Beware the path of financial repression
The path towards financial repression might seem attractive, but it's not without its costs, warns Ashmore's Jerome Booth.
There is no such thing as a 'risk free' asset. All investments are risky. Some risks are priced in, others not. There are numerous types of risk, and recent volatility is a poor proxy for many. Investors face different risks depending on both their access to information and their liabilities. Risk (unlike volatility) is non-additive. For those of us who are not day traders, the risk we care about most is often large, permanent loss, not volatility.
Yet, too often, when we say 'risk', we refer to past volatility. In part, that is because we can measure past volatility when we cannot as easily measure or even estimate risk. One-off events - where there is uncertainty - are even harder to factor into our thinking. We also cannot necessarily assume that past patterns, even of volatility, will continue. We use past volatility as a proxy for risk because it is easier than any alternative. We can tick the box and convince ourselves we have understood risk. Our regulators find it difficult to resist the same urge.
Today's really big risks - major political and/or economic catastrophes - largely emanate from the HIDCs (Heavily Indebted Developed Countries). Past volatility is misleading as a guide to such risks, not least when non-perceived risk leads to a long period of low volatility - low volatility that (because it is mistaken for low risk) may encourage excessive leverage. To gauge such risks, one instead needs to focus on history, economic imbalances that may build over multi-year or multi-decade periods and politics.
Financial repression is any policy that captures institutional savings to finance the government and at a lower interest rate than otherwise possible. It was used to help recovery in Europe after WWII, but comes at the cost of distorting bond markets and discount rates (and thus also assessments of liabilities). It is a robbery of savers by stealth. In an open economy, it can also lead to higher financing costs in the longer term as investors shy away from government-directed investment environments. Financial repression is a second-best policy: a crisis measure appropriate in extreme conditions when private confidence is lacking and the government cannot otherwise issue bonds to private investors at reasonable cost. The first best solution is to address the cause of lack of confidence in government creditworthiness, not to force investors to invest anyway.
There is a well-understood regulatory conflict between the objectives of recovery and future prevention of repeat crises - how much deleveraging should one force on banks during recession? However, there is also a potential increase in systemic risk being caused by regulatory zeal. The rapid implementation of Basel III is a form of financial repression, as is Solvency II. These so-called macro-prudential measures force institutions to buy more HIDC sovereign debt than they would otherwise. They have to buy large quantities of highly rated bonds - in effect HIDC sovereign bonds. Implicit is the assumption that risk is some understandable scale from risk free to high risk. But what if risk is non-additive and highly rated bonds are not less risky than other investments?
Rating agencies are part of the problem, rating HIDCs higher than justified by default risk. Discrimination against non-HIDC sovereigns but also corporates is clear, and to the detriment of diversification. The ratio of HIDCs' private plus public debt to GDP is about 250%, compared with 25% for emerging markets. The worst crisis scenarios are not insignificant: how to cope in such scenarios should be planned for. Yet these scenarios hold in prospect massive contagion across the HIDCs as crisis is fuelled by high economy-wide indebtedness. The high ratings given to HIDC may be three or four notches higher than justified as stand-alone credits, but significant contagion risks compound the problem further. Standard ratings-based regulatory approaches do not take this into account.
Financial repression creates investor homogenisation through segmentation. By pushing HIDC sovereign yields down compared with the market's assessment of the risk, investors who have a choice are incentivised to avoid HIDC sovereign debt. Increasingly, those who remain holders are those who have no choice. The investor base becomes increasingly homogenous. This increases systemic risk. The regulatory response is yet more control and suppression of market forces. More types of investor 'bailed-in', even to the extent of the currently (for many) unthinkable imposition of capital controls on foreign investors who want to exit - a slippery slope indeed.
As taxpayers, Europeans may be unwilling to make the hard adjustments for their governments to regain market confidence. The alternative route towards financial repression may seem convenient. It comes with one clear cost and another possible one: government robbery of investor savings by stealth, and possible increased systemic risk, in turn leading to ever more suppression of markets.
Jerome Booth is head of research at Ashmore Investment Management