Be Prepared [NOT] To Be Financially Repressed

7/29/2019 Be Prepared [NOT] To Be Financially Repressed

1/19

Be Prepared [Not] To Be Financially Repressed(*)

Evangelos Ch. Dounias

Geneva, September 2012

(*) James Saft (2011)


2/19

FOR INTERNAL USE ONLY 2BANQUE PRIVE EDMOND DE ROTHSCHILD S.A. 2

Summary

Executive Summary

Chapter 1 A Sea of Debt p. 4

Chapter 2 Four Ways Out of the Debt p. 8

Chapter 3 Financial Repression p. 9

Chapter 4 Implications for Financial Repression p. 13

Chapter 5 Wealth Management Strategies p. 14

Appendix Captive Markets Some Recent Examples p. 18

References


3/19

FOR INTERNAL USE ONLY 3

Executive Summary

BANQUE PRIVE EDMOND DE ROTHSCHILD S.A.

In the years to come Developed Economies will be struggling to rein in their record

levels of Public Debt.

Financial Repression will increasingly be one of the -not so many- tactics availableto that end.

The resurgence of Financial Repression will have serious consequences in the free

functioning of markets and will push towards more fragmented / regulated domesticmarkets.

As a result, Global Wealth Management will be facing the challenges of maintainingflexibility and scope for decision making options while protecting the purchasing powerof the family wealth. This is a fundamental change compared to the recent past as itencompass all aspects of Wealth Management Strategies.

The last part of the presentation illustrates examples of such Strategies at variouslevels of Wealth Management.


4/19

FOR INTERNAL USE ONLY 4

1. A Sea of Debt

Source: A Decade Of Debt Carmen M. Reinhart Kenneth S. Rogoff, NBER Working Paper 16827

Public debt in the

Advanced Economieshas surged in recent

years to levels that

have not been

recorded since the end

of World War II.

Through 2011, thepublic debt-to-GDP

ratio average for all the

advanced economies

has surpassed the pre-

World War II peaks

reached during the

First World War andsubsequently during

the Great Depression.


Gross Central Government Debt as a Percent of GDP: Advanced andEmerging Market Economies, 1860-2010


5/19FOR INTERNAL USE ONLY 5

1. A Sea of Debt: Developed vs EM Economies

Debt-to-GDP Ratios 18802009


This trend is not universal. The Debt burden is

concentrated in the Developed Countries and

is the result of the Financial and Economic

Crisis of 2008.

On the contrary, Emerging Markets have

managed to rein in their public finances after

the 1990s crisis and face less headwinds in

their future growth.

Country sizes proportional to their 2009 GDP level (in PPP terms).

Source: IMF, Historical Public Debt Database


6/19


Public Debt, 2013e, as a % of GDP

121%

112%

100%

51%

6

%

91%

36%

107%

19%

32%3

6%3

9%4

4%

45%4

7%

58%

77%

86%

55%

54%

66%

92%

71%

72%

78%

7

4%

80%

119%

20%

0%

20%

40%

60%

80%

100%

120%

140%

Greece

Ireland

Italy

Portugal

Belgium

France

Germany

Spain

Austria

Malta

Cyprus

Netherlands

Slovenia

Finland

Slovakia

Luxembourg

Estonia

UK

Hungary

Poland

Latvia

Denmark

CzechRep.

Lithuania

Romania

Sweden

Bulgaria

EuroArea

USA

Japan

Switzerland

216%

199%

By 2013 Most OECD Countries Debt Will Exceed 60% of GDP

Source: Banque Prive Edmond de Rothschild, Financial Studies

1. A Sea of Debt


7/19


Source: Boston Consulting Group

The Debt becomes explosive ifunfunded liabilities are taken intoconsideration.

1. A Sea of Debt

or if, on top of Government

Debt, one looks at PrivateDebt alsoas the latter can

at least partially turn intoPublic Debt under certaincircumstances.


8/19


2. Four Ways Out of the DebtNone of Them an Easy One

1. Austerity saving and paying backalso a recipe for a long, deep recession andsocial unrest.

2. Higher growth difficult to achieve within a de-leveraging cycle and an inherent lackof competitiveness in some regions/countries.

3. Default/Debt restructuring, perhaps the most efficient way, but out of favour forthe time being because the banking sector is not strong enough to absorb losses.

4. Financial repression could be difficult to implement in a low-growth, low-inflation

environment and increased globalization.

Or, most probably, a combination of all the above at varying degrees andfor a longer period in the future


9/19


3. Financial Repression

Financial repression describes governments use of various regulations, laws, and

other rules and procedures (all non-market) to constrain the financial system fromfunctioning freely and channel funds to their financing need.

Financial repression has been most successful in liquidating debts whenaccompanied by a steady dose of inflation.

