How Financial Repression Shrinks Mountains of Debt 

Hans-Jorg Naumer 

Viewpoints 

6/30/2013 

Central banks globally are using financial repression to reduce their countries’ enormous debt burdens, but will it work? In a new research report, Hans-Joerg Naumer tests deficit reduction under multiple growth, inflation and yield scenarios.
Hans-Joerg Naumer is the Global Head of Capital Markets & Thematic Research at Allianz Global Investors.

Financial repression has become a hot topic. Central banks all over the world are loosening the money supply even further. The signs are growing that this silent way to reduce debt is shrinking the mountains of debt that have piled up over the years. But can this shrinking really succeed?

A simulation using the public debts of Germany and the United States of America makes clear the path that might lie ahead of us.

In late 2012, Germany's public debt totalled more than 80% of gross domestic product (GDP). While this figure makes Germany a role model for the euro zone, it also clearly exceeds the limit of 60% set forth in the Maastricht Treaty. There still remains plenty that needs to be done to improve the debt situation.

Can financial repression help? The mechanism behind it is simple: if an economy grows faster than the interest burden on its public debt, it can literally grow out of its debt. It sounds too good to be true. The problem is that a low real interest rate (the interest rate minus inflation) —or, ideally, a negative real interest rate—seems par for the course when opportunities for growth are limited.

So when could Germany once again return to the Maastricht Treaty's debt limit of 60%? And when could this happen in the US? The US provides historically significant evidence of "successful" financial repression. Now that the country has long since arrived at its debt ceiling, it is also taking a closer look at the possibilities offered by this silent way to reduce debt.

Case study: Germany
Scenario 1: Let us start by assuming the following:
A future, long-term (structural) growth rate of 1.5% a year
An average yield on government bonds across all maturities of 2%
A balanced primary budget: a public budget that takes solely into account revenues minus government expenditures without interest charges or servicing debt

For Germany, 1.5% GDP growth picks up on the average rate in recent years. This excludes the boom years in between, however, as a repeat of these growth rates seems unlikely, especially in the context of debt reduction.

The average returns are above the current yield on ten-year Bunds (as at April 2013). Although this is due in part to the yields on bonds with longer maturities (and higher returns), it can be mainly attributed to the fact that the meagre returns could normalise somewhat over the course of several years if, for instance, the situation in the euro zone grows increasingly stable. But these returns would still remain low, historically speaking. However, if we assume that the long-term real interest rate for investments corresponds to the real growth rate of 1.5% a year and factor in an inflation rate of 2.5% to calculate the nominal interest rate, the long-term nominal returns would actually amount to 4% instead of 2%. In this situation, it would still be safe to speak of financial repression.

By the way: we were not able to take into account the fact that inflationary expectations under "ideal" financial repression would be exceeded in reality, meaning it would be impossible to pass them on—at least in part —through wage demands, purchase prices or an interest surcharge. Let us nevertheless investigate two additional inflationary scenarios.



Chart 1: Simulation with 1.5% GDP growth
German national debt as a percentage of
gross domestic product (schematic representation)

Assumptions:
No further increase in debt (balanced primary budget)
Average real economic growth in Germany of 1.5% perannum (p. a.)
Average national interest charge: 2% p.a.

Chart 1

Source: IMF (International Monetary Fund) Historical Public Debt Database, IMF World Economic Outlook October 2012, Allianz Global Investors Capital Markets & Thematic Research. As at May 2013.

The simulations shown are for illustrative purposes only and do not represent actual performance; they are not a reliable indicator for future results.



Table 1: Rate of inflation influences the reduction of national debt
When will Germany fulfil the Maastricht criteria on national debt?

Assumptions:
No further increase in debt (balanced primary budget)
Average real economic growth in Germany of 1.5% p. a.
Average national interest charge: 2% p. a.
Inflation/Yield 2% 3% 4%
2% 2033 2075 Debt ratio increases
4% 2021 2025 2034
6% 2018 2019 2022
Source: IMF (International Monetary Fund) Historical Public Debt Database, IMF World Economic Outlook October 2012, Allianz Global Investors Capital Markets & Thematic Research. As at May 2013.



Table 2: An increase in real growth is substantially less evident
When will Germany fulfil the Maastricht criteria on national debt?

Assumptions:
No further increase in debt (balanced primary budget)
Average national interest charge: 2% p. a.

