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Peterson Institute for International Economics, Washington DC, 9 November 2017 Low Productivity Growth and Sovereign Debt Sustainability Elena Duggar, Chair of Moody’s Macroeconomic Board, Associate Managing Director, Credit Strategy & Research November 2017

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Peterson Institute for International Economics, Washington DC, 9 November 2017

Low Productivity Growth and Sovereign Debt Sustainability

Elena Duggar, Chair of Moody’s Macroeconomic Board, Associate Managing Director, Credit Strategy & Research

November 2017

November 2017 2

Agenda1. Low productivity growth is dampening the economic

outlook globally, with further downside risks2. Low productivity growth is raising challenging

questions about sovereign debt sustainability in a world of historically-high debt levels: • How will low productivity growth impact the interest rate-

growth differential, budget deficits, and the materialization of contingent liabilities?

• What is a sustainable level of debt in a QE or secular stagnation environment?

• Is demographics the most important credit driver given the unprecedented fiscal challenges?

1Low productivity growth is dampening the economic outlook globally, with further downside risks

November 2017 4

The collapse of productivity growth is global and persistent

Source: Moody’s Investors Service, Global Macro Risks: Collapse of Global Productivity Growth Remains Sizeable Risk to Credit Conditions, The Conference Board Total Economy Database™ (Adjusted version), May 2017

Developed Economy

Emerging Economy

November 2017 5

Given demographics, low productivity growth is dampening global prospects

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Global Real GDP (Y-o-Y, % Change) 1995-2007 Average, 4.7% 2011-2015 Average, 3.4%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

1995

1996

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2001

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2005

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2010

2011

2012

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2014

2015

2016

2017

2018

2019

2020

2021

Global Employment (Y-o-Y, % Change)1995-2007 Average, 2.1%2011-2015 Average, 1.7%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

1995

1996

1997

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2021

Global Output per Worker (Y-o-Y, % Change)1995-2007 Average, 2.7%2011-2015 Average, 1.8%

Source: Moody’s Investors Service, Global Macro Risks: Collapse of Global Productivity Growth Remains Sizeable Risk to Credit Conditions, International Labour Organization. Note: Exhibits are unweighted average across 122 countries.

Despite cyclical upturn, global growth post-crisis remains significantly lower than in the pre-crisis period

November 2017 6

Further sizeable downside risks to potential growth forecasts» We have a favorable near-term growth outlook and we expect productivity growth to

recover somewhat in 2017-18 driven by a rebound in aggregate demand and investment

» However, given demographic pressures and declining working-age population, lower productivity growth would imply large downside risk to growth forecasts

Global GDP growth under scenarios of lower labor productivity growth

Source: Moody’s Investors Service, Global Macro Risks: Collapse of Global Productivity Growth Remains Sizeable Risk to Credit Conditions, International Labour Organization. Note: Exhibits are unweighted average across 122 countries.

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Baseline Scenario: Moody'sScenario 1: Labor productivity grows at the avg. 2011-2015 (1.8%)Scenario 2: Labor productivity grows at 2016 pace (1.4%)

2Low productivity growth is raising challenging questions about sovereign debt sustainability

November 2017 8

How will low productivity growth impact sovereign debt sustainability?» Three main drivers of sovereign debt build-up: primary deficits, the materialization of

contingent liabilities and the interest rate-growth differential, with large debt build-ups typically coming from the first two factors

Source: Moody’s Investors Service, IMF

Debt-creating flows (in percent of GDP)

-10

-5

0

5

10

15

20

2002 2004 2006 2008 2010 2012 2014 2016

USResidual Other debt-creating flowsContribution from real GDP growth Contribution from real interest ratePrimary deficit

-10

-5

0

5

10

15

20

2002 2004 2006 2008 2010 2012 2014 2016

JapanResidual Other debt-creating flowsContribution from real GDP growth Contribution from real interest ratePrimary deficit

November 2017 9

What will low productivity growth mean for the risk of financial crises?» The materialization of contingent liabilities has lead to an average of 4.1 pp annual

increases in debt to GDP levels across countries

» Financial sector crises represent the biggest risk to sovereign balance sheets. Lower growth and lower rates are generally both negative for the banking system

Source: IMF, 2016, Bova et al., The Fiscal Costs of Contingent Liabilities: A New Dataset, IMF Working Paper WP/16/14, Moody’s Investors Service, Sovereign Contingent Liabilities: Public Enterprises Represent a Material Source of Fiscal Risk to Some Sovereigns

Realizations of contingent liabilities have material fiscal impact on sovereign balance sheets

