Bermudas New Normal Written by Nathan Kowalski CA, CFA, CIM Demographics is the single most important factor

that nobody pays attention to. - Peter Drucker Estimating a countrys Gross Domestic Product (GDP) in the short term can be difficult and is subject to many shifting and interrelated forces. Numerous factors can determine a countrys success: interest rate policy, government spending, inflation and consumer sentiment, for example, all matter in the short run. In contrast, getting a longer term idea of a countries potential growth rate essentially relies on two factors: population and productivity. A growing population is the source of an increasing workforce and the more productive these workers are, the wealthier they become. In the long run, a country becomes rich or stagnates depending on its mix of people, innovation and investment. If a country gets this critical mix right, short term fluctuations in economic growth seldom matter. This brings us to a very simple economic equation: Population + Productivity = GDP is the Greek letter delta which is the symbol for change. What this equation and financial axiom reveals is that there are only two ways to grow an economy: you can increase the size of the working-age population OR increase the productivity of the current work force. In this article we will analyze these two components for Bermuda and conclude with a likely long-term potential growth rate for Bermuda. Bermudas Population The demographic shift in Bermuda may be one of the least appreciated reasons for the change in longer term potential growth. Population growth or decline ultimately determines how many workers a country will have. Population growth depends on numerous factors such as the fertility rate, life expectancy and migration. The recent census in Bermuda gives us the most up to date statistics on Bermudas population and its workforce. Bermudas current population is 64,186 according to the 2010 Census. This is up only 3% over a period of 10 years or an annual rate of just 0.3% per year and represents a slowdown in growth from 0.7% experienced in the prior decade. By comparison the United States has grown its population by 10% over the same period, an annual rate of approximately 1%.

Exhibit 1: Selected Bermuda Census 2010 Data

Source: Bermuda Census 2010 This low rate of growth for the islands population is partially the result of a fertility rate below replacement level, roughly 1.76 by recent estimates, while the replacement rate is 2.1. As fertility rates fall below the 2.1 replacement rate, population inevitably shrinks unless the drop is offset by migration. Current immigration trends also do not seem to offer any help in maintaining a stable population level or labor force. The number of guest workers, who tend to be younger, has begun to fall just as Bermuda begins its inevitable demographic shift. Exhibit 2: Guest Worker Population Trends

Source: Bermuda Sun The Vital Role of our Guest Workers in Boosting GDP by Sir John Swan & Larry Burchall, October 28, 2011

In gauging Bermudas potential GDP growth we need to determine its future trajectory given the potential demographic shift and current composition. This is where the analysis gets a bit worrisome. The current low birth rate and aging population in Bermuda will act as headwinds for future growth. There has been a shift in Bermuda for what is called the dependency ratio. That is, the share of the economically dependent population, both children depending on their parents, and elderly parents depending on their working age children, is rising in comparison to Bermudas economically productive population. Although the dependency ratio remained constant at 42, the composition has begun to shift. The population component for the 20 to 44 cohort has dropped from 41% in 2000 to 35% in 2010. In contrast, the 45 to 65 age group has expanded over the last ten years and now composes 30% of the population, up from only 24%. This is similar to most developed world economies which are

seeing the Baby Boom generation age. This is likely to result in Bermudas dependency ratio climbing mercilessly higher over time. In fact the median age has already jumped from 37 years in 2000 to 41 years in 2010. Exhibit 3: Census Percentage Distribution by Age Group

Source: Bermuda Census 2010 According to population projections from the Census report, the portion of seniors (those aged 65 and over) is expected to be 22% of the population by 2030 while the proportion of children and the other productive age groups will continue to fall. The demographic pyramid, a visual representation of the age stratification of a country, projects a slow aging of the populations composition. Bermudas age-sex pyramid is not unlike most developed countries where one sees a smaller base in the younger ages with a bulging middle. A perfect age-sex pyramid is just that, a pyramid structure, in which the future productive age of the population is expected to rise and swell, contributing to economic growth. Inverted pyramids predict economic stagnation as the productive workforce is a very small component of the dependent one.

