Financial repression and asset allocation

Carmen Reinhart and M Belen Sbrancia have provided a strong argument that financial repression will be a solution to the government debt problem. They define three characteristics to financial repression:

1. explicit or indirect caps or ceilings on interest rates;

2. creation of a captive domestic audience for government bonds;

3. direct ownership of banks or management of financial institutions.

The objective is to get real rates low, so the cost of debt is low. Financial repression is an alternative to pushing economic growth or engaging in surprise inflation. Of course, growth should be preferred solution but governments have a hard time figuring out how to support private growth.

If this is the case, any portfolio based on holding fixed income as a safe asset will be a true danger. The real rates will eventually move higher and if there is less inflation or a loosing of the repression, there will be further reasons for not holding bonds. Real assets will make sense in this type of environment so there is a reason to hold commodities which may not be encumbered like fixed income assets. Equities will be mixed. There would be limited reasons for holding financial assets, so banks and other financial intermediaries will not do well.