The concept of Financial Repression was first introduced in 1973 by economists E.S.Shaw and R.I. McKinnon, in order to describe the emerging economies financialsystems during the 1960s, '70s and '80s.

Carmen Reinhart and Belen Sbrancia re-introduced the term in 2011 speculating on apossible return by governments to this form of debt reduction in order to deal withtheir high levels of debt following the 2008 economic crisis.


10/19


3. Financial Repression: Historically Common

After World War II, the Breton Woods arrangement of fixed exchange rates and tightly controlled

domestic and international capital markets enabled the combination of very low nominal interestrates and inflationary spurts of varying intensities across the advanced economies.

Reinhart and Sbrancia (2011): Developed Economies, 1945-1980:

Average Real short-term Treasury yields: -1.60% p.a.

Average Real Deposit Rates: -1.94% p.a.

The overall effect of financial repression was worth about 3% p.a. of GDP for the US, equivalentto about 19% of tax revenues and for India it was 27%. Italy's financial repression was worth128% of tax revenues.

In Continental Europe, in particular, Financial Repression has historically been more presentcompared to the Anglo-Saxon countries. Southern Europe in particular had predominantlyrepressive financial systems prior to the widespread financial liberalization that began in the1980s. This should be kept in mind given their current Debt predicament.


11/19


3. Financial Repression: What is it?

The main idea of financial repression is to force savers to loan their money to the government

at below-market rates; it has two main components, both of which are required for the systemto produce its desired results:

Explicit or indirect caps or ceilings on interest rates.

In the US, from 1942 to 1951, the Federal Reserve was agreed to buy sufficient long-termTreasuries to keep yields below 2.5%.

Today in China the government indirectly taxes savers by keeping bank account interest rates

below the inflation rate, and then directing bank lending for state ends.

Creation and maintenance of a captive domestic audience to facilitate directedcredit to the government.

For example, the latest international bank capital rules do not require any capital to be heldagainst government debt, thus encouraging banks to lend to the government.

More directly, exchange controls can prevent money from leaving the country, and ownershipof precious metals can be outlawed.


12/19


3. The Many Forms of Financial Repression

Financial Repressive Policies may include:

Directedlending to the government by captive domestic audiences (such aspension funds or domestic banks).

Explicit or implicit caps on interest rates.

Tighter connection between government and banks, either explicitly through publicownership of some of the banks or through heavy moral suasion.

Higher reserve requirements (or liquidity requirements), as a tax levy on banks.

Capital account restrictions and exchange controls, e.g. through the regulation ofcross-border capital movements.

Prudential regulatory measures requiring that institutions (almost exclusively domesticones) hold government debts in their portfolios (pension funds have historically been aprimary target).

Securities transaction taxes. Prohibition of physical gold purchases

Placement of significant amounts of government debt that is non-marketable, etc.


13/19


4. Market Implications of Financial Repression

A return of Financial Repression would distort market principles and thus investment options.

Risk Free rate can no longer serve as a benchmark as it is neither truly riskless nor market defined.

Financial repression can be considered a form of taxation, in particularstealth taxation which is easier toimplement from a politicians perspective.

Over the long term, financial repression results in a transfer of wealth from savers to borrowers.

It is mostly at odds with regional regulatory arrangements, such as the European Union or broader concept

ofGlobalization. Prudential regulation will probably provide additional impetus for a return to a system more akin to what theglobal economy had prior to the 1980s market-based reforms. The internationally coordinated effort torestrict capital flows could be a part of the Financial Repression strategy.

All of the above will be felt at different degrees in different national markets depending on the severity ofthe debt issues and historical tradition.

National Financial Markets can no longer be viewed as a unified financial place where capital allocationdecisions are being based on common risk/reward yardsticks.


14/19


5. Global Wealth Management Strategies

Although Financial Repression is directed primarily towards the financial system, it has seriousimplications in the Management of Wealth of HNW families of Global, Trans-generationalwealth.

Successful adjustment to the emerging Financial Repression era requires a radical change ofthe attitudes and practices of the last decade(s).

The new era of financial repression increases the complexity of the questions faced by GlobalWealth Managers.

Preparing for financial repression should include but shouldnt just be limited to hedging

against future inflation, nor is it any more an issue of asset allocation and/or investmentmanagers selection.

It encompasses the very bases and assumptions of Family Wealth Management Strategies,i.e.:

Jurisdictional Orientation

Structuring of Family Wealth

Asset Allocation Decisions


15/19


5. Wealth Management Strategies

Jurisdictional Diversification

1. Diversify towards countries/markets with a low Debt burden and a long history of open markets.Traditional Private Banking Hubs who have proven themselves through the decades to be a safehaven for free capital will retain their attraction in the future.

2. Jurisdictional Diversification is also required in order to preserve flexibility and also take advantage ofdifferent regulatory structures for various asset classes (e.g. real estate, securities etc) shaping up indifferent areas or countries.

