The threat from The Hague: How centenarians are ruining Europe's national debt
European debt markets are preparing for new troubles. The already high bond yields of most EU countries may increase further due to the pension reform in the Netherlands. The Central Bank of this country has already warned about the risk to financial stability that may come in January next year. Izvestia investigated why potential pensioners of a small country turned out to be critically important for the European financial system.
The little big player
Although the Netherlands accounts for only 7% of the eurozone economy, its pension system is a major player in the market. According to the ECB, it accounts for more than half of all pension savings in the bloc. Dutch pension funds hold a total of almost €300 billion in debt securities from different European countries with a total savings of €1.7 trillion.
Assets worth 300 billion euros represent more than 3% of the total debt market in the eurozone. In addition, Dutch funds are invested in securities of EU countries outside the eurozone, as well as in US debt.
Until recently, pension funds in the Netherlands offered participants the most reliable schemes based on investments in long-term bonds. The system assumed guaranteed payments. Since January, everything has been changing: now the funds will not be able to guarantee payments, instead focusing on the investments of each of the participants in pension schemes. In this situation, a significant portion of the funds will be transferred from long-term government debt securities (and swaps that hedge these securities) to other assets, such as stocks. Younger workers will invest more in risky assets, while people of pre-retirement age will remain in bonds, but, most likely, much more "short" ones. Updating the system is designed to help cope with the aging of the population and the changing labor market.
About 36 funds plan to switch to the new system on January 1, while the rest will follow in tranches every six months until January 2028. The situation is already pushing up long-term bond yields, and traders are preparing for volatility in the euro swap market, which funds use to hedge. At the turn of the year, when funds switch to the new system, it will reach extreme levels due to low liquidity during this period.
Since the first big wave will seek to get rid of their securities en masse at a time when liquidity is usually low, it may be difficult for investment banks and brokers to bring sellers and buyers together, which will plunge the system into crisis.
In recent weeks, the indicator of future volatility for 30-year swaps in euros has increased. Strategists from ING Group NV believe that this is partly due to the transition. The shift also affects the cost of funding in euros. As Bloomberg notes, asset managers, including BlackRock and Aviva Investors, recommend caution regarding the long end of the yield curve, preferring short-term securities. Against this background, others, including JPMorgan Asset Management, consider US Treasury bonds more attractive than European government bonds.
The preparations are complicated by the political crisis in the Netherlands, where early elections are expected after the collapse of both the government and the interim cabinet that replaced it this summer. Among those who left was the Minister of Social Affairs, Eddie van Heijum, who oversaw the transition. It was expected that he would give pension funds an additional year to reduce their interest rate hedges after the transition. The parliamentary debate on pensions will now be postponed.
Profitability is at its maximum
At the turn of 2025-2026, the situation will be felt much more acutely. January is usually one of the busiest periods for new bond issues, so the supply of government debt can significantly outstrip demand, and the whole situation can have a shocking effect on a multi—trillion dollar market.
High interest rates on debt bonds signal increased risks for the economy and investors, including issuer default, a sharp rise in inflation that eats into yields, market volatility and possible liquidity problems, as well as an increase in the cost of debt servicing for the government and business itself.
Many of these countries have a huge debt overhang. In Italy, it exceeds 130% of GDP, in France — 110%, in the UK it is approaching 100%. Even 12-13 years ago, during the European debt crisis, these figures were 20-30 percentage points lower, and even then they raised serious questions. High debt rates combined with high interest rates dramatically increase the cost of debt servicing, which is approaching and even exceeds 10% of all budget expenditures.
In other times, hardly anyone would have paid attention to this seemingly technical issue. However, the context is completely different today. Bond yields in the vast majority of European countries have risen dramatically over the past few years. This is especially true for long-term debt, including long-term 30-year bonds. In mid-August, it became known that the profitability of British 30-year loans reached a record level in 27 years, exceeding even the indicators of Liz Truss' "mini-budget". In the United Kingdom, debt problems are indeed quite acute. But there is no significant difference on the positive side on the continent either.
For example, the yield on such bonds in France is now about 4.5% per annum, more than twice as much as before the pandemic. The French have already caught up with the Italians in these indicators, but until recently Italy was considered the "sick man of Europe" in terms of debt troubles (and economic development in general). In Germany and the Netherlands, yields are around 3.3%, four times higher than at the end of 2019.
Vicious circles
According to the estimates of the investment bank ABN Amro, the largest investments of the pension sector fall on the debt of Germany, France and the Netherlands. Falling demand may put pressure on governments to switch to shorter repayment periods. This will make them more vulnerable to interest rate volatility as they will have to refinance their debt more often. It should be noted that demand is falling across the entire market, but in the case of Dutch funds, this will happen in a relatively short time.
The problems in the EU turned out to be even more acute than in the United States, although on paper the latter have higher total debt compared to GDP and current yields. But this is due to the fact that the base rate in America is twice as high as in the eurozone, with comparable levels of inflation. As a result, due to the difference in interest rates, American assets, and in particular government bonds, are more attractive, all other things being equal, which becomes another problem for Europeans.
There is a vicious cycle of debt problems. You need to borrow more and more to stay afloat, but as borrowing increases, it becomes more difficult to pay off debt. The economy is superimposed on another important feedback element — political instability. An example is the situation in France, which is on the verge of a potential collapse of the government. The difficult financial situation requires unpopular measures that lead to the collapse of governments, which only complicates the situation in the market — investors lose confidence.
The flywheel of debt problems in the EU continues to unwind. Although the Dutch pension reform is not likely to cause an acute crisis, it will bring it much closer. As the debt burden increases, economic stagnation and political turmoil continue, such events will have an increasingly strong effect on the eurozone debt market.
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