The RBA just acknowledged interest rates won't help business investment in Australia

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Glenn Stevens and his colleagues at the RBA have been asking business to invest and let loose their “animal spirits” for a couple of years now.

That’s because non-mining business investment is crucial to Australia’s economic transition.

More recently that call has morphed into a direct attack on business investment decisions. The RBA has begun saying that hurdle rates for investments are too high and Australian businesses need to lower them.

In that vein RBA deputy governor Phil Lowe recently said:

In today’s environment, it seems that many investors have, reluctantly, come to accept that they will earn lower yields on their existing assets. An open question though is whether the same acceptance of lower returns is flowing through to firms’ decisions about the creation of new assets – that is, their own investment plans?

The answer, to Lowe’s question, seems a firm no based on research released yesterday by RBA Economic Department staffers Kevin Lane and Tim Rosewell.

Lane and Rosewell found that business managers use a discounted cash flow approach to evaluating their investment decisions. That means that the very nature of the calculation of the NPV accompanying the DCF means interest rates are considered.

This process should kick out the firms “hurdle rate”.

Crucially however they also found that by augmenting this approach with an overlay of the payback period of the investment and by keeping hurdle rates high, as a kind of anti-cyclical risk management strategy, the interest rate sensitivity of investment decisions becomes a third-order issue for the company.

Many liaison contacts also report that hurdle rates are not changed very often and in some instances have not been altered for at least several years. These observations are also reflected in the recent survey by Deloitte; two-thirds of corporations indicated their hurdle rate was updated less frequently than their formal review of the WACC, and nearly half reported the level of their hurdle rate was changed ‘very rarely’.

Australian’s aren’t alone in their view of how best to approach these types of decisions, Lane and Rosewell said. They noted “available evidence suggests that firms in other advanced economies undertake investment decisions using similar criteria employed by Australian firms.”

One of the key points the research reveals is that it appears clear that business sees the current low-interest rate environment in Australia and around the globe as a reflection not of a new paradigm of lower interest rates but more of an economic growth and consumption demand that has driven rates to record lows in the developed world.

The research says:

In many instances it appears that firms are using hurdle rates that have not changed in a long time, set at a time when nominal long-term interest rates were far higher than they are today. Whether explicit or not, such behaviour is consistent with a reduced appetite for risk or the possibility that risks have increased.

That’s all we and the RBA need to know.

Business, like the rest of us, hate uncertainty. And in the current global economic environment, where it is hard for firms to see the growth in sales that would accompany investments, the easy thing to do is either keep the money on the balance sheet, pay it back to shareholders, and certainly not increase borrowings, rather than make what could be speculative investments.

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