (18.63 thousand euros) and the highest private gross savings per capita (6.84 thousand euros) in 212. Portugal had the lowest GDP per capita (15.61 thousand euros), the lowest gross disposable income per capita (15.12 thousand euros) and the lowest private final consumption per capita (1.24 thousand euros). Greece had the lowest private gross saving per capita (1.89 thousand euros) in 212. Our demographic focus on consumption and savings via gross disposable income is due to the savings-investment links with capital flows and current account. 6 Savings equal aggregate disposable income less consumption expenditure. Part of the savings are channelled through the capital markets both domestic and international. The depth of the capital markets can be analyzed by looking at their bond and stock market capitalizations as shown in Exhibit 13. Italy had the highest bond market capitalization (147.4% of GDP) with the bulk of it being public bond market capitalization (93.1%) in 21. The private bond market capitalization ranged from 23.4% (Greece) to 62.1% (Spain). The stock market capitalization as a percentage of GDP is the highest in Spain (86%) and quite low in Italy (15.2%), Greece (2.8%) and Portugal (38.7%). 6 Please see Credit Suisse Demographics Research, Demographics, Capital Flows and Exchange Rates (August 27) and Demographics, Japanese Current Account and a Disappearing Savings Rate (October 29). European Demographics & Fiscal Sustainability 7

8 17 January 213 Exhibit 12: GDP, disposable income, consumption and saving per capita, 212 Exhibit 13: Market depth, 21 Thousands of Euro GDP per capita Gross national disposable income per capita Private final consumption per capita Private gross savings per capita France Germany Italy Greece Portugal Spain Source: European Commission, UN, Credit Suisse Exhibit 14: Gross national savings % of GDP Private bond market capitalization Public bond market capitalization Stock market capitalization France Germany Italy Greece Portugal Spain Source: World Bank, Credit Suisse Private savings affect the sustainability of public finances through the following equation 7 : S p = I + CA + (G - T) where Sp denotes Private savings, I denotes Investment, G denotes Government Expenditure; T denotes Taxes and CA denotes current account. Hence a country's private saving can take one of the following three forms (a) budget deficit, purchase new government debt, (b) purchase of foreign wealth from foreigners and (c) investment in domestic capital. The evolution of savings-investment gap relative to the current account is presented in Exhibit 55 in the Appendix. In Exhibit 14, we present the gross national savings in selected countries. % of GDP % of disposable income 35 Exhibit 15: Household savings rates Source: IMF, Credit Suisse EU 27 France Germany Italy Greece Portugal Spain Source: Eurostat, AMECO, Credit Suisse There are wide divergences between these countries and significant changes over time. In 198, Portugal had the highest level of gross national savings (31.1% of GDP) and in 212, it had the second lowest level (13.6%), higher only than Greece (7.1%). Currently Germany has the highest level of gross national savings (23.4%). In Exhibit 15, we present the gross savings rates of households, defined as gross savings divided by gross disposable income, with the latter adjusted for the change in the net equity of households in pension funds reserves. Gross savings equal gross disposable 7 For more details, refer to Credit Suisse Demographics Research, Demographics, Capital Flows & Exchange Rates (August 27). European Demographics & Fiscal Sustainability 8