Inflation/GDP growth 0% 1.5% 2% 3%
2% Debt ratio increases 2033 2028 2023
4% 2028 2021 2021 2019
6% 2020 2018 2018 2017
Source: IMF (International Monetary Fund) Historical Public Debt Database, IMF World Economic Outlook October 2012, Allianz Global Investors Capital Markets & Thematic Research. As at May 2013.

Under these circumstances, Germany would return to the debt limit of 60 % in 2033 at an inflation rate of 2%, the European Central Bank's stability objective (see Table 1). Should inflation increase to 4%, Germany would arrive at the limit by 2021—or 2018 at an inflation rate of 6% (which we do not expect).

Scenario 2: If the average interest charges increase to 3% and inflation remains at 2%, Germany would not reach the limit until 2075! However, an increase in inflation to an average of 4% a year would shorten this time span dramatically to 2025. At 6% inflation, Germany would only need until 2019. Inflation remaining at or under 2% is therefore the deciding factor. If yields went up to 4%, public debt would continue to grow unabated at 2% inflation and get out of control.

In terms of debt, an increase in real growth rates would bring far less pronounced relief than an increase in inflation (see Table 2).

Scenario 3: If growth increases from 1.5% to 2% at average interest charges of 2%, then Germany will return to the debt limit five years earlier. If growth doubles to 3%, this period of time will shrink by yet another five years. The growth effect is moderated by an increase in inflation to 4%. In this case, Germany would reach the debt limit a mere two years earlier at a growth rate twice as high as originally assumed. The 1.5% growth rate assumed in the basis scenario could easily be disputed, especially in light of demographic developments indicating an imminent decrease in human capital, which is one of the most important drivers of growth.

But what if growth failed to materialize altogether?

At 2% inflation, public debt would remain unchanged. At 4% inflation, Germany would need until 2028 to reduce its debt to 60%—and until 2020 at 6% inflation.

A balanced budget is a must

The situation begins to get critical when we stop assuming a balanced budget and start assuming a primary deficit. A primary deficit arises when a government’s expenditures exceed its revenues, even without taking into account charges for interest and servicing debt.

What would happen if we took this restriction out of the picture?



Table 3: Development of debt with different primary deficit
When will Germany fulfil the Maastricht criteria on national debt?

Assumptions:
Real growth of German economy at an average of 1.5% p. a.
Average national interest charge: 2% p. a.

Inflation/Primary deficit 0% 1% 2%
2% 2033 Decline barely noticeable Debt ratio increases
4% 2021 2028 2083
6% 2018 2020 2024
Source: IMF (International Monetary Fund) Historical Public Debt Database, IMF World Economic Outlook October 2012, Allianz Global Investors Capital Markets & Thematic Research. As at May 2013.

Scenarios 4 & 5: At an annual primary deficit of 1%, Germany will only be able to make slow progress towards returning to the debt target at 2% inflation. At an annual primary deficit of 2%, the mountain of debt will continue to grow unabated.

At 4% inflation and an annual primary deficit of 2%, Germany would return to the debt limit in 2083. However, at 6% inflation, this date moves significantly closer to 2024.



Chart 2: Development with primary deficit
German national debt as a percentage of
gross domestic product (schematic representation)

Assumptions:
Further increase in debt (debt growth=2%)
Average real economic growth in Germany of 1.5% p.a.
Average national interest charge: 2% p. a.


Chart 2


Source: IMF (International Monetary Fund) Historical Public Debt Database, IMF World Economic Outlook October 2012, Allianz Global Investors Capital Markets & Thematic Research. As at May 2013.

US: Back to the future?
What is the situation like in the US? Financial repression was already once a major success in America. It took the country from the 1940s until the 1980s to reduce its public debt in relation to GDP from 122% to approximately 35% in the late 1970s. America’s creditors who invested their money in US Treasuries were the ones to pay, albeit indirectly in the form of paltry interest rates. The current situation is nearly as dramatic as the one right after the second world war. The mountain of debt currently amounts to nearly 110%. The debt ceiling of USD 16.4 trillion has been reached.

So what about "silent" debt reduction here? Will we be heading back to the future, picking up once again on last century’s phase of repression?

In the case of the US, let us first assume the following conditions:
No primary deficit and a balanced budget—something the US has not seen since 2001 Real economic growth of 2% a year
An average yield on government bonds of 2%
Slightly higher growth than Germany, in keeping with the US’s higher growth in potential and its more favourable demographic situation: the country’s population is forecast to continue growing until 2050.