Exhibit 4: Bermudas Age-Sex Population Pyramid

Source: Bermuda Census 2010

Population growth is the source for all future workers. All things being equal, a shrinking or smaller workforce limits how much any given economy can produce. The confluence of an aging demographic, a lower fertility rate and a stagnant immigration policy is likely to put pressure on the growth of Bermudas labor force in the future. Given the inevitable aging of the population and assuming no net benefit from immigration, we estimate Bermudas labor force could shrink about 1.4% per year (see exhibit 5). This presents a very large obstacle to overcome and would negatively affect the potential output of the island. Exhibit 5: Bermudas Estimated Labor Force
2010 Labor Force Age Groups: 20 to 29 30 to 44 45 to 64 Total Potential Labor Force Estimate 2011 Estimating Bermuda's Shrinking Labor Force Year 2012 2013 2014 2015 2016 2017 2018 2019 2020

7,420 14,835 19,331 41,586

7,403 14,539 19,016 40,958

7,388 14,261 18,703 40,352

7,374 14,002 18,392 39,768

7,362 13,759 18,085 39,206

7,351 13,532 17,782 38,665

7,341 13,320 17,484 38,146

7,332 13,122 17,193 37,647

7,324 12,936 16,908 37,169

7,317 12,763 16,630 36,710

7,311 12,602 16,359 36,271

Reduction in Labor Force -12.8% Annualized Reduction -1.4% *Major Assumption: Age stratification is equally dsitributed in groups and the unemployment rate is 0%

Source: Bermuda Census 2010, Anchor Investment Management Estimates

Bermuda Productivity Productivity and the growth of productivity must be the first economic consideration at all times, not the last. That is the source of technological innovation, jobs, and wealth. -William E. Simon (former secretary of Treasury in the U.S.) A country does not just exhibit economic growth based on its population growth. It can also grow by increasing the output of its workers over time. This helps determine what each worker earns, and creates economic wealth. In the past fourteen years of statistical data available (1996-2010) Bermudas annualized productivity growth was about 1.4% per annum, essentially identical to that of the G7 countries average more recent ten year average. While annual fluctuation is less important than long-term trends, in recent years, productivity has begun to decline. The current 5 year productivity rate has dropped to 0.6% and over the past 10 years productivity per annum has actually turned negative at a minus 1.2% annualized rate. Prior surges in productivity appear to be associated with waves of new international business expansion post 9-11 and the Katrina/Rita/William hurricane disasters. Exhibit 6: Bermudas Productivity Growth

Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Total Hours Worked for Total Employment ('000) Output Per Hour Worked Productivity Growth 60,012 61.96 60,939 63.31 2.2% 61,105 70.67 11.6% 64,866 66.92 -5.3% 50,505 85.49 27.8% 62,733 73.33 -14.2% 64,374 70.37 -4.0% 56,343 83.15 18.2% 65,077 73.89 -11.1% 67,279 72.90 -1.3% 70,522 73.45 0.8% 68,324 78.04 6.3% 67,373 79.90 2.4% 68,672 74.62 -6.6% 66,395 75.69 1.4% 1.4% -1.2% 0.6%

Long-term Annualized Productivity Growth (since 1996) Annualized Productivity Growth for Past 10 Years Annualized Productivity Growth for Past 5 Years
Source: Bermuda Government Department of Statistics

Future rates of productivity will depend on investment capital and innovation. A major source of investment is savings. A country with a higher savings rate has the ability to invest more in new productive endeavors. The more a company, individual or country saves the more capital they accumulate to provide for future productive

investment. We have calculated an estimated Gross National Savings Rate of Bermuda to get an indication of its future productive investment potential (see Exhibit 7). Exhibit 7: Bermuda Gross National Savings Rate

Gross National Savings Rate Calculation GVA AT BASIC PRICES Taxes on Production and Imports Less Subsidies GDP AT MARKET PRICES Net Income from Abroad GROSS NATIONAL INCOME (GNI) Net Current Transfers from Abroad GROSS NATIONAL DISPOSABLE INCOME (GNDI) Private Final Consumption Government Final Consumption Total Consumption GROSS NATIONAL SAVINGS Gross National Savings Rate
Source: Bermuda Department of Statistics

2008 5,882,678 227,250 5,655,428 1,621,406 7,276,834 (116,068) 7,160,766 3,452,118 654,286 4,106,404 3,054,362 43%

2009 5,583,020 223,358 5,359,662 1,402,792 6,762,454 (127,940) 6,634,515 3,376,200 683,570 4,059,770 2,574,745 39%

2010 5,559,506 205,078 5,354,428 1,423,854 6,778,282 (137,802) 6,640,479 3,276,392 679,496 3,955,888 2,684,591 40%