9 17 January 213 Exhibit 16: Gross disposable income of households income less aggregate consumption expenditures. In 1995, Italy had the highest household savings rate (21.8%). In 212, the household savings rate ranged from -4.1% (Greece) to 16.5% (Germany). Domestic private savings and foreign capital inflows also affect the fiscal sustainability of a system. Hot capital flows increase volatility and lead to high risk of contagion and crisis. Capital flows have been attributed as an underlying fundamental cause of the credit crisis in Fault Lines (21) by R. Rajan, the former chief economist of the IMF. Exhibit 16 displays gross disposable income of households and highlights the difference between Portugal and Greece (as well as Spain) relative to Germany. The standards of living are very different not just on a per capita but also on a household basis. Exhibit 17 highlights the differences in the debt/income ratio of households, a proxy for indebtedness on a household basis. The gross debt/income ratio of households is defined as loans divided by gross disposable income, with the latter adjusted for the change in the net equity of households in pension funds reserves. Household indebtedness has increased over time for the selected countries apart from Germany. In 211, Portugal had the highest household gross debt/income ratio (125.5%). Billions of euro % Exhibit 17: Gross debt/income ratio of households Source: Eurostat, Credit Suisse Source: Eurostat, Credit Suisse Having discussed the projected ageing trends across the selected European countries and household savings and debt, we next examine the effect of ageing on government budgets and fiscal sustainability. 3. Age-related government expenditure and fiscal sustainability In this section we focus on the impact of ageing on fiscal sustainability, presenting three quantitative indicators over different horizons that help measure and assess fiscal sustainability. The fiscal balances of selected European countries have fluctuated a lot since the 199s (Exhibit 18). Greece s general government structural balance was -18.6% of potential GDP in 29 and in 212, Spain s structural balance was lower than that of Greece. The IMF projects the general government structural balance to remain negative for all our selected countries except Italy until 216. Exhibit 19 shows the dramatic increase in general gross government debt since 199. European Demographics & Fiscal Sustainability 9

10 17 January 213 Exhibit 18: General government structural balance % of potential GDP Dotted lines represent projections Exhibit 19: General government gross debt % of GDP Dotted lines represent projections France Germany Italy Greece Portugal Spain Source: IMF, Credit Suisse Source: IMF, Credit Suisse Greece s general gross government debt increased from 73% of GDP in 199 to 171% in 212 and is projected to fall to 164% in 216 as part of the reforms agreed with the European Commission and the ECB. The credit-worthiness of each country or sovereign can be measured by either a credit rating that is assigned by the ratings agencies, or a market related creditworthiness measure, which is the yield spread on sovereign debt of ten-year maturity against a benchmark. Exhibit 2: Ten-year sovereign spread over the German equivalent Basis points France Italy Greece Portugal Spain /1/28 15/1/29 15/1/21 15/1/211 15/1/212 15/1/213 Source: the BLOOMBERG PROFESSIONAL service, Credit Suisse In Exhibit 2, we present a country s credit-worthiness by comparing its ten-year sovereign bond yield against a benchmark, which is the ten-year German government bond yield. The trajectory of sovereign spreads reflects the relative credit-worthiness and investo confidence of the sovereign or the country. The differential spreads tell the story regarding the distressed periods for Greek and Portuguese debt in the euro zone crisis. European Demographics & Fiscal Sustainability 1

11 17 January 213 We also examine the five-year sovereign CDS spreads of these six countries. The sovereign CDS of these six countries are referenced to their sovereign bonds. The CDS spread is the premium paid by the protection buyer to the seller to gain protection from any sovereign credit event such as defaulting on its sovereign obligation. When a CDS spread widens, investors perceive a deteriorating credit condition and demand a higher premium. Markets are therefore pricing in the increased likelihood of a credit event. Due to different scales and pricing sources used, we present the sovereign CDS spreads of five countries France, Germany, Italy, Portugal and Spain in Exhibit 21 and that of Greece in Exhibit 22. Again, the uncertainty and the worsening of the fiscal conditions in Portugal and Greece resulted in the spiking up of their CDS spreads in January and March 212 respectively. It is also worth mentioning that regulatory changes have led to a loss of liquidity and market size in several of these default swap markets and instruments. Exhibit 21: Five-year sovereign CDS spreads Exhibit 22: Five-year sovereign CDS spreads 8 Basis points Basis points France Germany Italy Portugal Spain Greece /1/28 15/1/29 15/1/21 15/1/211 15/1/212 15/1/ /7/29 1/7/21 1/7/211 1/7/212 Source: the BLOOMBERG PROFESSIONAL service, Credit Suisse Source: the BLOOMBERG PROFESSIONAL service, Credit Suisse Exhibit 23 shows the forecasts for age-related government expenditure, including public pensions, health care and long-term care, as a percentage of GDP across the EU27 and the six selected countries. Age-related expenditure on public pensions, health care and long-term care are projected to rise from 2.3% of GDP in 21 to 24.5% in 26 in the EU27. Age-related expenditure is projected to increase in most cases except in the case of Italy where the public pensions spending is forecast to fall by.9% over the 21-6 period. In Germany and Spain, the overall increase across these three components has been the most significant. The age-related spending is projected to rise over 21-6 by 5.7% of GDP in Germany and by 5.5% of GDP in Spain. 8 In order to account for the missing data on Greek sovereign CDS spreads from March 212 to April 212, Bloomberg draws a straight line to make the series continuous. European Demographics & Fiscal Sustainability 11

