Adrian Blundell-Wignall, Director, OECD Directorate for Financial and Enterprise Affairs, Special Advisor to the Secretary-General on Financial Markets
The real economy will always seem to be disconnected from the financial economy during periods when the need for structural change is so overwhelming that it can hardly be otherwise. We have had the easiest monetary policy of any historical era outside of hyperinflations, and productivity fails to grow, economic activity is weak (particularly in Europe and China) and there is no sign of inflation. The 2016 edition of the OECD Business and Finance Outlook addresses the three main causes of this:
- The size and impact of the reversal of the supercycle centred on emerging economies.
- The problems with company productivity and growth in a global excess capacity situation.
- Forcing a zero time value for money onto investors distorts financial investment and works against long-term investment.
We focus on the first of these in this first taste of the 2016 Outlook to be released on 9 June 2016.
Many commentators simply do not seem to understand the sheer size of the supercycle now in reversal.
Two different economic systems butting are up against each other. The group of emerging economies, now comprising around half of the world economy, is not open and (via financial repression) has built up massive savings over a short period of time. These savings have been forced into investment with a heavy role of state industrial policy. Indeed, some very large economies are behaving as though they too can develop just like the small Asian Tigers in the post–1945 period. The other group of more open market based economies is responding to the reversal of the supercycle and other structural factors (such as the failure in some regions to deal with huge bank non-performing loan problems up front) mainly with monetary policy. But little is happening.
This is not so surprising. How big was this saving and investment rise? The sum of the world’s national saving (and investment) since the early 2000s has risen a startling 225%. Most of this occurred in a single country, China.
This investment in emerging market economies (EMEs) has created massive overcapacity in the supercyle sectors, like steel, aluminium, cement, energy (particularly fossil fuels), transport (especially shipping), utilities and similar.
How do we know this other than by industry anecdotes and anti-dumping duties being imposed on emerging country’s exports, such as steel and aluminium?
Well, let’s have a look at the return on equity (ROE) based on 11,000 non-financial companies versus their cost of equity (COE) and their cost of capital (COK):
Excess capacity: ROE-COE and ROE-COK in advanced and emerging economies.
Declining in advanced economies; out of control in emerging economies.
Note: See Chapter 2 of the OECD Business and Finance Outlook 2016 for lists of advanced and emerging economies.
Source: OECD calculations, Bloomberg.
The ROE-COK is negative in EME companies, and spectacularly so versus the COE (which means managers can’t add value for shareholders). This is pulling down ROEs in advanced countries too.
Just how big is this supercycle investment? If only one point is to be taken from this year’s Outlook, let it be this: the size of investment related to the supercycle is much bigger than you think and its reversal is having an impact that monetary policy in advanced countries cannot hope to cope with.
Let’s look at the facts from the world’s largest companies. The figure below shows global capital expenditure by sector. The energy and materials sectors alone account for 40% of the total. This is now in decline with links to many other sectors.
Source: OECD calculations, Bloomberg.
The energy and materials sectors alone rose to 40% of capital spending of the 11,000 biggest global companies (shown in blue and grey). These are huge sectors. Energy consists of oil, gas, drilling, oil and gas equipment and services, exploration, refining, storage, transportation, coal and consumable fuels. Materials consists of chemicals, fertilisers, industrial gases, construction materials, metal and glass containers, paper packaging, aluminium, diversified materials and mining, gold, precious metals and minerals, forest products and paper products.
If industrials and utilities (for the energy to drive all this) are added, the numbers rise to 60%. The supercycle sectors have a huge derived demand for inputs and services from other sectors, so that the linkages go even further than this.
Now, capital spending in all of these sectors and their demand for goods and services from other sectors is in decline. Chinese growth collapsed in 2014-2015, and, from late 2015, it is repeating the mistakes of 2009; it is embarking on a new real estate shantytown rebuild funded by state-owned enterprise bank credit.
What does this do? Once more it raises demand in the supercycle sectors and delays the much needed creative destruction phase. Local government steel, cement, aluminium and other factories in each province (all too big to fail) have no incentive to exit.
The reversal of the supercycle and the sheer size of what is happening is such a massive headwind that it is overpowering easy monetary policy.
Monetary policy has nothing to say about the sectoral misallocation of resources and excess capacity in the global industrial sectors; and certainly not in countries largely cut off from the discipline of openness and market forces.
The Outlook analyses this in some detail and then delves into the problems with company productivity in the excess capacity world since the crisis. It looks at what the companies that adjusted to the shock of the crisis did in terms of key corporate finance decisions, which helped them to negotiate this difficult post-crisis world. These companies are compared to those that didn’t adjust and are now part of the problem. It then looks at the portfolio consequences of setting a zero time value for money.
Watch out for the next blogs on these topics, but above all come and discuss the full publication being launched on the 9th of June.
Useful links
The launch of the 2016 OECD Business and Finance Outlook takes place at 9.30am CET on 9 June 2016. Register to participate or watch the live webcast www.oecd.org/daf/oecd-business-finance-outlook.htm
The 2016 OECD Forum on 31 May – 1 June, is entitled “Productive economies, Inclusive societies”. The Forum is organised around the three cross-cutting themes of OECD Week: inclusive growth and productivity, innovation and the digital economy, and international collaboration for implementing international agreements and standards.
