Sunday, September 22, 2013

Cheap Money - Good for the Economy???

Central bank governors are falling head-over-heels to reduce interest rates, which appears to be their only super weapon to help grow economies. Japan led the way in the 1990s. Their economy has never been in a worse shape after this. I am not an economist, but I hold dearly to this belief: don't expect free lunch! 

To me, there must be a cost attached to any business borrowing. Without a cost, there is simply no pressure for the business borrower to work hard! Easy and cheap money stifles productivity. It feeds real estate and stock market frenzies. Retirees suffer, but ultimately, it does irreparable damages to the economy at large.

Yet, many central bankers are competing to show who is the fairest of them all, meaning, who can dish out the lowest rate! I suspect many are patronizing Ben Bernanke’s tailor.

This crude thought of mine focusses on a micro-aspect of easy and cheap monies in business management.

To deliver a high Return on Equity (RoE) to please shareholders, one only has to make sure that his cost of borrowing is lower than his Return on Total Assets (RTA). The latter is really what a CEO is paid to manage. By gearing up, he can achieve extraordinary RoE.

The formula is simple, really:

RoE = RTA + D/E(RTA - CoD)

If the cost of borrowing is 5% and your RTA is 7%, you will have a spread of 2%. If your Debt to Equity is 5, which means your use $5 of borrowed capital and $1 of own capital to do the business, your RoE will be [7+(5x2)]% or 17%! Your contribution as a manager of the business is only 7% and OPM (other people's money) helps boost the rest of the glowing result for you! But the source of this 5% bank rate is the life-long savings of many old men and women. How much do they get? Probably 2 to 3%! Both the mediocre manager in you and your bank manager literally laugh all the way to where? The bank!!!

In reality, few banks would allow their borrowers to have too high a debt-to-equity ratio. A ratio of 2 or 3 is probably the max you could go for. However, in Japan, a ratio of 15 is not uncommon – there, banks and big businesses tend to lean on each other. Coupled with the fact that competition is intense (and hence margins thin), even though the cost of borrowings are low, the outcome can be fatal. I suspect this is the real reason behind Japan's overall decline.

Many have also been floored by this concept too. In the heyday of high interest rates, (RTA - CoD) turns negative and multiplying this by your D/E, you will have to cry all the way to the bank instead! As an illustration, if your D/E is 2 and your RTA is 5% and your cost of borrowing is 8%, your RoE becomes [5+2x(5-8)] = -1%! How not to cry all the way to the bank!
History tends to repeat itself. Economic cycles are for real. It is not for me to cry wolf, but surely you don’t need a PhD in economics to exercise common sense?

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