12 17 January 213 Exhibit 23: Forecast age-related government expenditure % of GDP Age-Related Expenditure Components Public Pensions Health Care Long-term Care Total EU France Germany Italy Greece Portugal Spain Source: European Commission, Credit Suisse Exhibit 24 presents a decomposition of public pensions expenditure that highlights five main drivers of government public pension expenditure: Dependency ratio Coverage ratio Employment rate Benefit ratio Labour intensity Exhibit 24: Decomposition of public pension expenditure Pension Expenditure Population 65+ Number of pensioners Population 2-64 = X X GDP Population 2-64 Population 65+ Working people 2-64 Dependency Ratio Coverage Ratio 1/Employment Rate Average Pension* Working People 2-64 Hours Worked 2-64 X X X GDP Hours Worked 2-64 Hours Worked 2-74 Hours Worked 2-74 Benefit Ratio 1/Labour intensity Residual *Average Pension= Public pension spending / Number of pensioners Source: European Commission, Credit Suisse The dependency ratio (demographic factor, which we referred to as the old-age dependency ratio) is the most significant contributor to the projected increase in pension expenditure as shown in Exhibit 25, ranging from 7.9% of GDP in Germany to 1.4% in Greece and Portugal. The dependency ratio is the only factor contributing to the increase in projected pension expenditure while the other factors offset this increasing trend. European Demographics & Fiscal Sustainability 12

13 17 January 213 Exhibit 25: Decomposition of gross public pension expenditure, 21-6 % of GDP 21 Dependency Ratio Coverage Ratio Employment effect Benefit ratio Labour intensity Interaction + 26 level level contribution contribution contribution contribution contribution residual effect EU France Germany Italy Greece Portugal Spain Source: European Commission, Credit Suisse The pension spending projections reveal that pension policies in a majority of EU countries will lead to a containment of the increase in pension spending through: (1) reduced generosity of public pension schemes, (2) gradually phasing in increased retirement ages and (3) restricting or penalizing early retirement. In order to better understand the impact of increasing the retirement age, Exhibit 26 shows the projected pension expenditure by age group. Pension expenditure for age groups younger than 65 is projected to decrease drastically for the EU27 and our selected countries, especially in Italy and Greece, due to increased retirement ages, increased restrictions for early and disability pensions as well as demographic factors. Pension expenditure for the year age group is also projected to decrease for the EU27 from 2.2% of GDP in 21 to 1.8% in 26. Pension expenditure for the age groups 7+ are projected to increase as retirement ages increase and the majority of pensioners reach higher ages. The age group 75+ shows a significant pension expenditure increase in the EU27 from 3.9% to 7.1% of GDP, especially in Italy and Greece. Exhibit 26: Gross public pension expenditure by age group, 21-6 % of GDP EU27 France Germany Italy Greece Portugal Spain Less than Source: European Commission, Credit Suisse Public expenditure on health is influenced by factors that affect both the demand for and the supply of health care goods and services. Population size and structure, health status, income as well as provisions regulating access to health care goods and services are factors that affect the demand side. Supply-side determinants include the availability of and distance to health care services, technological progress and the framework regulating the provision of those goods and services (institutional settings). The health care expenditure projections highlighted above assume that health care expenditure is driven by a combination of changes in the population structure, an assumption that half of the future gains in life expectancy are spent in good health and a moderate impact of income. European Demographics & Fiscal Sustainability 13

