Speech

Is There a Global Shortage of Fixed Assets?, Remarks by Raghuram G. Rajan, Economic Counselor and Director of Research

December 1, 2006

I want to talk about some puzzling phenomenon in developed country financial markets, and offer a hypothesis on why emerging markets may have something to do with them. The intent is to provoke discussion rather than to claim I have all the answers.

The phenomenon I want to talk about is the pricing of financial assets. First, even while the Dow Jones Industrial Average scaled new heights recently, the 10 year Treasury bond is yielding substantially less than the Fed Funds rate, a situation typically associated with recessions. The slope of the yield curve in the Euro area also briefly turned negative, even while Europe is enjoying strong growth. Second, despite all the talk of recession and a global slowdown, all forms of credit risk seem to be priced at historically narrow spreads. Third, even though both equities and bonds are enjoying high prices, equities seem to be underpriced relative to bonds, with the earnings yield on the S&P 500 about 5.5% while the yield on the 10 year bond is 4.5 %, a reversal of traditional relationships. What is going on?

I will argue that underlying these seeming anomalies may be a global shortage of creditworthy hard real assets relative to desired savings. This has resulted in a financing glut that is particularly pronounced in debt markets. Of course, I cannot prove this is what is going on, but it does fit the facts reasonably well. Moreover the implications are quite important for policy.

Let me draw on three global ingredients to build the case for my hypothesis. The first is a widespread surge in productivity across the world. The second is a desired savings rate that continues to be high, particularly supported by corporations, but also by emerging market governments. The third, and perhaps least well understood, is global nominal investment in physical assets that has yet to return to past levels (as a share of GDP) despite the higher productivity and available savings.

The Productivity Revolution

We are now in the fourth year of strong world growth. Productivity growth, fostered in part by the revolution in information technology, but also in part by the rationalization of production through the creation of global supply chains, has played a critical role in this expansion. While much attention has been focused on the extraordinary surge in U.S. productivity since 1995, equally impressive productivity growth in emerging markets has been little commented upon. Taken together, rapid, and largely unexpected, worldwide productivity growth can explain why the demand for commodities is so strong, how emerging markets have weathered commodity price increases without a serious slowdown in activity, why inflation is still largely contained despite the unprecedented rise in raw material costs, and why both household incomes and corporate profits are buoyant at the same time.

The Rise in Desired Savings

Even though incomes have grown (albeit unevenly within countries), the global desire to save has kept pace. This is not because of the behavior of households in industrial countries where, with a few notable exceptions like Germany, savings have been drifting lower.

Instead, one important component has been an increase in corporate savings. As I will argue shortly, this is not because corporations are investing a lot. Instead, they are paying out less of their extremely high profits and investing more in financial assets including cash. While academics are still puzzling over this behavior, one explanation of the mounting corporate cash hoards has to do with the increasing competitiveness of the environment for individual corporations, causing it to be more volatile even while the overall macroeconomic environment is calm. It may also have to do with the increasingly fierce market for corporate control, though cash could attract unwarranted attention as much as it could be a weapon of aggression.

In emerging markets too, desired savings remain high. Certainly, governments have played a part by becoming more careful with their finances—many countries are running primary fiscal surpluses for the first time, some on the back of gains in commodity exports. Households too are playing a part. In some countries like China, where citizens are increasingly experiencing the uncertainties associated with a market economy, the absence of a safety net is an important factor driving higher desired household savings. Moreover, with little ability to borrow against future incomes because of the paucity of retail credit, emerging market household also have an incentive to save to buy the durable goods such as cars and houses that they are increasingly able to afford. And finally, emerging market corporations, especially but not exclusively those in the natural resource sector, are also building cash hoards—perhaps because they too face an uncertain environment with increasing global competition and corporate takeovers. A continuing global desire to save out of the larger income generated is the second ingredient of the story.

The Fall in Realized Nominal Investment

Given strong productivity growth and an unabated desire to save, it is therefore surprising that actual corporate physical investment has not kept pace. After all, if productivity growth is strong as is the desire to save, investment should be both profitable and easily financed. Yet investment is only slowly returning to the levels reached in the last decade, and I would conjecture, probably below the quantities that might be warranted by the tremendous growth experienced over the last few years.

