The Cost of Capital: China, Commodities, and Credit
The cost of capital is the linchpin that directs investment to the worthiest causes in a free market; however, sometime the market is not so free, and the actual behavior differs from that of the rational economic person. As the world’s central bankers direct, the cost of debt is lowered in a slowing economy to promote lending and discourage saving. A strategy that stimulates investment through debt comes with risks for real growth in an economy that is dominated by services and consumption. Risk increases with a fixed currency to a large trading partner, China, and globally traded commodities. The US economy will discover if the grand experiment will work.
The economics of loans is simple: lowering the cost of a good will increase its demand. The lower price induces business and consumers to gorge on cheap debt to finance investment and consumption, which then deploy slack resources. Low returns on savings persuade consumers to spend more as the opportunity cost is low. The expectation of higher growth leads the astute investor to move from low yield debt to the higher returns of risky assets, which itself increases consumption from the wealth effect. There is little to dislike of this virtuous circle.
Lower price, higher supply. In the last 20 years and all around the world, the counter-cyclical monetary policy of choice was the lowering of interest rates. The US, in particular, led the charge in the late 1990’s to avert danger through the Asian Crisis in 1997 and the failure of LTCM in 1998. These actions resulted in a stock market bubble as investors pushed into stocks in general and technology stocks in particular. The Federal Reserve countered the hot economy and elevating equity markets by reversing course and increasing rates. The subsequent equity deflation led to a pull-back in investment and final demand, which then resulted in an unprecedented lowering of interest rates.
Lower interest rates in the early 2000's led to an increase of debt issuance in the consumer sector as mortgage debt exploded across the US. The cost of this debt alone was not sufficient to provide debt financing to the US consumer: increased credit availability by financial institutions was required. Not to be outdone by the household sector, corporations, municipals, and asset-backed debt expanded to unprecedented levels. The flood of supply could not happen, however, without an indifferent buyer.
Buyer Beware. Two investors clamored for the debt: first, in response to low interest rates, insurance companies and pension plans moved into riskier and higher yielding assets in a search for yield. Second, the entry of China into the WTO with its fixed currency to the US dollar, which required them to neutralize their trade surplus through the purchase of US Treasuries. Supply thus met demand.
This collision of lower interest rates and increased demand also created the incentive for companies to issue debt. What was once funded by equity was now financed through debt. When combined with indifferent investors, corporate and household debt expanded in the US, particularly mortgages and asset-backed debt. This credit expansion changed the financing of houses; however, the impact on the real economy was not material and did not improve consumption. While real economic activity did increase in the housing sector, it was because of the distortion in credit supply, not housing demand. Irrespective of the catalyst and as did all credit expansions without basis before, it ended poorly in 2008-09.
Exporting Imbalance. In parallel to the US debt expansion, China ignited the commodity cycle. The US dollar fell and the price of commodities increased as China entered the WTO in 2001 and started to grow exports of good and imports of commodities. These countervailing actions reflected the fact that commodities are traded in US dollars and, most importantly, the fixing of the CNY to the US dollar. With the currency fixed and a restricted capital account, the balance of payment was unable to adjust to the surplus in the current account. Thus, the only expression left were globally traded goods priced in US dollar, commodities.
Three factors supported commodity prices: increased demand from China to meet its exploding export demand and infrastructure expansion after entry into the WTO, a global regime that traded commodities priced in US dollars, and a fixed exchange rate for the CNY. As China poured more cement in three years than did the US in the prior 100 years, the signal for commodities was initially correct in the early 2000’s. After the Great Recession, commodity prices were supported by the combination of artificial demand and political malfeasance in China. They were in turn supported by the availability of cheap debt supplied by the state to support growth.
With Chinese interest rates low compared to their growth profile, another incentive was provided to finance projects with debt. The subsequent debt expansion in China was of a scale that the world might never have seen before. As the trade deficit between the US and China continued, the quasi-fixed exchange rate between the US and CNY sent misleading price signals to the markets for commodities and foreign exchange.
Mining Credit. The combination of artificial demand, an artificial price signal, and low cost of capital led to massive capital raising and expenditures in the commodity complex. There were arguments for industrial goods and crude oil initially, however, the demand for agriculture was largely illusory: agricultural demand did not materially expand at a rate that justified the price expansion. It too was pushed along by the US dollar. The challenge now is that demand for industrial goods is returning to normal trend rates as China deals with its policy mistakes and massive debt. Oil faces the dual prospects of slowing demand growth and blossoming supply: a mixture that signals lower prices.
The world is left on the precipice: enormous debt loads in the two sectors that drove demand for most of the last decade: China and the commodity complex. The major developed economies of the world that are laden with government debt further augment the burden. These heightened debt loads limit their ability to expand fiscal policy when needed to fill a gap in demand and may subdue future growth. With central banks continuing to maintain low interest rates the debt service remains low; however, the risk continues to build.
Strategy Risk. This brief history of the last two decades does suggest that lowering the cost of debt capital can lead to increased capital demand. The question is whether stimulating artificial demand resulted in any persistent improvement in the US real economy. There was certainly real growth in China. Whether the world economy is better off for over investment in US and European housing, industrial capacity in China, and commodity production and extraction globally may take years to determine. The events of 2016 suggest the quick answer is to extend the time horizon and wait for balance to return to the global economy. The timing of the outcome will determine the future return on capital and particularly equities.