14 17 January 213 Our selected countries are quite diverse in terms of health expenditure per capita. France spent the highest amount per capita while Portugal spent the least in 21 as shown in Exhibit 27. As a share of GDP, France spent the highest share of GDP on health expenditure in 21 (11.9%) while Italy spent the least (9.5%). We also note that Greece had the highest share of private health expenditure (4.2%) in 21 (Exhibit 28). Exhibit 27: Health expenditure per capita, 21 Current USD Exhibit 28: Health expenditure as a share of GDP, 21 % of GDP France 4,691 France Germany 4,668 Germany Italy 3,248 Portugal Private Spain 2,883 Greece Public Greece 2,729 Spain Portugal 2,367 Italy Source: WDI, Credit Suisse - 1, 2, 3, 4, 5, Source: WDI, Credit Suisse Health spending fell across the EU in 21 as cash-strapped governments curbed outlays to help cut budgetary deficits. From an annual average growth rate of 4.6% between 2 and 29, health spending per capita fell to -.6% in 21 across the EU24 9. This is the first time health spending has fallen in Europe since 1975, after the first Oil Shock. In Greece, estimates suggest that health spending per person fell 6.7% in 21, reversing the annual growth of 5.7% between 2 and 29 while in Spain health spending fell by.9%. In France, Italy and Portugal, health spending per capita growth slowed down in 21 compared to 2-9 while it rose in Germany (Exhibit 29). Exhibit 29: Annual average growth in real per capita expenditure on health, 2-9 & 29-1 Rate per annum The term "long-term care (LTC) services" refers to the organization and delivery of a broad range of services and assistance to people who are limited in Source: OECD, Credit Suisse their ability to function independently on a daily basis over an extended period of time. Projected public expenditure on LTC comprises both in-kind and cash benefits. In the future, the demand for formal long-term EU24: Ireland, Estonia, Greece, Lithuania, Czech Republic, Denmark, Slovenia, Spain, United Kingdom, Cyprus, Austria, Belgium, Finland, Poland, Portugal, France, Italy, Sweden, Netherlands, Hungary, Slovak Republic, Germany, Malta and Romania. European Demographics & Fiscal Sustainability 14

15 17 January 213 care services is likely to grow, since the number of people who reach 8 years and above is growing faster than any other segment of the population. In the light of current sovereign debt crisis and the demographic transition in Europe, more and more people are calling to assess each member state s fiscal strength and the ability of the government to deliver its promises on pensions and health care spending. Both of these affect a country s fiscal sustainability. Fiscal sustainability relates to a government s ability to maintain the same policies without causing the debt to rise continuously as a share of GDP. In its latest Fiscal Sustainability Report, the European Commission has examined the fiscal strength of its member states over different time horizons. Greece and Portugal are currently experiencing severe fiscal problems and are implementing adjustment programmes to restore their ability to repay debt and investors confidence. As there is uncertainty and changes in terms of fiscal conditions, these two countries are not analyzed in the 212 Fiscal Sustainability Report of the European Commission. Therefore, in the following section, we only focus on the remaining four countries France, Germany, Italy and Spain. Apart from the two original S1 and S2 sustainability gap indicators constructed by the European Commission (EC) and covered in our previous report which measure the medium-term and long-term fiscal sustainability risks 1, a new measure S has been created by the EC to address the current sovereign debt issue and to look at the risk of fiscal stress in the short term. Unlike S1 and S2, S is not a quantification of fiscal adjustment required but a composite indicator of short-term fiscal stress using a range of macro-financial and fiscal indicators. The short-term fiscal sustainability indicator S gives an early warning about a country s short-term fiscal challenges. It takes into account two sub-indexes incorporating fiscal and financial-competitiveness variables, which have been proven to be good detectors of fiscal stress in the past. For example, balance and gross debt as a percentage of GDP, interest rate and old-age dependency ratio are incorporated to construct the fiscal index whereas factors such as yield curve and real GDP growth are included to calculate the financial-competitiveness index. By comparing the S indicator to the critical threshold, which is separately derived to be.44 in 212, we can see a country s vulnerability to fiscal stress over a one year horizon. Of the four countries, Spain is the only country which has its S value at the threshold level of.44 and is classified to be at risk in 213 (Exhibit 3). The fiscal subcomponent score is.54 and the financial competitiveness score is.4 against critical threshold values of.34 for the fiscal and.46 for the financial competitiveness index. Spanish government debt is projected to be 97.1% of GDP (above the EU average of 88.8%), up from 69.3% in 211. Exhibit 3: Fiscal Sustainability Indicator S, France Germany Italy Spain Source: European Commission, Credit Suisse Threshold:.44 The two fiscal sustainability indicators, S1 and S2, quantify the required fiscal adjustment, the so called fiscal gap and measure sustainability risk in the medium and long term respectively. S1 measures the upfront budgetary adjustment required to reach a target government gross debt of 6% of GDP by 23. This is expected to be 1 Credit Suisse Demographics Research, A Demographic Perspective of Fiscal Sustainability: Not Just the Immediate-Term Matters (21). European Demographics & Fiscal Sustainability 15

