Last week, the governor of the Reserve Bank of Australia called on governments and business to take advantage of sustained low interest rates by lowering their rate of return hurdles used in determining whether projects get the nod.
Dr Philip Lowe says there is a ‘global norm’ for hurdle rates for new projects of ‘somewhere around’ 13% to 14%, while global interest rates are at rock bottom. In the US, the official interest rate is set at 1.5% to 1.75%, in the UK and Australia it is 0.75%, in Japan it is minus 0.1% (i.e. negative) and in Europe it is a negative 0.5%.
Nor are there warning signs ahead that this is going to change any time soon. The US yield on a 10 year bond is 1.8%, while the German Government this year issued a 30 year bond with a negative yield of 0.1% and the Swiss government’s is at negative 0.2%. This means that a bond buyer gives the Swiss government 106 Swiss Francs today and is scheduled to receive back just 100 Swiss
Francs in 30 years’ time, with no other payments between now and then. A lender paying the government to lend it money is a remarkable reversal of normality.
All up, there are now US$14 trillion of bonds trading at negative yields around the world. And around a quarter of all government bonds globally are now trading at negative
Dr Lowe, in almost the same breath, bemoaned the problems businesses face, and acknowledged they may not be taking his advice anytime soon.
But before we go there, let’s examine why are interest rates so low. Simply put, the amount being saved around the world is higher than the amount that is wanted for investment in new ventures and projects. The supply of money exceeds the demand for it.
Why are savings so high? Demographics are playing a key part. The population in many countries is aging rapidly and life expectancy is increasing. After growing for many decades, the share of the global population aged between 15 and 64 is now falling and is expected to continue to do so. The United Nations estimates that average life expectancy has increased from just 55 years in 1970 to over 70 years today, and this trend too is expected to continue. People are having to plan for more years in retirement and have been saving more to finance this.
Then there is the rise of Asia. Asian countries now account for around one-third of global economy, up from just 10% in the early 1980s. People in Asia tend, on average, to save a fairly high share of their incomes. This partly reflects the less extensive social safety nets and the nature of the financial systems. As incomes have risen in Asia, average savings rates in the region have fallen a little in recent years, but they remain higher than in most other parts of the world.
A third factor contributing to higher savings in many economies is the high level of borrowing in previous years. While the experience differs across countries, at the global level, the amount of debt relative to GDP has steadily increased for the past 50 years, and is now at a record high. The big shift has been in private debt, particularly in the advanced economies, but public debt has also trended higher over recent decades, after declining following World War II.
One likely consequence of high levels of debt is that people are more careful with their spending and are less inclined to take on yet more debt, especially when most people and governments have not seen their income grow, as has been the case over recent times. In a number of countries, both government and households feel constrained by their previous decisions to borrow and are seeking to put their balance sheets on a sounder footing. One way they can do this is by spending less and saving more.
These factors suggest interest rates are going to be in the doldrums for the foreseeable future.
So why aren’t businesses and governments rushing out to borrow cheap money and get projects underway, as Dr Lowe would so like to see. There are three factors holding them back.
The first is uncertainty, the sources of which are well known. The long list includes the trade and technology disputes between China and the United States, as well has global nervousness about what stunt President Trump will produce next. There is the Brexit issue, the ongoing tensions in the Middle East, the problems in Hong Kong and the tension between Japan and South Korea.
Central banks monitoring business report that, not surprisingly, these events are making businesses nervous and they are responding by putting off investment decisions. Many would prefer to wait until some of the uncertainties are resolved before proceeding. Businesses face a range of other significant uncertainties, including from the rapid pace of technology change, increased competition as a result of globalisation and ongoing changes to regulatory arrangements.
A second reason for lower levels of investment is a slower population growth, especially in the advanced economies. In the late 1960s, population growth in these countries was running at 1.2%. Since then, it has steadily declined, and is now running at just 0.4%. In several countries in north Asia and in Europe the population is declining and other countries are forecast to join that group before too long.
Slower population growth means there is less need to add to the capital stock to accommodate more people. Less home and other building is required, and there is less need to invest in infrastructure to meet the needs of a growing population. While there are some specific areas where more investment might be needed, the overall effect of lower population growth is to reduce investment.
A third explanation for lower investment demand is that people are less optimistic about future economic growth. The slower population growth is part of the story, but it is not the full story: there is less optimism about future productivity growth as well. One way of seeing this shift is in estimates of advanced economy potential growth . In the mid 1980s, estimates of potential growth were clustered around 3%. They are now clustered around half of this. Similarly, there has been a downward shift in estimates of potential growth in Asia, especially in China and South Korea. With economies expected to grow less quickly than in the past, there is less incentive to invest.
So what are Central Banks to do when their interest policy is not working? What they have tried so far is what they call quantitative easing (QE). This involves buying government-issued bonds at a sometimes frantic rate, thereby pumping more money into the economy. Before the 2008 financial crisis, central banks held around 5% of government securities on issue. Now, they hold nearly 30%. Japan’s central bank holds almost 50% of government securities on issue.
QE is a counterintuitive policy. It means that the government borrows money from the private sector and issues a bond. The Central Bank (an arm of government) buys the bond back. Where does the Central Bank get all this money to buy the bonds? Not from the Government arm that borrowed the money. Nor by raising taxes; instead it makes a an entry in its books that creates another few billion dollars.
The other odd thing about QE on such a scale is that it helps keep interest rates low by adding to the supply of money but doing very little to increase the demand for it.
The world’s Central Banks have run out of steam.