To my mind, overall investment restraint is the real macroeconomic conundrum (Bernanke (2005) offered an early discussion of the phenomenon, though based on work at the Fund, I believe the problem of the excess of desired savings over realized investment is better described as investment restraint rather than a savings glut). One explanation is simply that the world is still working off the consequences of past excessive investment. For instance, telecoms may have invested too much in capacity during the boom in the late 1990s, and may still be working off the overhang of those investments as well as the debt taken to finance them. Emerging markets too have become aware of the past inadequacies of their financial systems in allocating investment, and some of the caution displayed by their corporations now may reflect their experience of past booms and busts.

A second explanation is that the nature of investment may have changed—from hard physical assets like plant and equipment to items like training and research and development that are expensed and not as easily tracked. But if such expenses were high enough to compensate for the "missing" physical investment, profitability would be lower—however, corporate profitability is high the world over. Alternatively, employees may be bearing some of these costs, especially investments in human capital or firm specific capital, with the intent of recouping these in the form of higher wages in the future.

A third explanation is that capital goods are now cheaper (think how much the cost of computers has fallen), so that lower nominal amounts have to be spent to get the same amount of real investment. Indeed, real corporate investment is not low by any means. However, this cannot be the complete explanation. First, the kind of capital goods such as computers whose price has fallen the most are also ones with high depreciation rates. So it is not clear that lower nominal amounts have to be spent to get the same net real capital stock. Second, if capital goods were indeed cheaper, corporations should buy more of them, so it is not obvious that this could account for the fall in overall investment.

And finally, perhaps investment is low because of economic uncertainty. In emerging markets, uncertainty about the policy environment has always been significant, even more so in the current highly competitive global markets where small policy errors can rapidly make domestic industry uncompetitive. In addition, government intervention to hold down the value of the exchange rate can make investment in non-traded goods unattractive, even while subjecting the profitability of traded goods to the vagaries of government policy and the threat of protectionism.

In industrial countries, a different dynamic may be playing out. As the cost of trade falls and emerging markets become more cost-competitive, it makes sense for industrial country corporations to invest, not domestically, but primarily overseas—indeed this conjecture is supported by the fact that FDI in emerging markets is near an all time high. The key question is "Is it smaller than it ought to be?".

Put differently, from investing in their predictable domestic environments, industrial country corporations now are looking to invest far more in non-industrial countries, where despite recent policy improvements, the environment is still substantially less predictable than it is at home. Not only do industrial country corporations have to worry about whether China is a better place to invest than Vietnam, they also have to forecast whether it will continue to be a better place ten years from now. No wonder then that many corporations are focused on trying to improve the efficiency of their existing production, as well as their stock of easily transportable knowledge, rather than on making really long term, hard-to-move, fixed investments in distant places. Indeed, the uncertainties surrounding industrial country FDI into emerging markets could also serve as a deterrent, limiting investment by emerging market corporations.

To summarize, I have argued the world has experienced strong productivity growth, and desired savings that continue to remain high, but actual investment, after plunging at the turn of the century, despite rapid rates of growth recently, is yet to recover fully. Let me now turn to the consequences.

The Global Shortage of Hard Assets

The mismatch between unabated global desired savings and lower realized investment, between the amounts available for finance and the flow of hard assets to absorb it, has led to a financing glut.

Let me now argue that the glut is likely to be particularly pronounced in debt like instruments, and this is partly responsible for low long term real interest rates the world over lower. Here is why: Regardless of whether nominal investment in physical assets is unnaturally low, whether it has been naturally displaced by investment in intangible assets, or whether physical goods have become cheaper so that less is spent on them, there is less in the way of incremental collateralizable assets being produced the world over. The collateral value is even lower if more of the assets are being created in emerging markets that, typically, are less well governed.

Debt securities typically need to be backed by hard assets that can be repossessed in case of default. So if incremental collateralizable corporate assets have been low for some time, there are fewer available assets on which to base corporate debt. Given that a substantial portion of the world's desired savings are put to work by governments, central banks, and financial institutions like insurance companies, many of which have statutory prohibitions on buying anything other than debt (and some of whom have rediscovered maturity matching after bad experiences with equity in the late 1990s), we have many buyers for debt, especially long term debt, but too few debt instruments being issued. Thus my sense that the financing glut is particularly pronounced in debt markets, which may account for some of the discrepancy between debt and equity valuations I referred to earlier.

