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A world in which 'frugal capital' reigns.

With capital scarce and demands limitless, the main untapped source of financing for the developing countries is the risk-taking equity investor.

Consider the following opportunities and challenges confronting the global capital markets. The United States needs capital to finance economic recovery and rebuild aging infrastructure. The other major industrial countries, especially a newly unified Germany and a financially chastened Japan, face considerable public and private investment requirements of their own that will generate a formidable demand for capital. Many of the largest developing countries of Latin America and Asia are moving into a new stage of industrialization, based on market liberalization and private enterprise, and that process, too, will necessitate capital for investment purposes. On top of all of these substantial capital demands, a new set of countries has arrived in the international financial arena with needs for financial and physical capital that are essentially limitless. These are the former Soviet bloc countries of Eastern Europe and the numerous republics of the defunct Soviet Union itself that have to reconstruct their economies from the ground up.

Given these vast, impending demands for capital, it is only logical that concerned people, even those with considerable familiarity with economics and finance, are wondering where these huge sums of money will come from and who will provide them. They frequently ask whether the basic institutional structures, which together comprise the global capital markets, are in sound enough shape to support any large-scale transfer of resources or whether, instead, governments will have to provide the great bulk of the money. And if it is governments that will be left with this prodigious task, how will they get the money to do it? Will taxpayers in the U.S. and other industrial countries pay the bill?

In absolute terms, the impending global demands for capital are unprecedented, but we should not be overawed by the numbers themselves. After all, virtually every decade has produced record capital demands, well above what was predicted beforehand. The reason is clear: Healthy rates of capital formation are an integral part of the economic growth process. So, it is not solely the prospective size of the demand for capital in the 1990s but the distinctive financial market setting and the political context that make this such a complicated subject. Admittedly, the prospective demand for capital is far in excess of the likely supply. But I would remind you that it is virtually an iron law of economics and finance that a share of the total demand for capital will always be denied.

Conventional Wisdom

In reviewing the current discussions on capital scarcity and capital allocation, I find that three substantive policy conclusions stand out.

The first conclusion we often hear is that, because the private capital markets are not presently capable of funneling financial resources to the areas where the prospective investment yields are highest, the governments of the industrial countries must ensure that the necessary resource transfers take place. I would go so far as to say that this prescription has become conventional wisdom: more money and most of it from official sources. The U.S. and the other major industrial countries have already committed to a sizeable financial support program for the Russians. While the International Monetary Fund (IMF) is playing primarily a coordinating role for this program, at some point substantial sums of IMF and World Bank money may be brought in, along with resources from the new European Development Bank. The leadership of those agencies are all of a view that financial needs are more like $45 billion at the time of this writing - a magnitude beyond the capacity of the multilateral lending agencies and their government shareholders to mobilize.

The second conclusion we occasionally hear is that to the extent that financial resources do manage to be attracted to such places as Eastern Europe, the former Soviet Union, or Latin America, the real rate of interest will, in the process, be lifted for everyone. The newcomers will gain access to credit, but that will be at the expense of existing borrowers around the world, including some countries far poorer or less advantaged than the new borrowers. Thus, several authors have argued that a new round of foreign aid, including debt relief or outright forgiveness, is justified.

The third conclusion we frequently encounter is that the only way out of the dilemma is for the consumers and businesses of the richest countries to increase their rates of saving. Unfortunately, no one knows how exactly this can be accomplished. The one recommendation shared by virtually all the experts is to reduce government budget deficits in the U.S. and several other industrial countries in order to reduce government dissaving. But elected officials have been unable to do this, and there is no reason to suspect that it will become any easier in the years ahead.

Principal Conclusions

I agree that higher savings rates and more lending by official multilateral institutions would be helpful. However, I believe that the problem of meeting new capital needs is also rooted elsewhere. Let me summarize my principal conclusions:

1. I maintain that the underlying financial problem is global in its scope: It is the problem of too much debt and too little equity. It is as much of an obstacle to adequate capital formation in the advanced Western countries, including especially the U.S., as it is in Eastern Europe or in developing countries elsewhere.

2. Relying primarily on more debt to finance the physical capital needs of the emerging economies is a mistake and will not succeed in supporting either higher levels of capital investment or greater economic efficiency.