The 2010 rate of 40% compares to a rate of 11% in the U.S., and is in line with the IMFs estimated 2010 figure of about 32% for the developing and emerging nations. This large pool of savings does provide a source of future investment potential. It is likely that this high gross national savings ratio will continue to fall as Bermudas dependency ratio rises over time. It is important to also note that a high national savings rate does not necessarily equate to a higher potential productivity rate as attractive avenues and opportunities for investment are required WITHIN the nation. Future innovation is, of course, impossible to predict. As an example, one of Bermudas greatest ideas over the past ten years was the formation of its large offshore reinsurance market. It is difficult to predict new future products or services that Bermuda will offer but it is fair to say that industrious entrepreneurs will create some and spawn future job growth. Future innovation can also help transform the islands economic production by combining the capital and labor that it has in different ways. If resources are shifted effectively, the island could produce different or better products at lower costs. Countries at the leading edge of technological adoption tend to exhibit slower future productivity gains while late adopters can copy other countries technological advancement and see future benefits. Because many industries in Bermuda would not be considered a technological leader or innovator, it is fair to assume that it does have some ability to copy other countries more extensive adoption of newer telecommunications technologies and business processes to enhance future productivity. Given the aspects discussed above it would seem reasonable to assume Bermudas future productivity growth in the long term will be similar to that of its past or about of 1.4% per year. This assumes a rebound from its lower ten year and five year average and more in line with it recent one year figure of 1.4%.

Bermudas Long-term Potential Growth (doing the math) If we take our assumptions as discussed above and plug the constituents in the simple formula we realize Bermudas long-term potential GDP growth rate is effectively zero. Population +Productivity = GDP -1.4% + 1.4% = 0%

Effect on Bermuda As indicated above, Bermudas future long-term growth is determined by the change in size of its labor force and the productivity of its workers. The contracting population and minimal productivity gains will prolong Bermudas current economic malaise, in effect creating a lower equilibrium for the economy. As Japan has amply demonstrated, the worst possible time to come up against a demographic crisis is immediately after an economic bust. The implications of this lower level of potential economic growth for the island are many: 1) The unemployment situation will likely become structural in nature and not merely cyclical. No or low economic growth provides little opportunity for job creation and the absorption of the unemployed. 2) A lower level of economic activity (especially one associated with anemic population growth or lack thereof) lowers the total aggregate demand in the economy. This essentially forces a rationalization of the countrys assets, both capital and labour. Domestic companies will either need to adjust to a new, lower or stagnant demand level by focusing on efficiencies or suffer through profitability declines or the potential closure of business. As a result it is typical to see a reduction in businesses as fierce competition pursues a shrinking share of business. 3) Government debt left unchecked can rapidly become a problem as its value as a percentage of GDP could escalate. Servicing the debt also becomes more difficult, as a lower or flat economic prospect essentially reduces the tax base used to pay interest and principal. If fiscal deficits get too large they will crowd out private investment.

Policy and Ideas to Support Growth Supporting and fostering long-term growth requires an environment that addresses both demographic change and productivity issues. Unfortunately, the long run effects of demographics are essentially not reversible. Bermuda has already received a large share of its demographic dividend: a rise in the rate of economic growth due to a rising share of working age people in the population. This is a one-time benefit and as the dependency ratio increases the island will receive less and less benefit from its size of labour force. The only way to counteract this drag is to foster an immigration policy to offset the decline. To simply stem the total potential decline in the labour force over the next ten years, immigration policies should target a roughly 1.4% annual net migration ratio roughly over 500 people per year. This accommodative immigration policy should be focused on promoting new business formation. Without a pro-immigration policy, it is very unlikely that Bermuda will be able to grow economically. A nations productivity can be assisted and enhanced by corporate leaders and policy makers in the following ways:

1) Embracing Creative Destruction and Free Markets. Ironically, a positive aspect of capitalism is failure. The term creative destruction was coined by Austrian-born economist Joseph Schumpeter and refers to the process where bad companies or ideas fail and free up that unproductive capital for good companies and ideas. Nations where government policy hopes to defend weaker industries or companies by artificially assisting them with uncompetitive policies actually holds capital hostage. Without failure, capital and labor cannot be released to find more productive and effective endeavors. They essentially get stranded in a low productivity area which ultimately hampers future economic growth. Policies that encourage competition should be adopted. All policies which restrict foreign investment and companies from entering the market should be relaxed. Policies that protect monopolies or duopolies should also be removed as well as any restrictive labour laws. 2) Education and Labour Training. The training and advancement of the islands labour force is critical for future economic productivity enhancement. Governments and corporations should continue encouraging education and continuing professional development to ensure the work force does not fall behind or made irrelevant in todays globally competitive landscape. A concerted effort should be made to ensure Bermudas youth have unfettered access to the best educational standards and vocational training opportunities. 3) Private Capital & Labor Friendly Rule of Law. Capital flows to where it is treated best. Today even labor is fungible and lucid. Laws and regulations need to be transparent and business friendly. In order to commit sizeable capital investments, foreign investors need to know they are investing in something that is not subject to various forms of appropriation or rule change. Government processes and regulation need to be efficient and transparent. In general, less government means more economic growth potential. Empirical evidence and academic studies suggest that private companies are much better at increasing productivity and creating jobs than government.