Overview: Doing business in a fragmented world

It is seven years since the global crisis and despite easy monetary policy, financial regulatory reform, and G20 resolutions favouring structural measures, the world economy is not making a lot of progress. Indeed, responses to the crisis seem mainly to have stopped banks from failing and then pushed the many aspects of the crisis around between regions – currently taking the form of excess capacity in emerging markets. Productivity growth raises income per head, allows companies to pay better wages and raises demand to help eliminate excess capacity and improve employment. However, this element is missing in the global corporate sector. The theme of this year’s Business and Finance Outlook is fragmentation: the inconsistent structures, policies, rules, laws and industry practices that appear to be blocking business efficiency and productivity growth.

A world economy beset by two major headwinds

The broadest fragmentation in the world economy concerns two very different approaches to economic organisation that are now butting up against each other: advanced economies run with more open markets; and emerging economies where the role of the state plays a central role. Emerging economies built up savings rapidly and state-owned enterprises have played a key role in driving investment in the supercycle sectors (energy, materials, utilities, capital goods and industrials) that has led to excess capacity and high debt levels. Fragmentation is also reflected in financial reform, which has focused mainly on banks, opening the way for the products of other financial sectors to fill gaps and respond to countries’ attempts to use unconventional policies to help their own regions, sometimes at the expense of others.

Following the financial crisis, the world economy is now beset by two major headwinds:

• the reversal of the commodity supercycle, with investment now falling led by the excess capacity sectors; and

• the L-shaped recovery in the advanced economies resulting from deleveraging as banks continue to struggle with non-performing loans in many parts of the world while new financial regulations are imposed.

The interaction between these two forces is taken up in the opening chapter 1. Central banks have stepped in to deal with the lack of growth because other policies have not dealt with these structural problems at their source. Quantitative easing and low-interest-rate monetary policy can do little to correct over-investment in global industrial sectors. This has led to innovative responses and new and building forms of liquidity and leverage risks. At this point, such policies may be harming the prospect of a sustainable recovery.

• Regulatory reform has focused on banks that are being forced to hold minimum amounts of high quality liquid assets while raising capital, before non-performing loans on bank balance sheets have been properly dealt with. The combination of low and negative interest rates with rules that force banks to hold the very assets to which they apply hurts bank profitability. Nor do negative interest rates lead to predictable effects on exchange rate transmission mechanisms to help growth and counter deflation. This is because other countries are changing monetary policy too and altering the way they manage their currencies to ensure maximum advantage to their own citizens, contrary to the collective interest.

• Zero (or worse, negative) interest rates imply a zero time value for money and encourage short-termism by investors, whereas innovation and productivity growth requires the financing of long-term risk taking in capital expenditure and its financing. These policies are creating incentives that lead investors in new directions that interact with banking in different ways, and where the solvency and liquidity characteristics of products are untested. Very low rates have created a demand for a kind of portfolio “barbell” in institutional investment: large asset allocations to both i) private equity and low-cost exchange-traded funds (ETFs) at one end; and ii) capital market risk assets, based on leverage, that pay higher short-term cash yields (e.g. hedge and absolute return funds, etc.) at the other end. In between is an allocation to equities, cash and bonds within which further herding of investors into concentrated positions is found: into high-yield non-investment grade bonds; and into equities that focus on providing strong dividends and buybacks.

The reversal of the supercycle emanating from emerging economies is arguably an even stronger headwind than the L-shape recovery in advanced economies. Excess investment is always accompanied with financial consequences where borrowing is a factor, and there is little doubt that non-performing loans are building up in emerging economies and energy sectors more generally. The size of the impact of the supercycle reversal is easy to under-estimate. At its recent peak, some 40% of corporate investment in the global economy was carried out in just two sectors, energy and materials, and its full influence goes well beyond these two driving forces. Investment is now flat in advanced economies and is declining in emerging markets (see the blue segments of the columns in Figure 1.17 in chapter 1).

Dividends and buybacks have been rising in advanced economies since the crisis and have reached about 60% of what companies spend on investment. Advanced economy companies could raise this investment very easily without any need for external finance – but they do not do this. Investors resist companies that want to use earnings to invest for the long term, and they demand cash-like returns that are better than those available in actual cash and investment grade bond markets. This works against companies wanting to take on long-run projects needed to promote innovation and productivity – they would be punished by investors for doing so. This is a direct result of attributing a zero time value to money via low interest rates.

The return on equity in emerging markets is far below its cost, a sure reflection of excess capacity (in sectors like steel, energy, resources, cement, glass, chemicals, automobiles and the like). Investment is still running at double the rate in advanced economies (around 10% of net sales). But it is capital-widening investment in the main, using existing technology, often as a part of global value chains. The value added of these companies per employee has also not risen (the company productivity problem which is discussed in detail in chapter 2).

“Inflation first” policies will delay a sustainable lift-off in rates

Policies need to restore “animal spirits” in the company sector by dealing with the global misallocation of resources and excess capacity and by creating incentives for long-term risk taking. When “animal spirits” recover to the point where “true” risk assets are desired in the company sector, and investors are willing to forego short-term income for long-term capital gain, there will be a significant asset allocation shift. Capital will move from cash returns and leveraged instruments to ”growth” investments simultaneously within and across all asset classes. This lift-off would lead to the end of secular stagnation. But how could this happen?

In the event that inflation comes first – say because unconventional monetary policy in advanced economies and credit expansion in emerging markets are not supported by measures to deal with structural problems – the outlook would not be too encouraging. Central banks would be obliged to lift interest rates in response to inflation, while growth of capital-widening investment using existing technology in the near term would raise global supply without lifting productivity growth. This is what happened in some emerging economies in response to the 2008 crisis. Any success would be short-lived now, just as it was then. The “creative destruction” phase needed on the supply side would not happen: i.e. just as some policies after the crisis worsened the excess capacity problems and increased debt, the lack of structural adjustment now and the actual emergence of inflation would ultimately cause the “lift off” in interest rates to turn into a two-step process.

Near zero interest rates allow companies to carry excess debt, to borrow cheaply to carry out buybacks and to engage in unproductive investments that are based on a distorted cost of capital while waiting for the tide of aggregate demand to rise.  The global output gap will never close in a sustainable manner while the outstanding stock of unproductive and misallocated investment remains in place. Rising interest rates under an “inflation first” scenario would risk another financial crisis. The need for shedding excess capacity and debt would once more become a priority. If a healthy “creative destruction” phase ensued, because rates were not once again cut to zero and structural policies were implemented in advanced and emerging economies on the scale required, then the scene would then be set for more sustainable growth and normalised interest rates later on.

A “productivity first” corporate scenario

Rather than inflation first, it would be desirable to have a productivity first scenario. Such a scenario is not encouraged at all by making the time value of money zero – monetary policy is not the instrument needed at this point in time. But what policies would actually address the productivity problem in the company sector? To answer this question, better knowledge of what is happening to productivity in...