16 17 January 213 achieved by a steady improvement in the structural primary balance until 22 and then sustained until 23. Financing for any additional expenditure arising from an ageing population will also be considered in the calculation of the S1 indicator. The S1 indicator is based on the initial budgetary position as well as the debt reduction required to reach the 6% target in 23 and the adjustment required to deal with cost of ageing. If the S1 indicator is negative, the country is classified as low risk. If S1 is between and 3, the country is expected to undergo a structural adjustment in its balance of up to.5% of GDP per year until 22 and is assigned medium risk. If S1 is greater than 3, structural adjustment of more than.5% of GDP per year is urgently needed for the country to achieve the 23 target level. Therefore, the country is classified as being at high risk. From the definitions above, Spain is at high risk (5.3) whereas Germany has the lowest medium-term risk (-.3) as shown in Exhibit 31. S2 shows the adjustment to the current structural primary balance needed to fulfil the infinite horizon inter-temporal budget constraint. In other words, it is the adjustment needed to make current and future government revenue match current outstanding government debt and potential future expenditure, including paying for additional expenditure arising from an ageing population. If S2 is lower than 2, the country is at low risk If S2 is between 2 and 6, the country is at medium risk If S2 is greater than 6, the country is at high risk As shown in Exhibit 31, EU 27 (2.7) and Spain (4.8) are at medium risk whereas Italy has the lowest longer-term risk (-2.3). Exhibit 31: Sustainability Indicators: S1 & S2 Exhibit 32: Components of the Sustainability Indicator S EU 27 France Germany Italy Spain Total: Long term cost of ageing Initial Budgetary Position S1 indicator S2 indicator -4 EU 27 France Germany Italy Spain Source: European Commission, Credit Suisse Source: European Commission, Credit Suisse S2 is affected by two components ageing costs and initial budgetary position (the difference between the initial structural primary balance and the debt-stabilizing primary surplus to ensure sustainability). Exhibit 32 shows that long-term cost of ageing has a significant fiscal impact across the three countries and the EU27 except Spain. In Spain, its initial budgetary position contributes more significantly to its relatively high S2 level, hence pushing Spain to a relatively higher long-term risk level compared to the other three countries. European Demographics & Fiscal Sustainability 16

