Saft on Wealth: Repression: a promise, not a threat

(Reuters) - In this era of massive debt, governments need, want and will get hold of some of your investment money.

That's for sure. How to protect a portfolio is a lot less certain, though history indicates there are ways to limit, if not avoid, the damage.

Financial repression, taken broadly, is any measure that a government takes to funnel money to itself that, if investors were free to choose, would otherwise seek better returns elsewhere. And with governments around the world facing monumental debt bills and huge upcoming borrowing needs, we are already seeing policies, both monetary and regulatory, that have the effect of making it easier for countries to borrow the money they need cheaply.

Evidence that financial repression is more than just a theoretical threat is everywhere, be it the Federal Reserve's policy of keeping rates - and returns to savers - at rock-bottom levels, Irish pension fund money grabs or regulations that encourage banks to load their balance sheets with government debt.

As a political and social matter, there can be honest disagreement about the usefulness and appropriateness of financial repression. It is after all, how Britain and the U.S. paid down the debts they ran up in World War II. It's a bit harder, perhaps, to feel patriotic about making a donation for paying the costs of a massive bank bailout, but though that this is not the place from which we'd like to start, it is where we are. From an investment standpoint though, it is an unalloyed drag, forcing savers to give up returns and take on risks.

"One of the main goals of financial repression is to keep nominal interest rates lower than would otherwise prevail. This effect, other things equal, reduces the governments' interest expenses for a given stock of debt and contributes to deficit reduction. However, when financial repression produces negative real interest rates, this also reduces or liquidates existing debts. It is a transfer from creditors (savers) to borrowers," economists Carmen M. Reinhart and Belen Sbrancia wrote in a paper published last summer. here

They demonstrated how real interest rates (yield minus inflation) were kept low or negative for long periods following World War II, eating away at war debts.

PAYING TO LEND MONEY

In simpler terms, as anyone who relies on interest income can tell you, if your government bond yields less than inflation you are getting a negative interest rate, in effect paying for the privilege of lending to the U.S. Take, for example a five-year Treasury Inflation-Protected Security (TIPS) - on a constant maturity basis it now has a negative yield. Take on the extra risk of a 10-year TIPS and you'll get a positive yield - but only of a few basis points.

That is what the Federal Reserve is doing by pledging to hold interest rates near zero until late 2014 - it is showing its determination to keep yields low. And while the Fed will argue that its main goal is reviving the economy by increasing credit availability, it is also true that this policy takes from savers and benefits the Treasury, as well as other debtors.

More overt forms of financial repression have only been hinted at in the U.S. so far, but are becoming widespread elsewhere.

The Irish National Pension Fund Reserve was forced to plough 9.6 billion euros into ailing banks AIB and Bank of Ireland, hardly the sort of widows and orphans investments such a fund should make.

France too has put in place measures that induce pension plans to hold more government debt, as has Hungary.

And indeed banking regulation, both explicitly and through backchannel suasion, attempts to induce banks to hold government debt as reserves.

The ECB's recent offer of unlimited cheap three-year loans to banks is also a form of financial repression, as one of its unstated intentions was to get euro banks to buy more euro debt, a sort of bailout merry-go-round.

Interestingly, the two main forms of financial repression - monetary policy and regulation - push investors in different directions. Regulation tends to try to funnel money into government debt, while monetary policy keeps bond yields unfairly low, pushing investors to take on more risk.

And that's really what this is all about - a risk/reward mismatch. If U.S. bonds yields virtually nothing because the Fed buys them or pledges to keep money cheap, then investors don't get a fair return for lending to an increasingly suspect borrower.

Conversely, if you decide 'to heck with that' and put your or your clients' money into riskier assets in order to get the same return you used to, well then, you just assumed more risk for the same old reward.

You can try to play the angles but as an investor you are playing their game by their rules.

(Tomorrow, in Part 2, we'll look at how investors coped with financial repression in the past and what they can do to insulate themselves today.)

( James Saft is a Reuters columnist. The opinions expressed are

his own. At the time of publication Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns here)

(Edited by Walden Siew and James Dalgleish)