How the wheel turns. Recently Gao Xiqing, president of China’s giant sovereign-wealth fund, China Investment Corporation, warned Japan against using its neighbors as a “garbage bin” by deliberately devaluing the yen. In doing so he added his voice to growing concerns that efforts by the United States, Europe and Japan to spark growth via quantitative easing, which effectively devalues currencies and increases export competitiveness, could devolve into a currency war.
There is no better man to know. The artificial depressing of currency values to enhance exports is the very tool used over many years by China to grow its economy – and it worked. It is just one tool in a basket of measures taken to achieve growth or other specific economic objectives known collectively as ‘financial repression.’ It encompasses measures ranging from interest rate ceilings, liquidity ratios and bank reserve requirements to capital controls, credit ceilings and directives on credit allocation.
Selective use of these tools in the past has helped to build strong economies in Hong Kong, a bastion of free enterprise, as well as Singapore, Japan, Indonesia and many other smaller Asian economies. By exercising controls, it has been possible for leaders in these countries to direct flows of capital, both domestically and inward investment, into favored areas of activity, be it into particular types of industrial growth, as in China, or into property, as in Singapore, and to manage currency values.
A low interest rate is one such instrument that traditional Keynesian economics had long maintained would stimulate economic development, whether an economy is developed or not. However, in 1973
Stanford academic Ronald McKinnon challenged this wisdom. Defining financial repression as government financial policies strictly regulating interest rates, setting high reserve requirements on bank deposits and compulsory allocation of resources, he argued such measures have a negative effect on growth by discouraging both savings and investment, and thereby inhibiting efficient allocation of capital.
ENDURING CURRENCY RISK
When McKinnon was writing 40 years ago financial repression was used extensively in Asian economies. However, the relationships between repression, liberalization and economic growth are by no means clear cut and the topic has been hotly debated ever since. Furthermore, financial repression is not only a phenomenon of developing nations, and history supports the notion that it typically occurs in developed countries when debt-to- GDP levels are exceptionally high.
Provided that economic growth, such as nominal GDP, can sustain a rate higher than the yield on bonds, the net effect is a reduction in the burden of public debt over time. But that is only true when investors are so unsure of achieving any returns that they are willing to endure zero or negative returns in order to preserve the minimal value of their capital. There is the likelihood that such a position cannot endure for any length of time.
Today, policies of financial repression are increasingly being used by countries in the developed world as they seek to reduce the burden of massive public debt. The paradox is that at the same time, developing countries such as China are in the throes of leaving financial repression behind.
As investors in today’s global marketplace are more willing than ever to endure currency risks, if they have to, in exchange for the prospect of achieving real returns, there is a real prospect of a flight of funds into higher growth emerging markets.
“Our current yields on stock are artificially low,” says Tony Keogh, investment analyst and director of Irish-based Trinity Financial Services. “Yes, governments are intentionally interfering to get interest rates down. But that’s known. [US Federal Reserve Chairman] Bernanke has been quite clear about the use of interest rate policy and of ultra-loose monetary policy; in effect printing money. On that basis it’s wrong to suggest rates are ‘artificially’ low because everyone knows what’s being done.”
Looking back over the past 100 years and more, Keogh says, shows the implied return for cash deposits for the next 20 years is around -0.8%, while government bonds of the same maturity have an expected real return of close to 0%. It is a policy approach in part intended to drive investment back into productive assets, which is now being pursued by the Bank of Japan and the Bank of England as well as other authorities in Europe. As mentioned above, this process of quantitative easing, which has been through three phases in the recent past, has been accompanied by increased fears of currency wars, most recently fueled by the measures taken by Japan.
FINANCIAL REPRESSION “SELL-BY DATE”
There are certainly similarities between the quantitative easing being adopted in the developed world today and historical financial repression in Asia, says economist
Andrew Hunt of analysts Hunt Economics. In an Asian context there has been deliberate encouragement of a relatively narrow system which favors supply of resources to producers and governments over households.
