More and more we see central bankers around the world — but especially here at home and within the EU — engaged in financial repression as THE means to solve our economic woes.
What is financial repression?
A term that describes measures by which governments channel funds to themselves as a form of debt reduction. This concept was introduced in 1973 by Stanford economists Edward S. Shaw and Ronald I. McKinnon. Financial repression can include such measures as directed lending to the government, caps on interest rates, regulation of capital movement between countries and a tighter association between government and banks.
What are the challenges faced by investors in an era of financial repression? Thank you to the reader who shared a recent Citigroup research report, Heading for the Great Repression?, which addresses this question and more. Let’s navigate.
Every credit investor should consider the following: Why are real yields in so many countries near historical lows despite historically poor fundamentals?
One key reason is that burgeoning government debt burdens are leading to ever more measures to influence market pricing.
Financial repression takes many forms, but the primary aim is to keep real yields below market clearing levels. Some policies are already in place, many more will likely follow.
Central bank balance sheet expansion alone corresponds to almost half the increase in general government debt in the US, the UK and the Eurozone since 2008.
To begin with, repression seems likely to drive more money into risky assets like credit.
Longer term, however, history suggests the distortions and even bigger imbalances need to correct with a very negative impact on credit spreads.
Even during the benign period, volatility and uncertainty are likely to be far higher than investors have grown used to, thanks to abrupt and far-reaching changes in policy.
Financial repression clearly distorts the pricing of risk in the marketplace. What are the numerous forms of financial repression practiced by the central banking grand wizards, and what are some of the long term consequences of these practices?
Bail-ins of bank bondholders: violates bondholders’ rights, raises the cost of unsecured debt; Problem: Contagion to comparable banks.
Bans on ‘undesirable’ trading practices, like naked short-selling: distorting price discovery, likely to reduce liquidity, curtailing hedging possibilities; Problem: Finding an effective, water-tight definition of “naked short-selling”, avoidance.
Capital controls: distortions likely to build up over time; may limit return on capital.
Coercive exchanges: reduce the debt burden; damage to credibility, need to recapitalise banks; problem: International acceptance, technicalities like “domestic” vs. “international” law debt.
Deposit / interest rate controls: negative real interest rates, enticing savers to buy government bonds; fewer savings for retirement, banks more dependent on capital market funding, encourages off-shore markets
Ex-post subordination of bondholders (in banks and sovereigns): lowers political cost of bailouts; lower private sector recovery rates raise the cost of unsecured debt, increases risk of losing market access.
Financial transactions taxes: negatively impacts bank profitability, hinders market liquidity
Nationalization of financial institutions: costly, likely to lead to distortions in allocation of lending; takes bank balance sheet on the sovereign balance sheet.
Regulatory incentives to buy government bonds: create captive demand for government bonds through lower risk weights or liquidity requirements; crowds out private borrowing, may prolong an unsustainable fiscal deficit, raises domestic loss in default.
Citigroup continues a fabulous review by comparing and contrasting our current situation to our domestic economy and market experience post-World War II and to that of Japan of the last two decades. Citi believes we are much more likely to experience a Japanese style economic experience due to our current level of private indebtedness relative to GDP. In that scenario, what are the long term risks and consequences of kicking the can down the road via financial repression? Try low growth, higher deficits, increased levels of defaults, and ultimately inflation. Sounds like fun, heh? Citi concludes we should not let our guard down:
Increased financial repression today comes in response to a poor growth and fiscal outlook, which bears more resemblance to the experience from Japan than it does to the 1950s and 1960s.
We don’t think the market is fully discounting the shift in trend growth that has actually occurred – Figure 18 shows that trend growth expected for the next 10 years is still higher than it was for much of the 1990s. Although we don’t think the turning point is imminent, that leaves us sceptical about the long-term durability of the rally we have seen in recent months.
That said, credit is probably better equipped to handle this kind of environment than some other asset classes. Both in the US and in Japan financial repression did not prevent tight, or rather very tight, credit spreads for an extended period.
In Japan, the inevitable spike in default rates as overleveraged companies were unable to adjust to a radically different growth outlook led to a spike in defaults which weighed on credit spreads early on in the crisis. Europe probably has to go through a similar process, though on a smaller scale.
“Amending and pretending” to preserve a capital position won’t work for banks indefinitely, especially with the Eurozone in recession again. That will have a cyclical impact on spreads.
Ultimately though, the biggest danger comes from the possibility that the coming decades may combine the negatives from the US and Japanese experiences – low growth and unsustainable fiscal deficits taking financial repression to the point where it becomes inflationary. The mountain of un- or underfunded pension plans, public and private, will only make that latter outcome more appealing. Where inflation is not an option, sovereign restructuring seems the likely solution.
From a policyholder’s perspective a large part of the attraction of financial repression is exactly that it buys you time to fix unsustainable trends – by lowering your cost of funding and by creating captive buyers. However, in so doing, financial repression can also to some extent mask the true scale of the problem by suspending the disciplinary effect of the market. Why implement painful reforms if no one is forcing you to today? The inability of Congress to agree on a comprehensive deficit reduction plan is a good example.
As we saw in the early 1970s the pain is likely to be all the greater when the regime finally breaks down.
Note that Citi writes, “When the regime finally breaks down” . . . not, “If the regime finally breaks down.” Where are our leaders?
Thanks again to the reader for sharing. For those who would like to read the entire 15 page piece, I submit:
Do your friends, family, and colleagues a favour and get them to do the same. Thanks!!
I have no affiliation or business interest with any entity referenced in this commentary. The opinions expressed are my own. I am a proponent of real transparency within our markets, our economy, and our political realm so that meaningful investor confidence and investor protection can be achieved.
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