The rising risks of financial repression
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is chief European economist at T Rowe Price
Financial markets and fiscal rules are pressuring governments to lower historically high public-debt-to-GDP ratios. Fiscal restraint and inflation are politically unpopular ways of doing that. And growing out of debt is less likely today, given low expected real GDP growth rates. What is known as financial repression appears to be the path of least resistance to reduce debt and keep bond vigilantes at bay.
This is defined as any policy with the explicit purpose of reducing the cost of government debt — such as forcing down real interest rates or steering central and commercial banks to buy up government bonds. There is historical precedence for financial repression as an effective solution to reducing the public debt burden. Following the debt accumulation of the second world wear, the US Federal Reserve pegged interest rates on government debt at a low level until 1951. Thereafter, the Fed kept interest rates below the level of inflation for many years. As US president, Richard Nixon put pressure on Fed chair Arthur Burns to ease monetary policy in 1971 ahead of the 1972 election. A recent IMF working paper estimates that financial repression during this time led to a reduction of over 50 percentage points in the debt-to-GDP ratio.
Subtle repression of bond markets can be achieved by governments leaning on their central banks. Central banks will remain important participants in government bond markets, despite quantitative tightening programmes to reverse years of asset buying. And they will need to intervene in times of market dislocation. The Bank of England was able to successfully keep its bond market support temporary following the 2022 gilt crisis. But there is a risk that these types of central bank intervention will become more common and persistent.
Attempts to push central bank losses on commercial banks can also be a form of repression. Central banks are currently running large losses. This is because the yield on central bank investments in government bonds is much lower than the rate on the bank reserves that were issued to finance the purchase of these bonds during quantitative easing. There is a live debate on whether a larger share of these reserves should be renumerated at zero. This would push the costs on to commercial banks and eventually borrowers and savers, interfering with the capital allocation process.
A more direct form of repressing banks and bond markets may occur through abuse of regulatory policy. Following the financial crisis, bank liquidity requirements were designed for banks to hold enough liquid assets to sell in times of a run. This liquid asset is normally government debt. Financial repression is requiring banks to hold a significantly larger amount of government debt than is necessary for prudential purposes. Indeed, this has been the strategy of Italy for the past decade. In more recent times, Italian banks have been divesting from government debt securities. But their share of public debt in total bank assets remains roughly 10 times as high as in Germany or France. More governments could adopt this approach going forward.
Issuing debt directly to retail investors, if large in scale and with the specific purpose of lowering bond yields, also amounts to financial repression. Banks are unlikely to offer the same high yield on their savings accounts due to costs of intermediation. Direct debt sales to retail investors will therefore suck out funds from bank accounts. Rather than being intermediated to the private sector, these funds will finance government borrowing.
The economic consequences of financial repression are significant. These policies crowd out private sector investment. In the short term, this will lead to lower growth and inflation, as monies which would have been invested in the private sector capital stock are spent on public debt service and repayment instead. But in the medium term, lower accumulation of capital will result in a structurally more rigid supply side of the economy. When there is rise in demand, this will lead to higher inflation and therefore structurally higher interest rates.
Clearly, it is easier to repress domestic investors than foreign ones. This raises risks for countries dependent on foreign money to finance debt issuance. If foreign investors stay away, for fear of repression, yields on government debt will have to rise to attract more domestic investors. It is up to politicians to decide whether financial repression is a way out of developed markets’ current fiscal issues. However, they need to be aware that in the long term, such a policy could significantly backfire by leading to lower growth and higher interest rates.
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