Financial repression reappears. This time, it could stay awhile

by OBIYATHULLA ISMATH BACHA/ pic by BLOOMBERG

GOVERNMENTS, especially in the developed world, have often manipulated financial markets to favour themselves.

The advantage created seeks to either reduce their cost of financing government debt or liquidate the debt in stealthy ways. Such efforts, collectively known within the economics literature as financial repression, refer to policies implemented by a government to extract for itself resources that would otherwise go to market participants.

Regulations requiring pension funds/financial institutions to invest mainly in government bonds, regulating interest rates, controls on bank ownership, regulating capital flows to prevent outflows in search of higher returns etc, would all constitute financial repression.

Repression can also be in the form of “moral suasion”. These days, it is often euphemistically termed, “macro prudential regulation”.

The net impact of financial repression is the imposition of an opaque or often invisible tax on households and the private sector through lower returns on investments, enforced investment in certain assets or reduced access to investment opportunities.

At different times over the last few decades, countries like Argentina, India, Italy and the like have used stealthy financial repression for their debt reduction, thereby avoiding the needed but less palatable austerity measures or tax hikes.

Thus, financial repression has been used by various governments off and on since World War II (WWII). The post-war period of 1945-80 saw the most pervasive form.

Repression of interest rates at a time of inflation automatically eroded government debt. For example, Britain reduced its debt from 216% of GDP in 1945 to 138% 10 years later without much austerity or tax hikes.

Governments were in essence piggy-backing on savers to achieve an easy reduction in debt. This “liquidation effect” of debt reduction was achieved in two ways. Savers were being given interest rates lower than inflation and were being repaid in money that had much lower purchasing power.

Both the presence of inflation and a fixed exchange-rate regime, Bretton Woods, helped governments immensely.

Until Paul Volcker famously “slayed the dragon of inflation” in 1979, real interest rates were negative in developed countries.

Following this, in the 1980s with financial liberalisation, interest rates became positive. This lasted until the subprime induced financial crisis of 2007.

Since then, pump priming has gone into overdrive and real interest rates have again gone negative.

As a result, the world is once again sitting on a mountain of debt, only this time, the peak is much higher than seen after WWII in 1945.

The International Monetary Fund estimates the debts of developed countries will rise by US$6 trillion (RM25.68 trillion) this year to US$66 trillion in total or an average 122% of GDP. The US, Japan, China and Italy being among countries with the highest debt-to-GDP ratios.

With public debt being such a burden, governments will inevitably be tempted to use financial repression to wiggle their way out. Indeed, it is already happening. The clearest evidence being falling interest rates even as debt is increasing — a sort of anti-gravity. In several countries, not just real, but nominal interest rates too are negative.

Thus, the US government, the world’s largest debtor spent less on debt servicing last year than it did 20 years ago when its debt was much less.

That is the power of financial repression. Ironically, while the muted inflationary environment may not be providing governments the helping hand it once did, it has enabled a more rapacious form of repression.

Central banks can simply print money with little worry of inflation. Monetising government debt this way also drives down yields, repressing interest rates further.

There are ways by which governments can effectively repress without market players feeling short changed. Indexation, market conventions and regulatory guidelines, and even supranational regulatory frameworks like Basel III can be the means.

While emerging-market governments with much less debt may have less incentive to repress, their hands are tied given cross-border capital flows, particularly arbitrage capital in search of interest differentials. In a globalised world, small open economies may have little choice, but to go with the flow. As with everything in economics, there is a cost. Being interventions to market functioning, financial repression will inevitably result in distortions.

Chief among this is price distortion. When financial asset prices are not reflective of their underlying risk-return profile, price signals get distorted. This gives rise to asset bubbles and misallocation of resources, not to mention moral hazards and perverse incentives. Ultimately, financial repression, being an appropriation, transfers wealth from savers to governments.

But these may not be the only cost. As distortions get entrenched, the long-term cost to societies will be humongous.


Prof Dr Obiyathulla Ismath Bacha is the professor of finance at the International Centre for Education in Islamic Finance. The views expressed are of the writer and do not necessarily reflect the stand of the newspaper’s owners and editorial board.