Scenario 1: At both inflation and a bond yield of 2%, the US would return to a debt ratio of 60% of GDP in 2042. The country would only need until 2027 should inflation rise to 4%—and until 2022 at an inflation rate of 6%.

Scenario 2: If the average yield on government bonds increases to 3%, the country will need until 2071 to reach this goal at an inflation rate of 2%. However, an increase of inflation to 4% would bring the US down to 60% at a far faster pace, helping it reach the goal in 2032. An increase of inflation to 6% would shorten this timeframe even further to just 2024.



Table 4: Rate of inflation impacts reduction of US national debt
When will the US reduce its maximum deficit threshold to below 60%?

Assumptions:
No further increase in debt (balanced primary budget)
Real growth of US economy at an average of 2% p. a.
Inflation/Yield 2% 3% 4%
2% 2042 2071 Debt ratio remains unchanged
4% 2027 2032 2042
6% 2022 2024 2027
Source: IMF (International Monetary Fund) Historical Public Debt Database, IMF World Economic Outlook October 2012, Allianz Global Investors Capital Markets & Thematic Research. As at May 2013.



Chart 3: Development of the US debt ratio with 3 % increase in yield
US national debt as a % of
gross domestic product (schematic representation)

Assumptions:
No further increase in debt (balanced primary budget)
Average real economic growth in US of 2 % p. a.
Average national interest charge: 3 % p. a.

Chart 3


Source: IMF (International Monetary Fund) Historical Public Debt Database, IMF World Economic Outlook October 2012, Allianz Global Investors Capital Markets & Thematic Research. As at May 2013.

Scenario 3: Debt reduction will take longer or shorter depending on the development of economic growth.

A return to 60% debt would take nine years longer at a 2% rate of inflation if growth decreased from 2% to 1.5%. At 4% inflation, the impact would be far less pronounced due to a greatly increased inflation effect, shortening the period needed to return to 60% by a mere two years.



Table 5: Development of the level of debt with different growth rates in the US
When will the US fall below a deficit limit of 60%?

Assumptions:
No further increase in debt (balanced primary budget)
Average national interest charge: 2%
Inflation/GDP growth 0% 1.5% 2% 3%
2% Debt ratio increases 2051 2042 2032
4% 2041 2029 2027 2024
6% 2027 2023 2022 2021
Source: IMF (International Monetary Fund) Historical Public Debt Database, IMF World Economic Outlook October 2012, Allianz Global Investors Capital Markets & Thematic Research. As at May 2013.

Scenario 4: At 2% inflation, the time needed to reach a debt ratio of 60 % also increases dramatically if we no longer assume a balanced primary budget:
At a primary deficit of 1%, the debt ratio sinks at a negligible rate
At a primary deficit of 2%, the debt ratio remains unchanged

At 4 % inflation and a primary deficit of 1%, the amount of time needed to return to 60% increases by seven years in comparison to the development given a balanced primary budget. The country would need 24 additional years if debt grows by 2% a year.

At 6% inflation, the amount of time needed shrinks dramatically. In this situation, the country would only need 13 years (starting in 2012) to reach the 60% mark given a 1% primary deficit. At a primary deficit of 2%, the country needs 18 years.



Table 6: Development of debt with different primary deficits in the US
When will the US fall below a deficit limit of 60%?

Assumptions:
Real US economic growth of 2% on average
Average national interest charge: 2%
Inflation/Primary deficit 0% 1% 2%
2% 2042 Debt ratio falls slowly Debt ratio unchanged
4% 2027 2034 2058
6% 2022 2025 2030
Source: IMF (International Monetary Fund) Historical Public Debt Database, IMF World Economic Outlook October 2012, Allianz Global Investors Capital Markets & Thematic Research. As at May 2013.

While economic growth has a negligible influence on the development of the debt ratio…
the more inflation increases, the more debt decreases…
…and the more balanced the budget, the greater the debt reduction.
Financial repression appears to be the easiest way to reduce mountains of debt—for governments, but not investors!
However, what has not been taken into account is the fact that rising inflation could also lead to rising yields on government bonds, which makes it more expensive for countries to refinance. But since central banks go from lender of last resort to buyer of last resort of government bonds, the risk of rising yields should remain negligible.
Investors should remember that they have to look for real returns if they want to defend themselves from financial repression.





Past performance is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities. The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.

Data origin–if not otherwise noted: Thomson Reuters Data stream.

Allianz Global Investors Distributors LLC, 1633 Broadway, New York NY, 10019-7585, us.allianzgi.com, 1-800-926-4456.

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