The 4 Ds- Debt Deflation Demography and Default, Part II

Link to First Part:

https://thefellowinvestor.in/?p=281

Demography

The demographic dividend is the potential of economic growth that can result from shifts in a population’s age structure, mainly when the share of the working-age population exceeds the non-working-age share of the population.

However, the world is aging at a faster rate than most can ever imagine. The USA will be adding the highest percentage of population to the age group of senior citizens starting from 2020. According to the UN World Population Ageing report 2019, 1 out of 6 will be in the age group of 65 and above by 2050 from 1 out of 11 in 2019. The number of old age dependency ratio is expected to increase to 28 by 2050 from 16 in 2019(old age dependency ratio defined as number of people above 65 years of age per 100 working age population). For first time in 2018, the number of people aged 65 years and above were higher than the number of 5-year olds.  The old age dependency ratio (OADR) is increasing in all parts of the world and expected to touch 53 by 2050 globally from 28 in 2015 as per world economic forum. Barring Africa, most parts of the world will see a decline in their working age population and new born too. The two major factors contributing to this are increased life expectancy and declining fertility rates. Therefore, there will be growing need to keep working beyond retirement age.

Source:-

https://www.un.org/en/sections/issues-depth/ageing/

https://www.weforum.org/agenda/2018/06/the-effect-of-population-ageing-on-pensions/

Policy makers are left with difficult choices in the case of pensions. As per World Economic Forum, even for a financially balanced pay as you go pension system, a decrease of 1% in old age support ratio (number of employed people relative to number of retirees) leads to a decline of 1% in average pension or require a rise of 1% in contribution rate. Higher contribution rate, higher employment through later employment or female employment and or financing through taxation are only possible alternatives.

Given the precarious scenario of rising unemployment globally and strain on household budgets, it seems that the latter is the only option left. Even in that case, the standard of living is expected to decline. The burden of social security and medical expenditure will be increasingly difficult to bear. Further, government will have limited means to increase taxation as working age population declines and number of dependents increase. The same is visible in Japan where all Income growth for people of working age has been soaked up by rising taxes and social Insurance Premiums This would lead to a pension crisis which the world has not seen till date. Some form of basic income will therefore have to be guaranteed thereby increasing deficits as current incomes through taxation are unable to meet budgeted spending.

Defaults

Due to corona pandemic which has temporarily closed many businesses and stifling consumer demand, industries, especially those who have recently leveraged their balance sheets to take advantage of near-zero interest rates, companies are seeing their profits disappear virtually overnight, leaving too little cash flow to cover debt payments owed to creditors. During lockdown, the overall economic activity came to a screeching halt because of the coronavirus pandemic. Further, we have seen Financial Institutions creating multi billion dollars in reserves in anticipation of default waves. With sudden job losses globally, wave of mass defaults has started. Central Banks are openly buying investment grade and some junk bonds, there is a terminal disconnect between bond pricing (i.e., default probabilities) as a result of the Central Bank’s interventions, and the underlying cash flow dynamics. The dynamics are becoming dire especially for lower rated credits.

The magnitude of bankruptcies this year if compared with Asset size has already surpassed that of 2008 even after excluding the government’s Pay check Protection Program(669 billion dollars) and 2 trillion dollars of CARES Act, which aims to keep small businesses up and running with loans that can be converted to grants if certain terms are met, runs out and to provide economic assistance to American workers and families.

The largest Bankruptcy seen during the period is reflected in the chart:

Source: https://fortune.com/2020/06/29/companies-filing-bankruptcy-2020-during-coronavirus-pandemic-covid-19-economy-industries/

While the stimulus announced by government was necessary for sustaining the business, the scenario has changed. Even after the stimulus announcement, unemployed population is increasing and business environment has started worsening again. The expected recovery is looking weak due to second wave of Covid and lost business leading to demand and supply constraints on the business. The pandemic has dealt a huge blow to Tourism and Travel industry and all other industries associated with it. Restaurant and dining have seen a negative impact as people stay indoors. Not to mention demand is subdued in most industries due to lower discretionary spend. Central banks can create money but they can’t create demand. To create demand, consumer confidence has to return back which is looking bleak due to ongoing pandemic. Many individuals are now looking at retiring debt and saving increasing the hit on demand. Banks are reluctant to lend and credit is freezing due to lower credit scores and possibilities of further increase in defaults. Most banks around the world are increasing their allocation towards loan losses due to the pandemic.

In such a situation, it is possible that the anticipated recovery never comes and we may see deflation for a longer term once the stimulus measures retire. It is difficult to keep the stimulus measures going for too long as already the debt burden has gone too high and any further stimulus would have huge impact on the local currency. In such a scenario, assets will have to be sold off to pay off debts which is another unlikely scenario as the wealth effect will be highly negative and put the economy at risk. Therefore, the only outcome then would be to let the currency weaken and reduce the purchasing power of the currency leading to inflation which will eventually lead to a deflationary bust. It merely explains the conundrum the governments around the world are facing right now.

Impact of the combined forces

What does the above factors of debt, deflation, demography and defaults lead to? Combination of the above factors is pointing to a significant deflationary event which the central banks are trying to prevent through their stimulus measures. It has been tried and tested with little success for the past ten years. Should they fail, world economy is at a significant risk of shrinking and a depression may take hold too. Central banks hate deflation because it increases the value of the debt and the currency. Inflation helps to reduce the debt burden through loss of purchasing power. Hence the stimulus money but more important is the fact that even after numerous rounds of stimulus, world GDP growth is trending down year after year. Years of GDP growth have been lost in one Quarter due to pandemic. Not to mention the trade wars and currency wars are only going to increase and create further tensions in the global economy. Social upheaval is already happening in places around the globe and socialist policies are on the rise which is indicating capitalism is not working in the desired manner. Many feel that global central banks will keep on stimulating the economy with some help from the fiscal side. But if history is any guide there is not much confidence in their actions. Our understanding is that as the interest rate bubble bursts, we will see a totally different world. There is very limited possibility we can ever get out of the debt problem without defaulting which would mean ‘extend and pretend’ policy would continue until they don’t work. The demographic issues and lower fertility rates will ensure that future growth if any will remain benign as population ages. The above factors will also ensure that production capacity will have to be cleared by letting zombie firms default ensuring permanent job losses.

In a world where technological changes are bringing in Artificial Intelligence, smart manufacturing practices like 3D printing and robotics, the need for human labour will constantly be reducing and therefore a high number of jobs will be deemed redundant leaving many on the support of government. The use of automation is going to increase rapidly reducing the need for human intervention. The future is sending deflationary signals with few growth avenues left to chase. Technology will keep evolving and getting better but the big question is whether it will help alleviate the problems mankind is facing today? Only time will tell.

  • By Vishal Vora, Nishant Maheshwari

Disclaimer: The above article is based on views expressed by the authors and are meant for information purpose only. Readers are requested to take investment decisions by consulting financial advisors.

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