We are in an era of ‘financial repression’

In the realm of economic policy-making, we have come a long way in the last 40 years. In the 1980s policies defined that governments should control spending and only intervene to create a free market by lowering taxes and driving privatisation. Today, governments are at centrestage to solve economic issues through their policies. This is often characterised by protectionism, that has accelerated the pace of de-globalisation.

Indeed, the age of “laissez faire”, an economic philosophy of free market capitalism, where the driving principle is opposition to government intervention in business affairs, is past us.

The role of the governments would become even more important today when we see how the economies deal with the pandemic crisis. The pandemic has had a negative impact on social, financial, and economic aspects.

The global growth outlook has collapsed, and the depth and speed of the collapse is worse than the Global Financial Crisis (GFC) of 2008. In such situations, it is imperative for governments to adopt an expansive fiscal policy and central banks’ monetary policy must support these fiscal measures.

Role of central banks

Very simply, central banks are liquidity providers, and they can’t influence the lending activities of banks or spending patterns of corporates and consumers. The tools and policies adopted by the central banks helps them to influence short- and long-term rates, currency, stabilise financial markets and provide necessary liquidity measures to commercial banks.

If we revisit the last decade, in spite of balance sheet expansion by central banks, chief being US Fed post GFC, why did inflation not come back? Why were we in a state of deflation?

If we refer to the quantity theory of money equation, money supply and velocity of money influences the prices of goods and services in the economy. Central banks could use various policy measures like reduce reserve requirements for banks, cut discount rates or open market operations to increase money supply.

If banks are unable to lend, the velocity of money which is a measure of how fast the money is exchanged does not change and overall, the impact on prices is less — hence lower inflation and lower growth.

Thus, central banks, apart from maintaining stability of financial and banking system, cannot do much to stimulate an economy. To fight the battle of economic slowdown the mantle would need to be passed to the central governments — signalling an end to laissez faire economics.

Role of governments

For an economy to do well, apart from private investments and consumption, government spending on investments and consumption also plays a vital role. If an economy faces a demand slowdown, both private investment and consumption gets negatively impacted and that is when the governments have to adopt Keynesian economics i.e. spend more money and stimulate the economy.

Massive government spending would be required to support socialising of credit, to support infrastructure activities which would help increase employment opportunities.

This would lead to a higher fiscal deficit which means higher debt levels; through financial repression we would see central banks being forced to support the government initiative by intervening in the bond market and preventing long-term yields from rising.

Considering the negative impact of the pandemic on global growth, we are getting into a phase of global economics where monetary policy has reached an inflection point; there will be a need for an easier financial condition — where financial repression policy plays a key role.

But, what is financial repression and what is its purpose?

It is a policy of the central bank and government of very low interest rate for the purpose of providing cheap loans to the government and ‘inflate’ government debt. By inflating the government debt, the value of debt would become a lot less in the future because of the impact of inflation.

The purpose of financial repression is to keep interest cost low and inflate the economy. It is good for the government as they borrow cheap and the debt-to-GDP ratio looks more reasonable, but it hurts savers.

How is financial repression implemented? This is done by capping of interest rate, adopting capital controls, forced treasury purchases, having negative nominal interest rates, putting curbs on cash holding (via transactional limits, etc.).

What does this mean for the markets and investors? Since March 2020, central banks have been taking decisive actions to reduce interest rates, which has led to a decline in bond yields.

Lower yields lead to lower risk premium, reduction in the cost of capital. This has helped to drive the stock prices for growth stocks.

Implementation of financial repression policies also leads to higher inflation expectation. Higher inflation subsequently leads to a rise in bond yields — a regime in which growth stocks and bonds would under-perform.

Thus, investors need to be circumspect in terms of what they invest in.

Within equities, money could rotate from growth stocks into cyclicals like commodities, etc. which are considered as inflation hedgers. Gold as an asset class could also be considered for diversification benefits and it could help to hedge against debasement of fiat currency, monetary or fiscal policy uncertainty or deepening of the pandemic crisis.

Ghelani and Gupta are with DSP Investment Managers. Views expressed are personal