A warning over creeping financial repression, from Ashmore’s Jerome Booth
Financial repression is a stealthy, politically easy way to tax investors. It is on the rise, and investors in developed and emerging markets alike need to pay attention.
The term is used to describe policies that channel savings to finance government beyond the level that would otherwise occur, including policies reducing the interest rate, and hence the cost to government.
It can include policies ostensibly for other purposes, such as interest rate caps on private-sector lending, regulations that incentivise the purchase of government bonds, moral suasion to achieve the same end, directed lending to the government, banning of certain types of other investments, tax incentives and restrictions on cross-border flows.
Financial repression has been common in emerging markets, but also in developed markets as a means to reduce debt burdens.
Those with unhealthy debt burdens are most incentivised to use repressive measures to help capture more domestic savings and reduce the cost of government borrowing.
In contrast, some emerging markets are more focused on trying to keep money out.
In the EU, Basel II, Basel III and Solvency II regulations force captive institutional investors to concentrate their assets in eurozone sovereign bonds beyond levels that otherwise would occur or be considered prudent.
It is a conceit that eurozone sovereign bonds are safe. The main international sovereign rating agencies have lost credibility, as they lag fundamentals.
They have long rated developed markets at levels higher than justified by other criteria, simply because they are “core” countries.
Because major macroeconomic risks in the eurozone are likely to be highly correlated, sovereign ratings have become more critical to policy makers recently – an indication in itself of why many eurozone countries are still rated significantly higher than they should be.
The consequence of financial repression for foreign investors is first, that interest rates are artificially low, and second, there is a danger that controls are imposed to prevent capital repatriation.
If financial repression builds up in the eurozone through regulatory measures and moral suasion, particularly if measures are taken to encourage captive investors “voluntarily” to swap bonds into less attractive ones, policymakers may develop a desire to “bail in” foreign investors not persuadable using tax and regulatory actions and threats, such as via capital controls.
Emerging market central banks are particularly at risk of having their arms twisted to “help” the debt-addicted sovereigns in Europe and the US.
After Lehman collapsed, Western banks reduced their market making in many sectors, including emerging market asset classes.
The risk of a repeat is well understood and much better prepared for. Emerging markets should consider a “silo” approach of independent national bank regulation, whereby Western bank branches in an emerging market are capitalised locally and prevented from siphoning depositors’ savings back to the bank’s more distressed parent.
After Lehman, this siphoning happened in parts of eastern Europe where Western banks, desperate for cash, offered unsustainably high deposit rates to savers and so distorted the domestic banking system.
It is happening again now through large loans from emerging market-based subsidiaries to their parents in the eurozone.
On a more positive note, Western banks wanting to de-lever may prefer to do so at home, rather than lose market share in the emerging markets, which they rightly see as more promising in the longer term. The problem is that financial repression may force them to do so anyway.
This should be seen by emerging market policy makers as a risk, but also as an opportunity for their banks to take market share.
Emerging market regulators should also be reducing exposure to exogenous systematic banking risks by encouraging rapid bond market growth.
Investors may be advised to avoid financial repression through exiting certain markets and even savings pools affected or at risk.
As for foreign central banks, getting out early may also avoid future moral suasion or other measures to bail in investors later and can help avoid reputational risk.
Regulators and other policy makers may find it much more difficult to force new investments into eurozone sovereign bonds than to keep existing investors locked in.
Jerome Booth is head of research at Ashmore Investment Management