3. Domestic markets with increasing Financial Repressive policies should not be utterly excluded either.In contrast, a flexible Wealth Management Strategy could benefit from occasionally aligning itself withgovernments need for financing.

Structuring of Family Wealth

1. An effective deployment of the jurisdictional diversification strategy also implies reconsideringappropriateness of the different structures available of ownership of family assets (company

structures, trusts, insurance policies etc).

2. Increasingly, Asset Allocation Decisions may be held up by inappropriate vehicle structures.


16/19


Asset Allocation Decisions

1. In the future it will be almost impossible to preserve the purchasing value of the capitalby means of bank deposits or other liquid placements.

2. There are only 5 countries left with a comfortable AAA rating; compared to the past alarger allocation to Emerging Markets is warranted.

3. Income generation to recompense inflation will require new strategies like corporateCPs, EM corporate and government instruments, equity dividends etc.

4. Non traditional Real Asset holdings like REITs, commodities miners, farmland,buildings or timber should also be included in the investment landscape.

5. Avoid too much risk on Government Fixed Coupon Securities of indebted countries.FRNs and TIPs are clearly preferable as they carry less durational risk.



17/19


Asset Allocation Decisions(cont.)

6. Taking physical possession ofprecious metals, such as gold, could also be yetanother way for investors to protect themselves from the effects of financialrepression.

7. Avoid institutionsthat have a higher probability of government capturee.g.,insurance companies, financial companies, index/pension funds, or anyone else thathas to hold treasuries because the government forces them to.

8. Direct Investments, as opposed to marketable securities, should represent a largerallocation in portfolios.

9. For a given set of investment outcomes, Leverage could be considered since

Financial Repression is also a transfer of wealth from creditors to debtors.

10.Riskier strategies would focus assets in non-indebted countries, and fund it with thehigh-debt country debt!



18/19


Appendix: Captive MarketsSome Recent Examples

France, 2010:Conversion of a pension reserve fund to acaptive buyer of French official debt. The French government

liquidated the Fonds de Reserve Pour Les Retraites (FFR),designed to provide long-term financial support to the pensionsystem, and shifted the37 billion FFR to paying an annual

2.1 billion to the government agency Caisse dAmortissementde la Dette Sociale (CADES) from 2011 to 2024.

Ireland, 2010:Use of the national pension reserve torecapitalize banks.As a result of the banking crisis, IrelandsNational Pension Reserve Fund (NPRF) may have tocontribute up to17.5 billion to recapitalize Irelands banks.The NPRF was set up in 2001 to help finance the long-term

costs of Irelands social welfare and public service pensionsafter 2025. However, a 2010 law directed the NPRF toinvest in Irish government securities and provides the legalauthority for the Irish government to fund capital expenditurefrom the NPRF during 201113.

Spain, 2010: Interest rate ceilings ondeposits. The Ministry of Finance

required institutions offering depositinterest rates the ministry determines tobe above market rates to double theircontributions to the Deposit GuaranteeFund.

Since 2008, many Emerging Market Economieshave taken one or more steps to control the flowof foreign capital into their economies, includingBrazil, 2008, 2009, and 2010; Czech Republic,2008; Hungary, 2011; Indonesia, 2010; Korea,

2009, 2010; Peru, 2009, 2010; Philippines, 2010;Poland, 2011; Russia, 2010, 2011; South Africa,2010; Thailand, 2010; and Turkey, 2010.

United Kingdom, 2009:Increase in required holdings of government bonds. The Financial Services Authorityrequired U.K. banks, investment banks, and subsidiaries or branches of foreign institutions to hold more high-

quality government securities and cut their reliance on short-term funding by 20 percent in the first year alone.

Source: C. A. Reinhart, J.F. Kirkegaard and M. B. Sbrancia (2011)


19/19


References

S.A. Abbas, N.Belhocine, A. El Ganainy, and M. Horton (2010) A Historical Public Debt Database, IMF,

Working Paper 10/245,

George Pagoulatos (1999) Financial Repression and Liberalization in Europes Southern Periphery: FromGrowth State to Stabilization State. Pittsburgh, PA. (Unpublished)

Carmen A. Reinhart, J.F. Kirkegaard and M. Belen Sbrancia (2011) Financial Repression ReduxFinance & Development, June 2011, Vol. 48, No. 1

Carmen M. Reinhart - Kenneth S. Rogoff (2011), A Decade of Debt NBER Working Paper 16827,February 2011

Carmen Reinhart and M. Belen Sbrancia (2011) The Liquidation of Government Debt, BIS working

paper 363, (with discussion by Ignacio Visco and Alan Taylor), November 2011

James Saft (2011), Prepare to be financially repressed, Reuters, 16 June 2011

Documents

Be Prepared [NOT] To Be Financially Repressed