Protecting Against 'Financial Repression'

Includes: FXF, TBT, TMV
by: The PolyCapitalist

Financial repression, a subject last widely studied in development economics circles in the 1970s-80s, appears to be making a comeback. Bill Gross dedicated his May investment letter to financial repression, and an article by the FT's Gillian Tett just ran describing how both policymakers and investors are having to refamiliarze themselves with its tenets.

Just what exactly is the ominous-sounding "financial repression"? Below is an abridged definition from Reinhart & Rogoff's This Time is Different:

Banks are vehicles that allow governments to squeeze more indirect tax revenue from citizens by monopolizing the entire savings and payment system. Governments force local residents to save in banks by giving them few, if any, other options.

They then stuff debt into the banks via reserve requirements and other devices. This allows the government to finance a part of its debt at a very low interest rate; financial repression thus constitutes a form oftaxation. Governments frequently can and do make the financial repression tax even larger by maintaining interest rate caps while creating inflation.

The Era of Financial Repression

Carmen Reinhart and M. Belen Sbrancia recently published a paper analyzing the extent of financial repression among advanced economies in the post-World War II period. Here's Reinhart's and Sbrancia's updated definition of financial repression, which now includes pension funds along with banks in their list of domestic captives:

A subtle type of debt restructuring takes the form of “financial repression.” Financial repression includes directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks.

They studied the post-WWII period:

In the heavily regulated financial markets of the Bretton Woods system, several restrictions facilitated a sharp and rapid reduction in public debt/GDP ratios from the late 1940s to the 1970s. Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt.

And their key finding which has PIMCO's Bond King in a tizzy:

Financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation. Inflation need not take market participants entirely by surprise and, in effect, it need not be very high (by historic standards). For the advanced economies in our sample, real interest rates were negative roughly ½ of the time during 1945-1980. For the United States and the United Kingdom our estimates of the annual liquidation of debt via negative real interest rates amounted on average from 3 to 4 percent of GDP a year, or a 30-40% GDP debt reduction over a deacde. For Australia and Italy, which recorded higher inflation rates, the liquidation effect was larger (around 5 percent per annum).

Investment Implications

Will the international financial system soon be making a shift reminiscent of the era of financial repression? Any such move would require that governments institute capital controls, which interestingly was one of the hot topics at last month's INET Betton Woods conference, which Paul Volcker, Larry Summers, Adair Turn, Gordon Brown, George Soros, and other notables attended.

Barring a sudden financial panic or collapse, any internationally coordinated effort to restrict capital flows would take significant time to orchestrate. So the first thing for most investors to recognize is that there is probably still plenty of time to take action.

Having said that, if you are an investor in any of the European periphery countries with an acute debt problem (i.e., Greece, Ireland, Portugal, Spain, Italy, etc.), your time may soon be running out. Any decision to leave the euro zone, which Der Spiegel reported on Friday that Greece was considering, would necessitate the imposition of immediate capital controls. Investors should not expect to receive any advance notice of such capital controls as their whole point is to prevent capital flight.

How to Protect Yourself from Financial Repression

To effectively protect capital from financial repression, an investor would need to follow a two-pronged strategy. The first step is an inflation hedge strategy, which would include avoiding fixed rate government bonds, as Mr. Gross proscribes.

However, investing in domestic equities is not a surefire solution if, as Gillian Tett reports, "there are some intriguing hints that private sector institutions are being urged to hold more bonds." The large cash horde of corporations, such as Apple (NASDAQ:AAPL), has apparently not gone unnoticed by Uncle Sam. The track record of equities during higher-inflation periods is also mixed.

The second aspect of the strategy, dodging wide international effort to restrict capital flows, will also prove difficult for most retail investors to navigate through without engaging the exotic. Switzerland has proven itself through the decades to be a safe haven for free capital, and there is some evidence that investors are already shifting substantial assets there with the substantial appreciation of the Swiss franc over the past year. Investors may wish to establish accounts in countries like Switzerland with strong track records of resisting multilateral pressure and preserving free capital flows. As evidence of financial repression grows, investors could systematically reallocate assets offshore.

And while some might consider taking physical possession of precious metals, such as gold, an extreme step to protect wealth, this would also be yet another way for investors to protect themselves from the effects of financial repression.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.