There's a new theory on why low interest rates aren't working, and it's all tied to the rise of China

Getty/Darrell Ingham

Australia’s big economic problem at the moment is a lack of confidence from business, which is leading to low investment and hiring intentions. That means the economic transition is increasingly concentrated in housing and dwelling construction, and little else.

The situation is so serious that RBA Governor Glenn Stevens has multiple times now pleaded with Australian business leaders to unleash their animal spirits and get on with the job of investing.

But as the latest ABS Capital Expenditure (Capex) figures showed, his calls have gone unheeded so far. The Capex data showed at the initial estimate for 2015-16 is is 12.4% lower than the estimate for the previous year and the lowest in 5 years.

That’s not what’s supposed to happen when the RBA has rates at a generational low of 2.25%.

But James White, senior analyst in investment markets research, and Stephen Halmarick, head of economic and market research, from Colonial First State, have new research which offers to explain why in Australia, and elsewhere, business is not investing even though rates are super low by historical standards.

In their research, titled “The Great Transition”, White and Halmarick say the size and scale of China has been the game changer for Australian and global businesses at an industry-wide level. Their view is that “China has exported its perfectly competitive industrial structure to the global economy.”

This means the global economy is faced with many of the problems “identified by the ‘secular stagnation’ thesis, most specifically an absence of investment in productive capacity, despite the fall in interest rates, and dis(de)flation.”

If you remember your economics 101 you’ll know perfect competition “implies no excess return on capital across a particular industry.” That doesn’t mean that individual firms can’t do well. It’s just that their profits will be offset by someone else’s loses.

White and Halmarick argue:

Through the 2000s, strong Chinese profitability was offset by the destruction of capital elsewhere, particularly in the developed world’s manufacturing base. But each year, as competition leads some firms to exit, it becomes harder for all firms to achieve an excess return.

Stay with me. This is super-important in understanding why low-interest rates are not gaining traction in Australia and many other nations.

Any rational business manager who sees this happening in his industry is going to reduce new and potentially existing capital allocation to that industry.

White and Halmarick see evidence of this between Chinese and US firms, and say:

Though there have been different starting points, the trend is now clear; industrial companies are de-leveraging, despite much lower interest rates. This reflects both supply and demand factors, investors and firms have less reason to believe a firm might earn an excess return and so warrant external capital allocation.

White and Halmarick say the lack of external finance doesn’t stop firms accumulating capital. It’s just that they do it via “retained earnings rather than external financing.” They also say it leads to two important behaviours from firms.

Companies wanting to stay in the industry have to “re-invest any excess return to improve productivity and competitiveness.” What that means is that scale becomes an important determinant of competitiveness and success, in a perfectly competitive environment. The consequence of this is that it “promotes an abundance of product at increasingly lower prices. It is fundamentally de(dis)flationary.”

In the end then we have an explanation for disininflation, but equally, “a dearth of investment opportunities where capital can earn an excess return and lower returns on capital globally. It is ‘secular stagnation’.”

On the basis of their argument Australia, and Australian business, needs to find the scale to compete globally like BHP and Rio, dominate their market like the banks, or become innovative and move into emerging industries where they can gain scale and competitiveness.

The RBA is already on the record saying that Monetary policy has lost traction and White and Halmarick have highlighted the dynamic which is holding business back in the current environment. They have also articulated perfectly why low interest rates aren’t working. Perhaps they have also explained why in this new world economic order they never will in the way they have in the past.

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