“It can be seen as a blunt but effective tool to channel funds into infrastructure,” he says, adding that “at a similar stage in our development we liked building cathedrals.” But, Hunt says, the limitations of financial repression are now being understood in both northern and southern Asian economies. “In Asia it’s rapidly getting to its sell-by date.”
In Japan, for example, the Bank of Japan had long recognized that its models of financial regulation developed in the 1950s had no place in the 1990s. But it still found transition was easier to talk about than to do.
In China, too, there are serious question marks, Hunt suggests, over the economy’s commitment to liberalization. “Things are changing, but there are still deep inefficiencies,” he notes. “It has ended up with a banking system that is not good at allocating resources because that is something it has not had to do in the past.”
It works well for most countries at some point in their history, but often it simply hangs around too long Andrew Hunt
In Singapore, where savers were getting returns of 1-2% from the mid-1980s to mid-1990s, this allowed the country to build up a huge infrastructure. However, Hunt says, the process went too far. “Financial repression can be great at times, when you are building industries, but not when you are trying to build nursing homes. It works well for most countries at some point in their history, but often it simply hangs around too long.”
If India could provide itself with a stable economic system, he adds, he believes it could outperform China in terms of economic growth. His grounds for such a view? “India is much less financially repressed. It may be less effective than China at mass industrialization but it is a long-way ahead in terms of developing a service economy.” The point being that the ability to work efficiently in a liberalized market requires experience – something which it will take time for China to acquire as it moves away from repressive policies.
Raymond Chan, Allianz Chief Investment Officer, Asia Pacific, says the impact of financial repression in the West has clearly been seen in flows of funds into Asia. This has typically been reflected in the strength of real estate markets since around 2009. Hong Kong property, for example, has risen by 110% in the past five years. “If you look at how this can be afforded it’s hard to explain,” Chan says. “Most of it is due to excess liquidity in the system hoping to beat inflation and profit from capital gains on rising property prices.”
It is a similar story in Singapore, where the authorities have recently imposed new taxes to try to cool the market, with limited success to date. But, says Chan, fears of a property boom and bust cycle like that seen in Western economies is not as great in Asia.
REFORM THE WAY TO GO
Places like Hong Kong are used to peaks and troughs. Against the peak in 1997, for example, prices collapsed by 70% in 2003. If that happened in many other economies they would go belly up, but not in Hong Kong. “Even when we had massive negative equity, owners still did their best to service the debt. This time round there’s even less leverage in the system because the government has been more careful about down-payment requirements for people buying property,” Chan comments.
Although the United States QE1 and QE2 programs saw money flowing into Asia, especially in the third quarter of 2012, QE3 coincided with large outflows from that country, with funds thought to have been largely destined to buy property in Australia and Canada. But QE3 also saw continued inflows of foreign funds into Thailand, the Philippines and India.
Chan believes that the pressure is now squarely on China to drive onwards with reforms of financial repression. “It is very difficult for us (in the West) to see how China is going to implement the policies it needs to. There’s going to be a lot of resistance to that and there are a lot of vested interests, but even if it involves a process of two steps forward and one step back the direction is clear. Reform is the way they have to go.”
This is apparent, for example, in the desire by China to develop its bond market through planned removal of caps on deposits and lending rates. There is no question in Chan’s mind that 10 years from now, Western economies will be more regulated, while China’s will be less. Does that mean that Asia’s lessons on financial repression are not being learned – that history is doomed to repeat itself?
Not necessarily, says Keogh. “There are still huge differences between economies in terms of how they operate and how they are regulated. But globalization of markets encourages flows across borders and, huge cultural differences notwithstanding, the trend is increasingly towards a consensus of policy approaches.
“That may not be immediately obvious to us now and clearly there are ebbs and flows, but financial repression, in terms of control of financial agencies, is gradually being replaced by a somewhat more informed market regulation. Financial repression in terms of monetary policy, however – that’s another ball game entirely!”