[A-List] Global Economy: capital shortage

["Keaney Michael" <Michael.Keaney@xxxxxx>]

Stephen King: Where will the money come from to fuel a healthy recovery?
The bet by US policy makers is that strength in consumer spending now
will boost capital spending later
The Independent, 30 September 2002

Had the assembled masses who gloried in the greatness of Greenspan last
week taken a look at the performance of their personal share portfolios,
they might have been left scratching their heads a little bit. "Sir
Alan" is revered wherever he goes, having apparently stamped out some of
the wilder excesses of the business cycle. And, to his credit, there
have been some - admittedly mixed - signs this year of a recovery in
economic activity after an incredibly mild recession last year. This all
looks very good. Yet the contradictions are obvious: a recovery in
growth against a background of collapsing share prices; consumers
spending like there's no tomorrow while companies are engaged in a slash
and burn exercise to restore profitability.

Many will argue that the US economy has proved relatively immune to the
declines in share prices. The standard argument relates to consumers'
wealth. Share prices may have fallen a long way but consumers are still
spending. Why? For the simple reason that, for the majority of
consumers, the biggest single asset is their house. While the top 10 or
20 per cent of the population in income or wealth terms has been hit
very hard indeed by the declines in share prices, the vast majority has
benefited from continued gains in house prices. So long as house prices
remain buoyant, consumer spending should remain in good shape.

And who to thank for this outcome? Well, it's Alan Greenspan and his
merry men on the Federal Open Markets Committee. Mass selling of
equities may have robbed from the rich but there's been a windfall gain
for the mortgaged poor. The Fed's prompt action to lower interest rates
may not have saved the equity market but there's increasing evidence
that the FOMC board members have insulated the broader economy from the
worst effects of stock market declines.

Or have they? The danger with the argument is simple: it assumes that
only households and consumers are likely to be affected by changes in
share prices. In reality, the effects are much broader. The majority of
consumers may be fine for the time being but the real mayhem has been
taking place within the corporate sector. It's becoming increasingly
obvious that the declines in share prices are having a bigger effect on
corporate - rather than consumer - activity. This conclusion applies not
only to the US but to many other countries which, like the US, have seen
major declines in both profits and capital spending over the last two
years.

The relationship between share price movements and capital spending is
never entirely clear but, luckily, the Federal Reserve provides a lot of
useful data on how exactly capital spending is funded. In essence,
capital spending can be funded either internally - through re-invested
profits - or by resort to external funds. These funds include bank loans
and, particularly over the last decade or so, equity issuance and
corporate bond sales. The bigger the investment boom, the more likely it
is that an increasing proportion of investment will be funded through
these external sources: after all, heady optimism increasingly leads to
decisions based on future hopes - reflected in rising share prices -
rather than existing reality - constrained by current levels of
profitability.

According to the Federal Reserve's Flow of Fund accounts, the late 1990s
saw a massive increase in the so-called "financing gap" - the gap
between investment that can be funded through internal profits and the
total amount of investment that takes place (see left-hand chart). And,
chief among the factors that fuelled the widening of this "financing
gap" was a dramatic increase in funds raised via new equity issues. We,
the investing public, were so convinced of the merits of the New Economy
that we gave away money to any old crazy dotcom start-up. It didn't
matter that many of these companies made no money. So long as there was
a vague commitment to make profits in the distant future, the great and
the gullible alike were happy to park their money in assorted
hare-brained schemes. Unfortunately, others then drove off with it,
leaving very little behind for savers and future pensioners.

What does all this have to do with the broader economy? The simple
answer comes from my right-hand chart. Here, I have shown the level of
both consumer spending and investment spending in the US, in both cases
re-indexed to 100 at the start of the recession in the first quarter of
last year. For consumers, the question might well be "Recession - what
recession?" For companies, however, it's a different story.

Since share prices began their terrible journey downwards in 2000, the
financing gap has fallen back a long way and, linked to it, there's been
a collapse in capital spending. The decline in the financing gap implies
either that the investing public is no longer quite so gullible and is
not prepared to give money away to risky business propositions, or that
companies themselves are no longer prepared to take the risk of raising
money in the capital markets given the greater uncertainty about future
profitability.

In fact, there's evidence of both effects. The declines in government
bond yields that have coincided with the falls in equity values suggest
that the investing public is heading for safety and security rather than
risk. Meanwhile, companies continue to announce downgrades to their
future plans for capital expansion, based on a persistently murky
profits outlook.

Given these changes, what are the prospects for capital spending in the
next couple of years? The bet made by US policy makers is that strength
in consumer spending in the short term will boost capital spending later
on. By looking at the financing gap, however, it becomes a little easier
to assess how likely a recovery in capital spending really is.

The first concern is obvious. Normally, when the Federal Reserve cuts
interest rates, share prices rise quickly. As a result, it should be
possible for companies to raise funds increasingly easily from external
sources, thereby making it more likely that capital spending will pick
up. In our post-bubble world, that process simply hasn't happened.

A second concern is that, in the initial stages of the declines in share
prices, companies were able to switch the source of finance from equity
issuance towards debt issuance via the corporate bond market. Yet, as
investors have become increasingly concerned about corporate balance
sheets, this source of finance has also dried up, at least as far as
some of the riskier areas of the market are concerned.

A third area of danger is bank lending. The role of bank lending as a
support for capital spending fell back significantly during the 1990s.
Bank lending could, of course, make a comeback if capital markets remain
weak. But it is difficult to imagine banks being prepared to take the
same risks today as the capital markets were taking in the second half
of the 1990s.

I would say that we're back to a world of investment being financed
primarily by internal funds alone. That means profits. And the one thing
you hear from companies the world over is that profits are not good and,
moreover, are not expected to be good even with consumer spending
holding up well in, for example, the US and the UK. For the time being,
therefore, it's difficult to see a sustained recovery in capital
spending coming through. Moreover, should companies decide to rebuild
their internal funds - planning for higher profits - there are only two
obvious ways of doing so given the obvious lack of pricing power: either
slash capital spending or slash labour costs. Either way, the prospects
for a healthy recovery in economic activity do not look good.

Stephen King is managing director of economics at HSBC.