17 17 January 213 Exhibit 33: Fiscal adjustment required to achieve debt target of 6% in 23 A prudent macro fiscal policy frameworks across EU should monitor all the three sustainability risk measures at different horizons to ensure that fiscal stability provides the underlying support for growth. The S1 and S2 indicators for the rest of EU 15 countries are presented in Exhibit 56 of the Appendix. It is important to note that Belgium (6.2) and Luxembourg (9.7) show up as the highest in terms of the S1 and S2 scores relative to EU15 average of 1.8 and 2.7. The direct effect of commonly followed demographic variables on the short-term sustainability indicator S is likely to be minor and much less than the impact on S1 and S2. In addition to the EC s sustainability gap indicators mentioned above, there are other indicators constructed to measure fiscal gaps that need to be closed in order to achieve fiscal sustainability. The latest IMF Fiscal Monitor Report 11 presents a measure on fiscal adjustment, calculated as the gap between the current primary balance and the balance required to reduce the debt/gdp ratio to a specified level over a given horizon, i.e., to improve the primary balance by 22 and subsequently maintain the balance to achieve a sustainable debt level of 6% by 23. % of GDP % of GDP Required adjustment between 211 and 22 Required adjustment and change in agerelated spending during France Germany.9 3. Italy Greece Portugal Spain Exhibit 34: Fiscal adjustment to achieve debt target of 5% in Source: IMF, Credit Suisse Source: OECD, BIS, Credit Suisse Greece and Spain top the league with the highest adjustment needed to achieve the target by 23. After considering the projected increase in age-related expenditure between 211 and 23, the fiscal gaps rise for most countries except Italy as shown in Exhibit 33. OECD 12 also took a similar approach to calculate the fiscal gap in 27 and 212, but with different targeted debt level: 5% of GDP by 25. The calculation takes into account health care and long-term care costs and projected increase in pension spending. Italy, Greece and Portugal have reduced their fiscal gap since 27, largely due to decreased deficit on primary balance thanks to their recent fiscal consolidation efforts (Exhibit 34). Hence we note that ageing in European countries is projected to have a significant impact on fiscal sustainability in the future. In similar spirit to us the EC Vice President Olli Rehn (212) 13 states: Only an aimed policy action, to achieve the medium-term objectives would bring the government debt on a downward path and bring the debt down to 6% of GDP by IMF, Fiscal Monitor: Taking Stock - A Progress Report on Fiscal Adjustment (October 212). 12 OECD, Fiscal consolidation: how much is needed to reduce debt to a prudent level? (212). 13 Olli Rehn, Vice-President of the European Commission, Current Account Surpluses in the EU and the 212 Fiscal Sustainability Report: - Rebalancing for Sustainable Growth (Dec 212). European Demographics & Fiscal Sustainability 17

18 17 January 213 The ongoing sovereign debt crisis as well as publication of the 29 Sustainability Report and Ageing Reports by the European Commission has already led some of the countries to reform their fiscal, pension as well as labour policies. An outline of the countries reform efforts is provided in the report by our Credit Suisse European Economics team, Nothing like a crisis (November 212). 4. Policy prescriptions for ageing European countries 14 a) Abolish mandatory retirement ages and adopt flexible enabled retirement Since 1983, life expectancy after pensionable ages, i.e., the expected duration of retirement has increased for the selected European countries (Exhibit 35). The increase is particularly significant for French and Italian men whose life expectancy after pensionable age increased by 7.5 years and 5.7 years respectively over Also, French women had the highest life expectancy increases of 8.1 years post-pensionable age, over the period. The OECD projects further increases for the selected countries in 23, except for Italy and Greece. Exhibit 35: Life expectancy after pensionable age Years Men Women France Germany Italy Greece Portugal Spain Source: OECD, Credit Suisse Exhibit 36 presents the economic activity rate by age in 212. France showed a dramatic fall in economic activity rates of 45.1% upon reaching 6 years of age. Germany similarly experienced a rapid decline of 41% in economic activity rates, when moving from the 6-64 year old age group to the 65+ age group. Exhibit 36: Economic activity rate by age, 212 % TOTAL France Germany Italy Greece Portugal Spain Source: ILO, Credit Suisse Exhibit 37 displays economic activity rate by age for males and females and the changes over time. Female economic activity rates by age have risen significantly especially in Spain and Germany from 1985 to 212. Female economic activity rates for the younger age groups, i.e., years, have fallen while they have risen for the other age groups over time due to increased years of education. In 1985 the female economic activity rate 14 Credit Suisse Demographics Research, New Jobs, New People: Demographic Manifesto (2). European Demographics & Fiscal Sustainability 18

