A Couple of Trinities

Trinity #1 – CFO.com carried an interesting article from The Economist on Thailand’s recent bungling with capital controls, a problem related to the ”impossible trinity” of domestic liquidity, exchange rates, and capital accounts. We’re not so much interested in the trinity or the theory behind it as in this tidbit — the authors correctly point out that, although this episode might have reminded the markets of the currency crises associated with the ‘Asian Flu’ in 1997, it’s actually quite different [diametrically opposed, in our view]. Where the 1997 crisis was marked by capital outflows, the current challenge facing emerging Asian economies is one of capital inflows, a symptom of the so-called ’savings glut’ theorized by some economists in recent years. I suspect that many non-theorists would be curious to know how the world could go from a shortage of savings to a glut of savings in such a short span of time, given that we tend to think of ’savings’ as a reserve of wealth accumulated over long periods of time. The answer actually has to do with the money creation process, which is controlled largely by the U.S. Federal Reserve, and how this process influences the use of existing assets. Rather than delve into the theory behind it, we’ll just offer this pithy rule of thumb: when Federal Reserve policy supports a high real rate of interest, the demand for savings rises, pushing up the marginal cost of investment capital; while a low real interest rate dampens the demand for savings, thus lowering the cost of capital available for investment. From roughly 1996 to 2002 (ignoring the runup to Y2K), the Fed enacted policy that tended to raise the real rate of interest, and ended up causing all kinds of trouble globally, as capital became scarce: Asia in 1997, Russia in 1998, Argentina in 2001, and finally the U.S., starting with commodity and cyclical industries in the first half of the period, and ending with the infamous corporate debacles and bear market slides of the period. Since 2003, the Fed has kept the real rate of interest historically low, thus encouraging a ‘glut’ of savings available for investment globally. The recent episode in Thailand merely shows that both extremes (too tight or too loose) have global consequences.

Trinity #2 — Another Economist story carried on CFO.com discusses the ‘misaligned triangle’ between public companies, private equity, and investment managers, as articulated by Morgan Stanley strategist Henry McVey. The basic thesis is that long term investment by publicly traded firms is falling short of the level required to ensure long term profitability, because: (A) the executives of public companies are tending to hoard cash as a reserve for hedging against regulatory risk and for buying back stock in order to boost earnings per share and thus maximize expected compensation; (B) private equity firms are often attracted to firms with cash on the balance sheet, but rather than putting that cash to work in long term investments, their interest is typically in maximizing short to intermediate term cash flows, which naturally precludes capex; and (C) rather than fighting for the cash reserves that public shareholders are entitled to, many fund managers instead accept the performance pop their portfolio receives whenever a private equity bid is at a significant premium to market (or more precisely, to carry value). This is a great example of agency theory in action, and leads us to take a rather interesting long view: in coming decades, more and more of the heavy lifting related to investment will be carried out by closely held private firms (or consortiums of such firms), while larger pools of capital will take over an increasing share of financing such investments. In fact, we can think of several current examples that might mark the beginning of such a trend, and thus lend support to the hypothesis. The long term impacts on markets, investors, businesses, and governments could get very interesting.