Financial Sector

Legal

Natural Disaster(s)

Other

PPPs

Private Non-Financial Sector

SOEsSubnational Government

0

10

20

30

40

50

60

0 2 4 6 8 10

Num

ber o

f Epi

sode

s

Avg. Fiscal Costs (% of GDP)

Developed Markets

Financial Sector

Legal

Natural Disaster(s)

Other

PPPsPrivate Non-

Financial Sector

SOEsSubnational Government

0

10

20

30

40

50

60

0 2 4 6 8 10 12

Num

ber o

f Epi

sode

s

Avg. Fiscal Costs (% of GDP)

Emerging Markets

November 2017 10

What is a “sustainable” level of debt?» Historically, sovereign defaults have occurred at a wide range of debt-to-GDP ratios

» In a world of historically-high debt levels, how relevant are traditional debt thresholds like the IMF’s 90% and 60% debt to GDP thresholds for ADV and EM countries? Should debt thresholds be adjusted up over time?

Source: Moody’s Investors Service, Sovereign Defaults Series - The Aftermath of Sovereign Defaults - October 2013

Sovereign defaults have occurred at high as well as low debt to GDP ratios (%)

84.2

0.020.040.060.080.0

100.0120.0140.0160.0180.0200.0

Rus

sia

Ukr

aine

Pak

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Ecu

ador

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Ivoi

re

Arg

entin

a

Mol

dova

Par

agua

y

Uru

guay

Nic

arag

ua

Dom

inic

a

Gre

nada

Dom

inic

an R

ep.

Bel

ize

Sey

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les

Ecu

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Jam

aica

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St.K

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and

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is

Gre

ece

Bel

ize

Gre

ece

Jam

aica

Cyp

rus

Arg

entin

a

Ukr

aine

Moz

ambi

que

Aug-98

Sep-98

Jul-99

Aug-99

Mar-00

Nov-01

Jun-02

Jan-03

May-03

Jul-03

Jul-03

Dec-04

May-05

Dec-06

Jul-08

Dec-08

Feb-10

Jan-11

Nov-11

Mar-12

Sep-12

Dec-12

Feb-13

Jul-13

Jul-14

Oct-15

Apr-16

November 2017 11

What is a “sustainable” level of debt in a QE or secular stagnation environment?» What happens to fiscal space as central banks hold increasing amounts of government

bonds? For example, the Bank of Japan holds 40% of JGBs as of Q1 2017, which is equivalent to 87% of GDP

» Should credit analysis put more weight on the combined fiscal space of the government plus the central bank?

Source: Moody’s Investors Service, Monetary Policy - US, Euro Area, Japan: FAQ on central bank policy normalization likely to proceed without market disruption, Haver Analytics

Sovereign bond holdings by Bank of Japan vs. others over time (% of GDP)

0.0

40.0

80.0

120.0

160.0

200.0

Q2/

05Q

4/05

Q2/

06Q

4/06

Q2/

07Q

4/07

Q2/

08Q

4/08

Q2/

09Q

4/09

Q2/

10Q

4/10

Q2/

11Q

4/11

Q2/

12Q

4/12

Q2/

13Q

4/13

Q2/

14Q

4/14

Q2/

15Q

4/15

Q2/

16Q

4/16

Q2/

17

Japan

Non-NCB Holdings/GDP, %

NCB Holdings/GDP, %

held by financial institutions42.7%

held by central bank39.4%

held by nonfinancial corps0.9%

held by social security funds4.6%

held by households1.2%

held by private investors0.2%

held by overseas10.7%

Estimated Ownership of JGB (Mar.2017)

November 2017 12

Is demographics the most important credit driver?» Europe and North America will remain the greyest regions, especially with the retiring of

the “baby-boom” generations. The US old age dependency ratio will double by 2050» Demographic shifts will further dampen productivity growth and will create pressures on

health care and pension spending

Source: UN. Note: Age dependency ratio, old, is the ratio of older dependents (people older than 64) to the working-age population (those ages 15-64). Data are shown as the proportion of dependents per 100 working-age population.

