Why Europe needs emerging markets

Europe’s pension system, like those in other developed countries, is underfunded. In the developed world, deficits in pay-as-you-go schemes vary between 40% and 250% of GDP because such schemes rely on an environment of strongly growing economies and few dependants versus a large number of contributors. However, this environment no longer exists as the developed world moves towards an ever-ageing population.

We know that Europe’s state pension schemes are in trouble and the same rationale applies to funded schemes. We are all, in the long run, supported by our children. In past times this was achieved directly. Today it is through modern pension schemes. At the end of the day, all our pension savings do is ensure that there is money to invest in our children’s education and provide sufficient equipment to produce goods which we will consume in our retirement. The problem is that with a rapidly ageing population, funded schemes require a real rate of return of 2% to 3% higher than the annual growth in OECD earnings in order to meet liabilities at current contribution rates. Not an easy return to achieve across the whole pension fund industry.

How then can we meet modern pension fund liabilities?

There would appear to be three routes. First, by increasing contributions. According to the OECD, in Europe we may have to increase the contribution rate to 26% of gross wages from 15%, and there are some moves in this direction.

Second, through immigration and thereby increasing total contributions. However, as one study by the EU concluded, the numbers required are substantial. In France alone it would require a net new immigration of about one million skilled workers over the next 15 years to fund France’s 300,000 new retirees every year over that period.

The third route is by increasing productivity, and the question here is: can it be done?

It is interesting to look at the historical growth rates of the developed world in order to find the answer. Over the first 50 years of this century, the growth rate of the United States was between 2% and 3%, on average about 2%. In the post-war period, the figures are the same. In Europe, if the recoveries from wars are stripped out, the growth rate of all the European economies is again between 2% and 3%. Even for much of the 19th century, Britain’s growth rate averaged below 2%.

It is also the case that there are faster growth rates as less developed economies catch up and that as time has progressed these catch-up periods are becoming compressed. For example, it took Japan about half the time, 30 years, to double its gross income during the 20th century, than it took Britain during the 19th century. In the case of Brazil it has taken 20 years and in the case of China, 10 years.

The further back you start, the less you need to invest. You can adopt technologies rather than invent them. It is when you have to start inventing technologies to increase productivity that growth comes back to the universal 2% to 3%.

So the key to productivity growth is investment. Or is it? A study from the Massachusetts Institute of Technology suggests that 80% of the increase in US GDP over the past 150 years is attributable to productivity growth which comes from investments and intellectual capital. Only 20% comes from labour and capital. Having resources is not sufficient: look at the African and central Asian economies which are resource rich and are among the poorest countries in the world.

Indeed, among the developing economies the shift away from manufacturing is making economies even less sensitive to capital investment. It should be noted that economies which are manufacturing-based necessarily have high depreciation rates on installed capital and must install high savings and investment rates to compensate. In countries such as Japan, the UK, the US and Germany, where the workforce involved in manufacturing is around 20%, savings rates are lower and yet output still increases. If this is all true – if increased investment produces only small increases in the rate of growth – what is the long-term rate of financial return in developed markets? A small survey of four leading actuarial firms suggests that the long-term real rate of return to holders of UK equities is around 5.75%, comprising 2% dividend growth and 3.75% dividend yield. If we assume an optimistic inflation figure of 2.25% this would give us a nominal return of 8%.

The numbers don’t add up

And here lies the crux of the issue. Over the last seven years we have experienced returns from the developed markets of two or three times this level and there is a feeling that these returns will be extended into the foreseeable future. You can only get back what companies have earned, and companies are not earning these sorts of numbers. Massive liquidity flows are reducing the yield on investments; ultimately people will not get the desired return on their investment. Mutuals and pension funds are buying at ever increasing asset prices thereby generating notional profits for investors who are taking those profits now to finance their retirement. Isn’t this a classic pyramid scheme?

Every generation is dependent for its pensions on the one that follows, and for the next 30 years the workforce is in place. But because we are an ageing population this workforce is insufficient to meet our needs beyond this timescale.

The upshot is that savers will be taxed heavily, either directly by governments or indirectly through dividends. When our liabilities begin to crystallize and we turn from net investors in the stock market to net divestors we will need those dividends to pay for our pensions. We will not get the capital gains of today and retained earnings will have to be paid out – effectively a tax on the whole economy.

So if we, Europe and the rest of the developed world, do not have enough children to generate the returns we will require, who does? The chart shows that today Germany and Japan are in the comfortable position of having more workers in proportion to dependants than any other country in the world. But look at the situation in 2025: they will be in the same position that Malaysia and India are in today. The key difference is that the dependants in Malaysia and India are children. The dependants in Germany and Japan will be elderly people who will expect a good standard of living. The net result is that those economies will slow down in growth and will not be able to fund those liabilities.

In which case, logic suggests that emerging markets will play an ever-increasing role in pension-fund portfolios. This is the actuarial case for investing there. The rate of return through domestic investment will decline from its current levels and therefore the place to look is towards countries which have made the demographic transition – countries like Brazil which will have a favourable worker-dependant ratio in 2025. Such countries will be hungry for capital and they will be in the position to provide the goods and services we need. There is an actuarial match.

While we can assume that our own weight of capital will cause our pension-fund assets to rise indefinitely, historical fundamentals suggest otherwise. The rationale for investing overseas and not just in developed markets is that it is a necessity. The necessity is an actuarial problem and an actuarial match is only provided by investing in emerging markets.

A World Bank survey of the world’s largest pension funds, as shown in the table suggests that they are already moving substantial funds into the emerging markets and that this will continue to be the case.

The short-term outlook for these markets lies between the Scylla and Charybdis of investment: fear and greed. But longer-term it seems there is a strong case that emerging markets, like Odysseus, will navigate these turbulent waters and continue their journey to become core holdings for institutional shareholders.

Arnab Banerji is chief investment officer of Foreign & Colonial Emerging Markets