A New Era of Global Financial Repression

June 2011                       

Scott Mather

• Any sovereign policy that interferes with free market activity and the pricing of debt or currency can be thought of as financial repression.
• Repressionary policy rates percolate through the global financial markets and affect asset prices across the risk spectrum.
• Many emerging market countries use repressionary tactics to capture a larger share of global growth.

Deeply indebted developed world sovereigns face fiscal challenges that suggest a new era of global financial repression is at hand. Investors need to prepare by relying less on historical relationships, and instead consider how repressionary policies are likely to reshape risk and return across developed markets in the years ahead and create new and different challenges in developing nations.

Financial repression is growing in prevalence throughout the world. Both developed and emerging economies use its tactics: developed sovereigns that struggle with explosive increases in their outstanding debt, and emerging market countries that face increasingly scarce external demand. Investors need to be especially alert to increasing financial repression, because it transfers value from savers, investors and creditors to government debtors. We are likely on the cusp of a new era of global financial repression, with important and far-reaching investment ramifications. 
What Is Financial Repression?
Any sovereign policy that interferes with free market activity and the pricing of debt or currency can be thought of as an act of financial repression. Policies can be designed to alter market prices of debt or currency through direct intervention, or indirectly through altering the amount of debt or currency demanded at a given price.

The most common motive for financial repression is to improve a country’s ability to finance government debt without resorting to painful fiscal adjustment. By artificially lowering the cost of debt financing below what would be demanded by free market forces, governments are able to reduce borrowing costs and slow down debt accumulation rates. One can think of financial repression as a form of “stealthy default”: a gentlemanly way for modern countries with fiat currencies to stiff their creditors while still ostensibly paying interest and principal in full.

Many policymakers are drawn to financial repression as a sneakier form of taxation or fiscal austerity. Direct tax increases or entitlement spending cuts are politically hazardous; the repression “tax” is much more subtle.

The tactics have morphed over the years, but financial repression has been around for as long as there’s been debt to tempt its use. Think of fiscally troubled Romans shaving precious metal from coins. Today, there are almost unlimited variations of repressive tools sovereigns use to help lower debt costs and shift the risk/return profile in the sovereigns’ favor and away from investors.

In their examination of a particularly intense period of financial repression that occurred after WWII, economists Carmen Reinhart and M. Belen Sbrancia recently outlined the broad set of policies that feature in financial repression.

1. Explicit or indirect caps or ceilings on interest rates. Recent examples include central bank interest rate targets and caps that set rates below the equilibrium free market level.
2. Creation of captive domestic audiences to direct credit to government at artificially low rates.Quantitative easing or asset purchase programs of central banks in Europe, Japan, the U.K. and the U.S. are good examples, as are capital account restrictions and exchange rate controls increasingly employed in many emerging markets.
3. Other government restrictions and regulations on the financial industry. Direct government ownership of banks or other large financial institutions that direct lending falls into this category, as do many new regulations over bank reserves and liquidity targets that effectively mandate more government bond holdings. Many so-called macroprudential regulations also act in this financially repressive manner.

Developed and Emerging Economies United in Repression
The most prominent tool of modern financial repression – employed by central banks around the world – is an abnormally low interest rate. In some cases they establish and hold policy rates below the rate of inflation, meaning that borrowing costs after adjusting for inflation are actually negative.

A look at average real short-term policy rates over the past 15 years shows how extraordinary the current environment is (see Chart 1). By this metric, the entire world is, on average, running a very repressive interest rate policy. Even the majority of emerging market countries are holding rates abnormally low compared with inflation and growth trajectories.

Repressionary policy rates percolate through the global financial markets and affect asset prices across the risk spectrum. Central banks have assured their sovereigns’ ability to borrow at very low and even negative real rates, but the sovereign’s gain becomes the investor’s and saver’s pain as they find themselves increasingly unable get more asset price appreciation from discounting at continuously lower rates; it becomes harder to earn a positive rate of return after adjusting for inflation.

While developed countries are primarily using repression to lower the cost of financing an explosive growth in the stock of debt, many emerging market countries – which do not suffer from the same poor debt dynamics – are primarily using repressionary tactics to capture a larger share of the global growth pie. Aiming to preserve external competitiveness, they adopt polices to retard currency appreciation and keep foreign capital out.

So what ultimately unites both the hyper-indebted developed world with the more fiscally sound emerging world in a repressionary policy stance is the need (or greed) for growth today – even if it comes with significant costs and risks tomorrow.

Other Recent Examples of Financial Repression
Recent working paper “Financial Repression Redux” by Jacob Kirkegaard, Reinhart and Sbrancia documents the resurgence of financial repression as developed country central banks around the world have engaged in new rounds of repressionary bond buying and balance sheet expansion.

Less obvious but just as important is the stealthy repression occurring as emerging market countries accumulate massive official reserves of foreign currency (largely a byproduct of repressive currency policy). Because these reserves are predominantly invested into government bonds of the largest debtor nations in the developed world, it creates a self-reinforcing repression cycle: Developed nations keep interest rates artificially low, causing emerging market currencies to tend to appreciate. In response, emerging markets resist currency appreciation via intervention, leading to an accumulation of reserves that (again) are reinvested mostly in developed world sovereigns, increasing the downward pressure on interest rates. Through this repressionary cycle, the markets for government bonds are dominated by price-insensitive official buyers who are motivated by repressionary goals rather than market-oriented risk and return objectives.

