Farewell to Cheap Capital - MGI Report

Another interesting report by the McKinsey Global Institute:

http://www.mckinsey.com/mgi/publications/farewell_cheap_capital/index.asp

As they rightly point out, interest rates in the developed world have largely been falling over the past 30 years. (The US 10 year Treasury yield graph from the late 70s till now is a beautiful representation in that respect). Yields and inflation in a reasonably long period such as this should be a function of the capacity of the economy to produce goods and services versus the demand for them.

The more the investment demand, the higher should be the interest rates. However, as capacity and infrastructure keep getting created, the long term supply will catch up with the long term demand thereby causing interest rates to fall over a period of time. (It is important to note that the use of the term investment is in the economic sense i.e. capital expenditure, rather than financial investments).

Keeping this in mind it is not difficult to understand why interest rates have trended lower in developed countries in tandem with greater capacities and efficiencies and lower inflation.

One may thus view the entire leveraging cycle from 2000 to 2007 and the subsequent Great Recession as a failure of the world to improperly allocate capital - a large amount of capital was forced upon those economies which were already saturated and did not require expansion.

I wish MGI had elaborated more on what they see as the drivers for their projected investment boom in emerging economies.

My own belief is that it is increasing openness and interconnectedness amongst economies which acted as the catalyst for latent demand in emerging economies, led by China, to be tapped. The flow of capital took place from the developed markets in a relatively stable post-Cold War era from the 1990s which saw many economies opening up. Amongst the significant developments which gave a fillip to trade, capital and speculative flows, one can trace the following particularly in and around the year 2000:

1) China's accession to the WTO
2) The Commodity Futures Modernization Act which excluded OTC derivatives from the purview of the CFTC
3) The repeal of the Glass-Steagall Act (which used to keep commercial banking and investment banking activities separate)
4) The formation of the Euro which caused nominal yields to decline across previously high yield economies such as Greece
5) The dominance of Tech & Finance in the global economy: Both Tech & Finance have one thing in common - they lack physical form unlike most other goods and services. Thus, their pricing is less dependent on marginal cost compared to other goods and services. Consequently, speculation, liquidity and the like have a multiplier effect on these two sectors and valuations get affected drastically.It's all in the air!

If one expects the broad trend of globalization to continue, then it is acceptable to imagine that sustained investment demand will continue. But I am not amongst those who believe that the investment boom will dwarf anything that we have seen before.

I am more comfortable with view of rising interest rates from the supply side. That is, the developed world's stock of savings will decline, putting upward pressure on interest rates.Two strong reasons why this may happen (as has been mentioned in the report as well) are:

1) Sovereign debt - The developed world governments are stuck with massive amounts of debt, all ranging between 70% to 200% of GDP. It will take a long time to reduce this stock. Without economic growth, they will find the going tough. In fact, most governments do not even expect to have a budget surplus before 2013 / 2014, which means the numbers will keep rising till then before they have a chance of reducing.

2) Demographics - As the average age of people in developed economies rises, more and more people will retire and start drawing down on their savings without replenishing them. Thus, the savings rate as a percentage of income starts declining (Japan is the best illustration in this regard - the savings rate has decline over the past two decades from 18% to just 3%). With less savings available, there is less capital for people to borrow and hence they have to pay a higher price (interest rates in this case)