There are a number of implications. First, given financial markets are integrated, the glut has spilt over into markets for existing real and financial assets—real estate, high-risk credit, private equity, art, commodities, etc—pushing prices higher. Indeed, casual empiricism suggests that the most illiquid markets, where typically there are few transactions, and small infusions of liquidity can have substantial effect, have been pushed very high. So too have markets for assets that have a debt like character such as utilities, which pay a steady dividend.

The attention a market gets from buyers can be flattering. A number of commentators have noted that emerging market debt has become an accepted part of investor portfolios—it is now a well accepted asset class. While indeed emerging markets have done much to raise their creditworthiness, the achievement is less praiseworthy when we recognize that almost all financial assets have now become mainstream. Our enthusiasm should be tempered by the realization that it is the shortage of collateralizable new real assets rather than the improved creditworthiness of old borrowers which is causing financial markets to rediscover the latter.

The attention can also be self-fulfilling. If refinancing is easily available, no borrower will default, allowing lenders to believe that a "structural" change has brought down the credit risk associated with hitherto untrustworthy borrowers.

Finally, the attention is worrisome. I have argued elsewhere that low interest rates engender agency problems among investment managers, and potentially amongst borrowers, that seldom have a happy ending.²

Given these concerns, it is important that emerging market countries continue to take advantage of the benign financing conditions to reduce risk associated with their debt structures. It is also important they improve the business climate as well as reduce impediments to cross-border investment. Industrial countries should also not erect protectionist barriers against emerging market investment.

Second, while uncertainty may hamper cross-border corporate investment, no such uncertainty hampers domestic investment in non-traded goods such as real estate. So in a number of countries, lower corporate investment has been offset in part by residential investment. Of course, while corporations may have learnt to be cautious through recent experience, builders and households have not faced adversity for some time, and may have a greater propensity to overinvest. This clearly is proving to be a source of risk.

Third, different financial systems have different abilities to take advantage of the global hunger for savings instruments. The United States financial system is particularly adept at creating instruments the market wants. For instance, the recent phenomenon of large leveraged buyouts may simply be the financial system catering to a market that is desperate for debt. The system's ability to repackage and sell financial claims on US assets to the rest of the world has helped the smooth financing of the US current account deficit, and may indeed be partly a cause of the deficit. But the smooth resolution of global imbalances then becomes partly tied to a continuation of the financing glut.

Finally, give this discussion, I would suggest that the easy financing conditions the world over are not primarily because of the accommodative policy followed by the G-3 central banks in recent years, though clearly monetary policy can add or subtract at the margin by affecting liquidity conditions and carry trades.

Indeed, monetary authorities face a particular dilemma. If they raise policy rates they could reduce investment in sectors sensitive to short rates or liquidity, increasing the financing glut, pushing long term interest rates even lower, and increasing the possible mis-pricing in other asset markets. Indeed, the dramatic slowdown in residential construction over the last few months (offset partly by non-residential construction) may have taken some demand for financing off the market, partly explaining why long term rates have trended down. If on the other hand, monetary authorities allow the environment to be excessively accommodative, they allow inflationary pressures to build, even while the liquidity glut adds to the financing glut. The pragmatic approach, of course, is to target inflation over the medium term, which involves keeping an eye on financing conditions, while also making use of the full range of prudential measures to tackle possible excess.

Let me conclude. Current conditions are unlikely to be permanent. Indeed, investment does seem to be picking up steadily. My hope is that as a better balance between desired savings and realized investment is achieved over time—long term interest rates will move up steadily, certain pumped up asset markets will deflate slowly, exchange rates will adjust, and global imbalances will narrow, without major blow-ups. In some sense, if the underpinnings of the buoyant financing conditions are reflecting a real sector imbalance, rather than simply irrational exuberance or accommodative monetary policy, the situation is not overly fragile. However, the real imbalance will correct at some point. We also know adjustments, either on the real or financial side, rarely take place as smoothly as hoped for. Appropriate caution is warranted. Thank you.

¹ The following reflect my views only and are not meant to represent the views of the International Monetary Fund, its management, and its board. I thank Roberto Cardarelli, Charles Collyns, Hamid Faruquee, Laura Kodres, Subir Lall, and David Robinson for helpful comments.

² See Rajan (2005) "Has Finance Made the World Riskier?".