Financial repression is ascendant in many areas:

1. New bank and capital regulations that favor government debt. Examples include the Basel III bank rules, Solvency II insurance rules and U.K. bank liquidity requirements.
2. Growing proportion of sovereign issues on domestic bank balance sheets. This is happening globally and especially fast in the peripheral European countries with the worst debt dynamics.
3. Pension fund regulation and suasion. Government-directed shifts in asset allocations favoring domestic government bonds have occurred in France, Ireland, Portugal and elsewhere.
4. Expansions of capital controls and currency interventions. This type of financial repression has increased throughout the world and particularly in emerging market countries. The G-7 intervention in the yen is also notable.

Will It Work?
Financial repression is helping to temporarily stabilize the rapid deterioration in developed sovereign debt dynamics. But will it be enough to turn the tide?

In the absence of additional measures, probably not. The current degree of repression, as painful as it is for savers and investors, is simply not helping liquidate government debt as fast as it accumulates; it isn’t large enough to significantly lower or even stabilize debt/GDP metrics over the medium term. Some intensification of financial repression, fiscal austerity or stronger growth must occur to diminish the likelihood of a future debt crisis.

Growth is obviously the hoped-for outcome. But little is being done to improve the structural growth prospects in the developed world, and history has shown that such proportionally high debt loads stunt economic growth prospects.

It is tempting to be encouraged by Reinhart and Sbrancia’s study of how financial repression techniques helped bring down the post-WWII sovereign debt load in the U.S. However, history in this case offers a flawed comparison, because there were several critical factors present in the postwar era that are missing today:

1. Growth prospects were much brighter in the developed world, given global rebuilding efforts and more favorable demographics.
2. Fiscal balances were quickly reversed, so that flow to the debt stock reversed more quickly.
3. Private sector leveraging/indebtedness grew quickly, which allowed the sovereign to deleverage without badly hampering growth.
4. Global capital mobility was much more limited; capital was easier to capture and retain via repressive policies.
5. Persistent inflation surprises were tolerated well by the markets in the postwar period.

Overall, while the repressionary tactics of developed world sovereigns are helping to slow down the accumulation of debt, the ongoing fiscal deficits are so great that the debt hole is being dug faster than financial repression can fill it back in.

Costs and Risks of Financial Repression
Beyond the pain of low real returns imposed on savers and investors, there are other costs and risks associated with financial repression. It can inhibit growth over the medium to longer term because it tends to promote very inefficient capital allocation and to crowd out more productive investment. In addition, repression can potentially lead the economy toward significant (unintended) market distortions: asset booms/busts, uncontrollable bouts of inflation, sudden stops in economic activity from loss of confidence, or capital flight.

“Successful” financial repression also becomes challenging to conduct as the scale and scope of tactics increase. Tipping points and self-reinforcing feedback loops introduce new risks to the markets, but unfortunately these are very hard to identify and quantify in advance. Investors will need to learn to analyze economic developments and risks differently now, as the approaches that worked well historically may not serve as a good guide in the new era of financial repression.

Investment Implications
Sovereign debt is at the core of our modern financial system: It is the supposed “risk-free” asset class used as the baseline to value the vast array of investment options around the world. Unfortunately, many sovereigns are becoming credit risks; the debt dynamics of developed sovereigns are lurching farther into uncharted territory and risk destabilizing the global economy and markets over the next several years. And sovereigns have the ability to tax, confiscate and enact various forms of financial repression that affect all asset classes, not just sovereign bonds. Expect governments to turn toward financial repression with increasing frequency as they attempt to avert future crises resulting from the unstable debt dynamic.

Investors may not be able to outrun financial repression and poor debt dynamics by simply avoiding the sovereign bonds of the most repressive country – it depends on the mix of financial repression and austerity eventually imposed. And poor debt dynamics have infected so much of the developed world that it’s become a choice among increasingly bad alternatives. Moreover, because poor debt dynamics and increasing repression tend to affect riskier asset classes even more dramatically than sovereign bonds, avoiding sovereign bonds may put investors at greater overall risk if their only remaining options are these riskier assets.

In addition, the economic and financial market effects of repression can easily spill over into countries and asset classes, making the process of picking winners more difficult. Lastly, politics will play a much more important role in shaping economies and financial markets in this new era of financial repression – and politics is a shaky variable that tends to inherently introduce more uncertainty into the outlook.

The unnerving conclusion is that the advent of a new era of financial repression increases the complexity of the questions faced by investors, whose savings and investments are being “clipped” just as the Romans saw their currency whittled away. Equally troubling is that investors’ resources for avoiding this repression would seem to be limited, as financial repression is occurring in various forms over much of the investing world, so simply favoring emerging nations over developed or corporate debt over sovereigns is not necessarily the answer. Investors must seek to make informed, specific views on country and asset class risk.