Monday, June 13, 2011

How Low interest rates create mal-investment?

Interest rate identifies the minimum return that the business must generate. In a way, it is a fitness test for the business. It signals to the entrepreneur if he/she is truly adding value to the economy or if they are better off doing something else. Thus in a way, interest rate represents a threshold above which businesses should operate. This is Hayekian view of interest rates. 

Low interest rates and value addition 
When interest rates are too low, they are encouraging entrepreneurs to take risk. This impacts the business models differently. 

At one end are business models, like infrastructure projects, that cannot add threshold value in the initial years of the venture. The low interest rate regime, allows a valuable gestation period for such business models. Often, government artificially lowers interest rates for such projects. 

At the other extreme, there are weak business models, those that are viable only in low return scenario. In a low-interest rate regime, even such business models get funded. These business models, however, die out once the interest rates start rising. In between, there are experimental and innovative business models. Some of these use the low interest rate period to forge better, more robust models. Such businesses thrive later. Others, however, end up going bust. 

The role of banks is to identify each of these business models and fund them while appropriately mitigating the risks.
How low interest rate leads to mal-investment 
A bank takes risk by investing in a venture. Interest rate is also a reward bankers get, for taking the risk. This is another way of framing the value addition threshold principle. Yet, the difference in the two has implications for the economy. 

Banks are conditioned to finance lowest risk assets that are available to them. Debt simply happens to be a low risk asset. So if banks have the opportunity to invest in assets more liquid and less risky, banks will move away from debt. Even in lower interest rate scenario, those projects with best risk-return trade-off should get financed. However, anecdotally, lower interests rates actually lead to mal-investment, to borrow Hayek’s term. This is other aspect of the reputation problem we discussed earlier. 

Lower yielding large borrowings backed by reputed corporates get access to financing more easily than new ventures. This means, irrational mega-projects or mal-investments of large corporates get financed at the cost of genuine investments of new ventures. Typically, irrational mega-projects consume a lot of credit requiring load syndication. This has twin benefits for bankers. First, there is a higher degree of comfort in being with the herd. Secondly, bankers do not have to go through credit appraisal of many small entities of questionable risk profile. This makes them assign a lower risk to these projects than appropriate. Despite the low interest rates, the risk with new ventures is always higher. Further, debt is not a very liquid asset at the lender-borrower level. 

The second blow to new ventures comes from crowding out. It implies that even in a low interest rate environment, small businesses and entrepreneurs may not have access to lower cost capital. Therefore this impacts the long-term strength of the economy. In high interest rate scenario, the irrational mega-projects seem less promising. Hence, contrary to popular belief, it may be easier for smaller businesses to compete in high interest rate scenarios.

This post is excerpted from my book "subverting Capitalism & Democracy.

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.