The Reserve Bank of Australia’s incoming governor, Phil Lowe, hasn’t wasted the last four years as apprentice to Glenn Stevens.
The deputy governor, who steps into the top job in September, has delivered 27 speeches since 2012, canvassing a range of subjects affecting the economy, from the role of government and the limits of monetary policy to national confidence and lending standards for banks.
He’s also posed what are, in the language of central bankers, tough questions to the business community over its investment approach as the economy transitions away from the mining investment boom.
In a speech 12 months ago titled “Managing Two Transitions”, one of his key themes was falling global interest rates and business investment decisions.
The part of the transition that is taking place more slowly than we had earlier expected is the lift in business investment outside the resources sector. As a share of GDP, non-mining business investment remains just above the levels reached in the recession of the early 1990s. For a few years now, each time we have updated our forecasts, we have pushed out the timing of the recovery in this part of the economy.
The latest update was no different. Many businesses tell us that while conditions are okay at the moment, they are not sufficiently strong for them to lift their investment plans. Many feel uncertain about the future and so are waiting until there is a sustained pick-up in demand before committing to new capital expenditure.
His core critique of business was that they’d set the bar too high for investment, and that had the potential to drag on the economy. He went on to address a very specific, but important, issue of policy that can determine whether an investment project can go ahead.
To explain this we need to take a quick step back and explain a “hurdle rate”.
This is a CFO’s plaything: a specific level of return attached to business proposals that determines whether a project can be declined or approved for investment. A hurdle rate can be as high as 12% or even 15%, depending on company policy, and the debt servicing costs associated with the projects.
In a low-interest-rate world, debt costs should fall. But in many corners of the private sector, these hurdle rates have not been dropped in line with base interest rates set by central banks.
“The hurdle rates of return that firms use for new investment are quite sticky and that they are not very responsive to movements in interest rate,” Lowe said, citing a Deloitte survey showing hurdle rates in Australia “are typically above 10 per cent and sometimes considerably so”.
He pressed on:
One issue that this raises is what is the appropriate hurdle rate of return in a world of persistently low interest rates? Each CFO will no doubt have a different answer to this, but in a world of persistently low interest rates, it may well turn out that the average answer is – or should be – lower than it used to be.
Recently, in a number of countries there has been a tendency for firms to return funds to shareholders. These firms are effectively saying to their shareholders, ‘here, you manage the money, as we do not have investment opportunities that satisfy our internal rate of return.’
In many cases, shareholders have welcomed this, seeing it as a disciplined approach to capital management. The difficulty is that if the majority of firms act in this way, shareholders in aggregate get left holding the cash. And, on that cash, they earn very low rates of return – almost certainly lower than the rate of return that would, on average, be earned if that cash were invested by businesses in real assets.
This is really just another way of saying that if the appetite for investment is low, savers, in the end, will get low returns on their savings.
So, as I said, this world of low interest rates is creating many challenges for you as CFOs – whether you are a CFO needing to fund future liabilities, a CFO valuing and managing assets or a CFO determining the appropriate hurdle rate of return for your firm’s investment decisions.
The future RBA governor was throwing down the gauntlet to Australian CFOs to not take the easy option with the company’s shareholders to keep them on side in the short term. He wanted business to spend, just as the RBA has been banking on the nation’s households to do the same, shifting from a saving cycle to consumption.
The full speech is here.
The question now is whether Lowe will continue to be as outspoken once he assumes the top job in the nation’s central bank.