Low Interest Rates as Debt Cloak

This Brady-bond talk may seem largely academic, but it has a very important modern-day implication. It means that financial repression also matters a lot – even though it gets little attention in discussions about sovereign credit risk. In some countries, most notably Japan and China, interest rates are set artificially low – much lower than they would be by the market. Local central banks can do this because the financial systems in these countries are heavily banked (i.e. most savings and financing occur through the banking system), there are few investment alternatives, and the financial authorities determine deposit and lending rates.

Forcing down interest rates in this way has exactly the same effect as the lowered coupons on the “par bonds” described above. It implies significant (and hidden) debt forgiveness, so when we look at Japanese and Chinese debt-to-GDP ratios we must remember that we should conceptually reduce the nominal debt levels to reflect the fact that the interest coupon is artificially low – perhaps reducing nominal debt by as much as 30-50%.

This is why Japan was able to raise its nominal debt level to what seemed unimaginably high (and why if it is ever forced to raise interest rates to a more reasonable level, it will face real difficulty), and why although I believe China has a debt problem, I do not believe this problem will show up in the form of a banking or sovereign debt crisis (instead it will show up as lower consumption, as I explain in my July 4 post).
-China Financial Markets