“Financial Repression” is the Stealth Tax of Emerging Markets

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.