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“Financial Repression” is the Stealth Tax of Emerging Markets

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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.

The main types of financial repression are interest rate caps on private sector lending, regulations which incentivize the purchase of government bonds, the use of moral suasion to achieve the same, directed lending to the government, the banning of certain types of other investments, tax incentives and restrictions on cross-border flows. 

Financial repression has been common in Emerging Markets, as well as in developed markets as a means to reduce debt burdens after World War II. Currently, developed countries with unhealthy debt burdens are most incentivized to use financial repression measures to help capture more domestic savings for themselves and reduce the interest rates – the cost – of their government borrowing. 

A few Emerging Markets, in contrast, are more focused on trying to keep money out rather than in. Financial repression is in effect a form of stealth tax hurting future returns and its main forms fall under the rubric of macro-prudential regulations and quantitative easing. 

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. 

This element of the reform may increase systemic sector risk for the insurance industry. Where Solvency II is also being applied to pension funds – which have much longer liabilities – the distortion is even worse, constituting not only a tax on pensioners but also an increase in the risks to their future incomes. 

It is a conceit that Eurozone sovereign bonds are safe. The main international sovereign rating agencies have lost credibility. They have long rated developed markets at levels higher than justified by other criteria simply because of their being “core” countries. Ratings lag fundamentals and have been a poor tool at helping investors avoid risk in Greece, for example.

Because major macro-economic risks in the Eurozone are likely to be highly correlated, sovereign ratings have become much more critical to policy makers recently – an indication in itself of why many Eurrozone countries are still rated significantly higher than they should be. From a macroprudential point of view, forcing domestic savings into similar and similarly highly rated EU sovereign bonds does not look like prudence, but it makes rather more sense if the objective is financial repression.

EM reactions to DM Financial Repression

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. 

Should financial repression build in the Eurozone through regulatory measures and moral suasion, particularly should measures be taken to encourage captive investors “voluntarily” to swap bonds into less attractive ones, policy-makers may develop a desire to “bail-in” foreign investors not so easily persuadable using tax and regulatory actions and threats – i.e. via capital controls. 

Emerging Market central banks are particularly at risk at having their arms twisted to “help” the debt-addicted sovereigns in Europe and the US. It behooves them to be alert to developments which may end with them facing aggressive moves to prevent them repatriating their assets, or more likely, reputational damage should they do so. 

Better to reduce holdings gradually and early, realize and use bargaining power to gain concessions for staying invested, and start voicing concerns both to lobby against financial repression, but also to reduce the risk of future reputational damage should they pull the plug on the Eurozone or the US at a later date. 

Emerging Markets should also consider some broader risks and opportunities they might face should developed world financial repression accelerate. Financial repression is a contributory factor to EU bank deleveraging outside the Eurozone. After Lehman collapsed Western banks reduced their market making in many markets, including Emerging Market asset classes. 

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. 

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 will likely prefer to do so at home and not to lose market share in the Emerging Markets, which they rightly see as more promising markets 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. 

They should encourage more South- South financial and investment links. They should also move to reduce ratings-change related systemic risks by, following the Chinese example of the Dagong rating agency, creating their own alternative and more realistic sovereign ratings. These can then help guide their own institutional savings pools away from copying the West’s example of excessive portfolio concentration in the EU and US. 

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. 

Such dynamics are contrary to the interest of developed market based institutional investors, particularly at this time, where the long-term prospects for returns on developed market exposures are already depressed. 

Moreover, the resulting concentration of exposures in overbought developed market government securities increases risk by exposing already concentrated portfolios further despite opportunities to diversify into a faster growing Emerging Market asset base supported by vastly better fundamentals.

Prudence is the way forward

A wider awareness of the financial repression characteristics of various policy measures is the first step to trying to reduce the repression. There are other methods of tackling systemic risk (most notably through fiscal policy) which more directly can tackle current macro-economic problems. 

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. 

Ashmore is a top emerging market asset management company, headquartered in London, UK, with an AUM of $59 billion.