Old-age dependency ratio (ratio of population aged 65+ per 100 population 15-64, %)

*Estimates assuming medium fertility variant, 2015 - 2100

US: 36.4

0.0

10.0

20.0

30.0

40.0

50.0

60.0

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050

Africa Asia Europe Latin America and the Caribbean North America United States

November 2017 13

Demographic headwinds will present a formidable fiscal challenge for the USProjected health care (top) and pension (bottom) expenditure to GDP (2011-2050,%)

-2

3

8

13

18

2010 2020 2030 2040 2050

Hea

lth C

are

Expe

nditu

re

to G

DP

No excess costWith historical excess cost

-2

3

8

13

18

2010 2020 2030 2040 2050

Pens

ion

Expe

nditu

re to

G

DP

Pensions growing with wagesPensions growing with GDP per employee

Source: Moody’s Investors Service, Assessing Future Health- and Age-Related Government Expenditures in France, Germany, the UK and the US

0

50

100

150

200

250

300

2010 2020 2030 2040 2050

Incr

ease

d Ex

pend

iture

to G

DP

Lower bound Upper bound

Projected cumulative increase in growth-adjusted health and pension expenditure to 2010 GDP (2011-2050, %)

Note: Lower bound scenario includes health care projection assuming zero excess cost growth and pension projection assuming pensions growing with nominal wages; while Upper bound scenario includes health care projection assuming historical excess cost growth and pension projection assuming pensions growing with GDP per employee.

November 2017 14

The “optimistic” view on debt sustainabilityLow productivity growth will have no effect or a positive effect on sovereign debt sustainability (Mehrotra 2017):» r < g in many advanced economies» Even where r > g, the productivity slowdown reduces the differential by

pushing down r relative to g (in small open economies, domestic r is closely linked to world r due to capital mobility, whereas domestic g is less linked to world g)

» Going forward, r < g is likely to persist in most advanced countries, except for some euro area economies, and as long as r < g, debt is on a sustainable trajectory regardless of the debt-to-GDP ratio

» Furthermore, a low world r should continue to help countries with autonomous g

Additional argument: central banks’ holdings of government debt would further reduce rollover risk

November 2017 15

The “pessimistic” view on debt sustainabilityLow productivity growth will have a negative effect on sovereign debt sustainability:» r < g is not enough to ensure debt sustainability: historically, the most

important threats to debt sustainability come from increases in the primary deficit and the materialization of contingent liabilities, both of which become more likely with lower productivity growth (Dynan 2017)

» Further, even where r < g, there is a risk of reversion to r > g» r > g in many emerging and frontier markets» The r-g differential may not decline as the productivity slowdown is

global and not just in advanced economies (pushing down domestic g)» Additionally, the unprecedented demographic transition will exacerbate

the decline in productivity growth and the pressure on primary budget deficits

Appx. Additional Figures

November 2017 17

Source: Moody’s Investors Service, International Labour Organization.

Real growth contribution from changes in employment and in labor productivity for the US and JapanContribution to real GDP growth in the US Contribution to real GDP growth in Japan

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

Output per worker (y/y, % change)Employment (y/y, % change)Real GDP (y/y, % change) Forecast

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

Output per worker (y/y, % change)Employment (y/y, % change)Real GDP (y/y, % change) Forecast

November 2017 18

0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

1950

- 19

5519

55 -

1960

1960

- 19

6519

65 -

1970

1970

- 19

7519

75 -

1980

1980

- 19

8519

85 -

1990

1990

- 19

9519

95 -

2000

2000

- 20

0520

05 -

2010

2010

- 20

1520

15 -

2020

2020

- 20

2520

25 -

2030

2030

- 20

3520

35 -

2040

2040

- 20

4520

45 -

2050

Net migration rate (per 1,000 population)

Source: Moody’s Investors Service, UN (left), US Census (right)

Immigration has been a vital source of US working-age population growthNet migration rate in US (per 1,000 population) Population growth in prime working age (25-54) by

nativity and US citizenship status (y/y change, %)

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Native Naturalized U.S. citizen Not a U.S. citizen

November 2017 19

Moody’s Related Research

» Monetary Policy - US, Euro Area, Japan: FAQ on central bank policy normalization likely to proceed without market disruption, September 2017

» Global Macro Risks – Collapse of Global Productivity Growth Remains Sizeable Risk to Credit Conditions, May 2017

» Sovereign Contingent Liabilities: Public Enterprises Represent a Material Source of Fiscal Risk to Some Sovereigns, January 2017

» Population Aging Will Dampen Economic Growth over the Next Two Decades, August 2014

» Sovereign Defaults Series - The Aftermath of Sovereign Defaults, October 2013

» Assessing Future Health- and Age-Related Government Expenditures in France, Germany, the UK and the US, December 2011

» Topic Page: Sovereign Default Research

» Topic Page: Global Macro-Economic & Financial Risk Analysis

» Topic Page: Pensions and Retirement Benefits: Today's Promises, Tomorrow's Credit Challenges

Elena DuggarChair of Moody’s Macroeconomic BoardAssociate Managing DirectorCredit Strategy & [email protected]

November 2017 21

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