Financial repression is a stealthy, politically easy way to tax investors. Financial repression is on the rise and investors in developed and Emerging Markets alike need to pay attention.
The term financial repression is used to describe policies which channel savings to finance the government beyond the level which would otherwise occur, including policies reducing the interest rate and hence cost to the government of their financing. Specifically it can include a number of policies which are ostensibly for other purposes.
In the EU, Basle II, Basle III and Solvency II regulations force captive institutional investors to concentrate their assets in Eurozone sovereign bonds beyond levels which otherwise would occur, and indeed beyond levels which otherwise might be considered prudent. Basle II and III dictate different levels of provisioning for assets on bank balance sheets.
They use sovereign ratings to do this and, by mandating much higher provisioning, discriminate against, in our opinion, safer investments in government bonds of Emerging Market countries. Solvency II, designed to reduce insurance company insolvency through a number of measures, similarly forces greater concentration of insurance sector assets in Eurozone sovereign bonds.
The consequence of financial repression for foreign investors is first that interest rates are artificially low. Secondly, there is a danger of capital controls being imposed to prevent capital repatriation: very different and much worse than the few cases of capital controls being imposed recently in Emerging Markets, such as in Brazil, which try to prevent money coming in, not out.
The risk of a repeat is well understood and much better prepared for. EU bank deleveraging presents an opportunity for Emerging Market investment and commercial banks to grow and step into this space. 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.
Issues for DM-based Investors
Financial repression is not in the interests of savers. Keeping interest rates artificially low results in lower savings rates, which in turn causes under-financing of the private sector, and, as a consequence, lower growth. Meanwhile, the ‘hoarding’ of finance in the public sector tends to create excessive investment in developed market government securities, unsustainably low yields, an thus, in the long run, public sector debt problems.