Credit Rating Agencies, Pensions, Ageing and Debt

In a recent post here 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 based 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 taken 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!

Consumer Confidence Again

ISAE have today published their July 2007 reading for the Italian consumer confidence index (pdf).

This latest data point for consumer confidence (July) seems to confirm that people in Italy are nothing like as optimistic as they were last summer:

Italian consumer confidence remained near the lowest in more than a year in July, as rising interest rates and higher gasoline costs left families with less to spend. The Rome-based Isae Institute's index, based on a poll of 2,000 households, rose to 107.4 from 107.2 in June. A sub-index measuring confidence in the general economic situation rose to 90.6 from 89.4, still near the lowest level since January 2006.

Perhaps part of the reason is this:

Italians have seen their disposable income shrink as the highest interest rates in six years and a jump in energy costs erode what consumers have to spend. Gasoline prices in Italy have increased more than 12 percent this year, with the rise weighing on confidence as the summer driving season begins......Families are having a tough time setting aside money and sometimes have to dip into savings to balance household budgets

Credit Derivatives and Market Fluctuations

It probably does not come as news to anyone that last week saw a lot of movement in global financial markets. The Dow Jones fell the most in any one week in the last five years, whilst in Italy both The Mibtel and S&P/Mib indexes lost gorund during the week. It is far too early to say at this point whether this constitutes the start of a "correction", or all we have is increasing nervousness and market volatility. Nonetheless the consequences of growing concern about the extent of credit risk are already being felt in Italy, most notably in the Italease case.

The impact of what is happening as a result of the losses sustained on derivatives trading at Italease goes well beyond the traditional financial investment community, as this Bloomberg article points out:

Piera Levo and her husband, who run a 15-employee plumbing supply company in northeastern Italy, bought ``insurance'' against interest rate increases from UniCredit SpA in 2000.

Six years later, they paid 85,000 euros ($117,000) to extricate themselves from a derivative known as an interest-rate swap that is normally sold to large companies and fund managers. Derivatives are contracts whose value is based on that of another security, index or commodity, or linked to events such as changes in interest rates.

``I had no idea what I was getting into,'' Levo said. ``I don't even play slot machines. I would never sit down to play blackjack against Alessandro Profumo,'' chief executive officer of UniCredit, Italy's biggest lender.

Italian banks, including UniCredit and Banca Italease SpA, have sold swaps to as many as 100,000 small businesses, according to lawyers and industry groups. Concern about the contracts intensified last month, when Milan-based Italease said about 2,200 clients may lose 600 million euros on derivatives. Italy's central bank this week barred Italease from selling its most-profitable derivatives and ordered directors to resign.

The Bank of Italy estimates that non-financial companies had 3 billion euros of liabilities on derivatives at the end of 2006.

Banks sold swaps to clients as insurance against rising rates. They also made lots of money. Commissions from sales of derivatives represented 48 percent of operating revenue at Italease in the fourth quarter, according to John Raymond, an analyst at CreditSights Inc. in London.


Claus Vistesen made the following very valid point to me (e-mail communication):

"My guess is that there is a lot of this going around (i.e. in Denmark banks are persuading farmers to play the derivatives to hedge their harvests, the problem is just that they are often playing against other banks and of course also the fact they have no idea what they are doing) and really the whole subprime mess is a reflection of this since homeowners are the ones who end up in bankruptcy as well as of course those credit institutions who are exposed to something like +75% or something in subprime loans. Incidentally Scott, thanks for the comment on my credit channel post regarding the investment banks......in this respect FX trading might be comparatively easy and safe but the problem for the average retail investor is that she only needs to fail once and if she happens to be overly leveraged, well ... those books have to be settled at the of each month you know (or three months perhaps depending on the contract and regulations)."

And just in case you aren't sure what "swaps contracts" are (and don't like to ask), then this might help:

In a basic swaps contract, one borrower exchanges the interest payments on its floating-rate debt for the fixed-rate payments of the second. This helps the first borrower protect against rate increases, while the other profits if rates decline.