ROB PERRONE: Sticks, carrots and financial repression

Say you’re an economic policymaker — a president, finance minister or central banker. Decades of budget deficits have left your country with a growing debt problem, and markets are starting to sniff it out. What do you do about it?

You have to do something. If you do nothing and markets call time on your debt problem, your days as a policymaker are numbered.

You could attempt austerity — cut spending, increase taxes, or both, to balance your budget, and take your pain on the fiscal side to protect your currency and creditworthiness. Do austerity well, and both markets and historians may judge you kindly. Voters, however, will not.

You could grow your way out. That’s painless to promise but difficult to deliver. The easiest way to spur growth is to run larger deficits, which is exactly how you and your predecessors got into this mess.

For a government with a debt problem, most of the effective options aren’t palatable, and most of the palatable options aren’t effective. In our view, governments facing debt problems are likely to pursue the least painful option that offers some hope of success: financial repression.

How financial repression works

"Financial repression" is when governments use policies to keep real interest rates low or negative while channelling money towards government debt.

The core problem is that the ratio of a government’s debt to gross domestic product (debt-to-GDP) is too high. Reducing debt outright is difficult because it requires either austerity or a default.

That’s the debt-to-GDP ratio of the US, forecast to grow to 150% and beyond.

—  IN NUMBERS: 100%

Simply boosting growth is also hard. Helpfully, the existing debt burden is fixed in nominal terms, while GDP is not. That difference opens up another path: inflate away the debt.

If the government can find ways to suppress real (that is, inflation-adjusted) interest rates and bond yields, inflation can boost GDP and tax revenues without boosting debt or interest expense. In practice, this means using carrots and sticks to make government debt more attractive for non-yield reasons.

The US is the locus of our concerns. Its debt-to-GDP ratio is already at 100% and forecast to grow to 150% and beyond. Unsurprisingly, efforts at financial repression are already under way.

Yield curve control in practice

The most straightforward approach is yield curve control (YCC). With YCC, the central bank stands ready to buy as many government bonds as necessary to stop bond yields from rising above a certain level.

This has a recent precedent. The Bank of Japan enforced YCC from late 2016 through early 2024, buying up about 40% of all outstanding Japanese government bonds to hold yields at low levels.

There are other obvious routes, such as capital controls. If you don’t let people take money elsewhere, they’re stuck with the options they have, including your government debt.

Japan’s experiment illustrates the main pain of financial repression: a weaker currency. During the term of the programme, the yen depreciated more than 30% against the US dollar.

A weaker currency is the natural result of suppressing yields. With bond returns eroded by inflation, investors flee from assets in the repressor’s currency and into assets in currencies that better preserve purchasing power.

Stealthy approaches

The flaw of the obvious approaches is that they are obvious, which threatens confidence. Shrewder approaches aim to hold down real yields while holding up confidence. These involve a wider range of sticks and carrots.

Banks’ balance sheets make for attractive targets, and the scope to channel money into government debt is enormous. US commercial banks hold nearly $19-trillion (R329-trillion) of total assets but only $2-trillion of treasuries, and they have $4-trillion of cash-like reserves parked with the US Federal Reserve.

Insurers, pension funds and stablecoins offer additional scope for a would-be repressor to direct money into government debt.

Regulation can make government debt more attractive, but a bigger prize would be stealth YCC by the treasury. The US treasury sells government debt, which affords it great influence over government bond yields.

US treasury secretary Scott Bessent has already announced that essentially all incremental borrowing will be done through bills, where demand remains plentiful. If he wishes, he could push this further, using tools already available.

For over a decade, the US treasury has conducted buybacks of government bonds. Under Bessent, the treasury has doubled the frequency of these buybacks and modestly increased their size. Large buybacks of discounted old bonds could increase interest expense in the short term but would mechanically improve the headline debt-to-GDP ratio.

Short-term borrowing advantages

Concentrating borrowing in short-term bills has other advantages. If more of the debt is short-term, more of the interest expense will be at short-term rates.

Those rates, in turn, are tightly controlled by the Fed. If you can borrow at rates set by the Fed, then cajole the Fed into lowering rates, the government can save on interest expense.

The US pursuing financial repression is no sure thing, but stacking up policymakers’ incentives, it seems plausible to us.

If the US tries to hold down interest rates while letting inflation run hot, two conclusions are clear: holders of conventional bonds will suffer as inflation erodes their purchasing power, and the US dollar will weaken against real assets and other currencies.

Our financial repression concerns inform three of the fund’s major positions: our preference for inflation-linked bonds, gold-related holdings and caution on the US dollar.

It is a political truism that policymakers live in fear of the bond market. But if financial repression becomes the preferred path out of debt problems, the bond market should also fear policymakers.

• Perrone is senior investment specialist at Orbis, Allan Gray’s offshore partner.