The era of cheap capital draws to a close

By Richard Dobbs and Michael Spence

Worries about hot capital moving too quickly into emerging markets could soon be replaced by an era of financial protectionism—in which governments restrict outflows of capital as a defense against rising interest rates for corporations and consumers, write Richard Dobbs and Michael Spence in a comment article for the Financial Times.

The global economy faces a dilemma. Attempts to boost growth have lowered interest rates in advanced economies. The resulting hot money has moved exchange rates out of line with fundamentals, creating inflation and asset appreciation in the developing world. Accumulation of foreign reserves and the imposition of barriers to inward capital flows have begun to replace tariffs and quotas in the trade protectionism arsenals of governments.

Yet even as brewing currency wars threaten full-blown trade conflicts, we must remember one fact: This moment will not last. The 30-year era of progressively cheaper capital is nearing an end. The global economy will soon have to cope with too little capital, not too much. And worries about hot capital moving too quickly into emerging markets could soon be replaced by an era of financial protectionism—in which governments restrict outflows of capital as a defence against rising interest rates for corporations and consumers.

Since 1980 differences in the cost of capital in most countries have converged, as financial markets globalised and risk premiums in developing countries fell. Capital became plentiful, and long-term interest rates declined too—primarily as a result of falling investment in assets such as infrastructure and machinery. Global investment fell dramatically, creating a fall in the demand for capital substantially larger than the growth in supply created by Asian current account surpluses. In other words, the “saving glut” so often cited as a cause for low interest rates really resulted from a decline in global investment.

Today, however, this trend is reversing. Across Asia, Latin America, and Africa, rapid urbanisation is increasing the demand for roads, water, power, housing, and factories. Global investment demand will now rise considerably up to 2030, reaching levels not seen since the postwar reconstruction of Europe and Japan.

The global appetite to save, however, is unlikely to rise in step, for several reasons. China plans to encourage more domestic consumption. Spending will rise as populations age. Even increased expenditure to address or adapt to climate change will play a part. As a result the world will soon enter a new era of scarce capital and rising real long-term interest rates. Such rates will in turn constrain investment and could ultimately slow global economic growth by as much as 1 per cent a year.

An era of sustained tighter capital will have significant implications. Governments should anticipate higher costs of debt and should act now to improve their public finances. The fiscal deficits possible with recent low interest rates will not be as easily financed in the future and could result in greater crowding out of private investment.

Yet even with restrained public finances, there is still a very real danger that governments will quickly resort to financial protectionism to insulate their economies from rising capital costs. New rules could be introduced to stop state-insured banks or domestic pension funds lending and investing abroad, or to direct sovereign wealth funds to make only domestic investments. Such moves would be self-defeating for the global economy. Real interest rates would diverge between countries, meaning nations with big current account deficits would suffer lower growth. Savers in surplus countries, meanwhile, would receive lower returns too.

Governments must therefore be vigilant for early signs of capital hoarding, while international institutions must start to develop the financial architecture needed for a capital-constrained world. New mechanisms, supplemented by properly regulated cross-border bank intermediation, are needed to facilitate the flow of capital from the world’s savers to the places where it can be invested.

New ways of financing infrastructure in emerging markets will also be important, given their low domestic savings. Emerging economies must work to develop deeper and more stable financial markets to develop local saving, while mature economies should introduce policies to spur household saving (or at least less borrowing).

Businesses will also need to adapt to a world in which capital costs more. Just as Japanese companies with access to cheap capital in the 1980s held an advantage over western peers, companies with access to inexpensive capital—for example those based in high-saving countries such as China, or with links to sovereign wealth funds—will have a new source of competitive advantage. Financing is likely to become bundled with exports as a source of distinctiveness, while financial institutions need to refocus their businesses on accessing new global sources of savings.

For three decades the world has grown used to cheaper capital. But the next stage of globalisation will be different. Governments will soon want to stockpile capital, and efforts to boost today’s global recovery must also anticipate an era in which capital scarcity places new brakes on growth. A future of creeping financial protectionism would be just as destructive as today’s currency wars. We must begin to take precautions.

Richard Dobbs is a director of the McKinsey Global Institute. Michael Spence was a recipient of the 2001 Nobel Memorial Prize in Economic Sciences, and he is on the faculty of New York University Stern School of Business. Their report, 'Farewell to cheap capital', is published by the McKinsey Global Institute.

This article originally ran in The Financial Times.

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