19 17 January 213 peaked around the age group of 2-29, while in 212 it peaked around the age group of for the selected countries. This reflects the embodiment of human capital in female economic activity rates and the impact of a better skilled female labour force. Exhibit 37: Economic activity rate by age, male and female % 1 France 1 Germany Italy Greece 1 Portugal 1 Spain Source: ILO, Credit Suisse Male (1985) Male (212) Female (1985) Female (212) The economic dependency ratio, presented in Exhibit 38, measures the number of nonworkers per worker. In 199, the economic dependency ratio was greater than one in all six selected countries, hence the non-workers exceeded the workers in all countries. In 212, the economic dependency ratio was greater than one in France, Italy and Greece. Exhibit 38: Economic dependency ratio Number of non-workers per worker Source: ILO, Credit Suisse An increased number of older dependents as well as a longer post-retirement period reduces the productive labour force in the economy and increases the burden on the government and societies to provide post-retirement pensions and health benefits. As people live longer, there is a need to abolish mandatory retirement ages, so that people can continue to work beyond the traditional retirement age. European Demographics & Fiscal Sustainability 19

20 17 January 213 A point to note is that the duration of the working life increased in all the selected countries during 2-1 as shown in Exhibit 39. The duration of working life measures the number of years for which a person aged 15 is expected to be active in the labour market throughout his/her life. Spain has experienced a lengthening of the working life of its citizens by 3.5 years since 2; however, its level was still lower than the EU27 average in 21. Italy, with its duration of working life significantly lower than that of its peers in the EU, still has room to further increase the utilisation of its labour force. Exhibit 39: Duration of working life Years EU27 Source: Eurostat, Credit Suisse The proportion of the life span spent in work in advanced European countries has declined. In order for the governments to defray the costs associated with increasing longevity, they have to insist that individuals, families, employers and societies find ways of co-sharing in these costs by working flexibly, part-year, part-week, part-time beyond mandatory retirement ages. Flexible and e-nabled working is a work paradigm we have previously advocated. This is in line with the European Commission calling 212 the year of Active Ageing and Intergenerational Solidarity. b) Improve Labour productivity The labour supply dynamics in a country has an effect on real GDP growth 15. Real GDP growth can be decomposed into three components: working-age population (population aged 15-64) growth, labour productivity (real GDP/hours worked) growth, and labour utilisation (hours worked/working age population) growth. Exhibit 4 displays the demographic decomposition of real GDP growth for the six selected European countries. Labour productivity growth has been a significant contributor to real GDP growth across all the six countries, especially during Germany s negative working age population growth adversely affected its GDP growth during 2-11 whereas Greece s poor economic performance between 2 and 211 was partly due to its negative labour utilisation growth rate. Working age population growth fell in all the countries except for Spain over 2-11 compared to That has been one of the reasons why real GDP growth in 2-11 is lower than that in We identify a need to increase labour productivity growth rates to compensate for current and future working age population growth rate decreases in order to increase real GDP growth rates. 15 Credit Suisse Demographics Research, A Demographic Perspective of Economic Growth (29). European Demographics & Fiscal Sustainability 2

21 17 January 213 Exhibit 4: Real GDP growth decomposition % Source: UN, GGDC, Credit Suisse We now compare the countries in terms of current labour productivity figures. Exhibit 41 presents a sectoral decomposition of GDP and employment for the six selected countries in 21. Services was the dominating sector across these six countries. Exhibit 41: Sectoral decomposition of GDP and employment, 21 % Value added (% of GDP) % of total employment Agriculture Industry Services Agriculture Industry Services France Germany Italy Greece Portugal Spain Source: UN, ILO, Credit Suisse Greece had the highest share of gross value added in services (78.8% of GDP) among the six selected countries and France had the highest employment share in services (74.8% of total employment) in 21. Germany had the highest share of value added in industry (27.9% of GDP) whereas Italy had the highest employment share in the same sector (28.8% of total employment). Compared to the other six countries, Greece had the highest share in terms of value added (3.3% of GDP) and employment (12.5% of total employment) in agriculture. European Demographics & Fiscal Sustainability 21