3. What will be successful are significant capital transfers that take the form of equity. But an emphasis on equity investment carries with it powerful and, some say, uncomfortable preconditions for the recipients as well as the providers.

4. Whether there is a useful shift toward equity financing or whether financial flows stay mainly in the form of debt, the financing of looming capital needs will almost surely involve some degree of regional specialization. European investors will focus on Eastern Europe and the former Soviet republics. The Japanese will concentrate on East and Southeast Asia. U.S. investors will lean somewhat toward investing in Mexico and the rest of Latin America. This greater regionalism in finance may provide certain benefits. Investment decisions are apt to be better when they are made by investors who are committed to a particular market and who are prepared to do whatever is necessary to gain an intimate insight into the workings of the enterprises in which they invest. But there will be a policy challenge to keep financial regionalism from justifying a departure from the liberal, multi-lateral environment for world trade that we all benefit from.

5. I believe that the major commercial banks will play a supporting role, not a leading role, in facilitating global transfers of financial resources. They will not resume large-scale balance-of-payments lending during the decade of the 1990s, to the former Soviet republics or anyone else, unless they can pass the risks onto their governments or onto one of the multilateral official lending institutions.

It is worth bearing in mind that many countries have been able to achieve highly satisfactory rates of economic growth without relying on access to large amounts of foreign capital. What is necessary is a framework of law, institutions, government policies, and social attitudes that reward effort, promote change, and rely on markets.

Foreign Capital's Benefits

But access to moderate amounts of foreign capital does provide clear benefits:

* It allows a country to let its consumers enjoy a better living standard, even as it maintains a high rate of business investment, and this can have a definite impact on motivation and the willingness to work hard.

* It allows domestic businesses to leapfrog the level of technology that they might otherwise have had to settle for.

* It helps keep a lid on inflation while these positive developments are taking place.

The trouble arises when the foreign capital comes in too readily, in unsustainably large volumes, and in the wrong form. Each of these three mistakes was made in the 1970s and early 1980s, and we continue to live with the consequences. It would be naive to expect that the sources of credit associated with that period can be restored.

Large commercial banks are still struggling with the remnants of the loans they made during that period of excessive lending. Initiatives for putting the debt on a more stable footing had some tentative success, but formidable problems persist. Huge interest arrearages have built up, including a sizeable amount in Eastern Europe and the former Soviet republics. This represents forced lending by the banks, but to a small, select group of highly indebted countries. But it means that none of the banks are going to be eager to participate elsewhere, except where an outside guarantee is provided.

Constrained Capacity

What is making things worse, moreover, is that many of the banks with the largest exposures to developing country debt also have large exposures to the troubled real estate sector and to highly leveraged corporations. So, even if by some miracle the problem of arrearages and rescheduling of past less-developed-country debt went away tomorrow, many of the large commercial banks would not have the financial capacity to become active lenders again for some time. And most U.S. banks that have avoided the real estate and leveraged buyout pitfalls generally have neither the internal infrastructure nor the support at the board of directors level for entering the international lending business. Indeed, the coming consolidation of our deposit institutions during the 1990s will focus bank management even more intensively on business opportunities that are - or will be - available domestically.

In a broader context, the question needs to be raised whether it ever makes sense for banks to shoulder a substantial responsibility for financing long-term international capital transfers. Banks in the main have very short-dated liabilities with interest-rate costs that fluctuate widely over a business cycle. Floating rate financing may very well mitigate the problem of rising liability costs to the bank, but it will surely contribute to the problems of marginal borrowers. Moreover, in a market system, it hardly seems advisable for a bank to put itself in the position of extending credit to official borrowers abroad, with the near certainty that if there is a problem somewhere down the road, the bank will be largely dependent on its own government to negotiate on its behalf with other governments. Privately owned banks ought to confine their activities to market conditions where legal equality is the operative norm.

Other private sources of funds, essentially major multinational companies, are highly selective about where and how they will increase their exposure internationally. Over time, they will make sizeable direct investments, particularly in Eastern Europe. But not yet. The framework is not yet in place to support large-scale ventures. So, for the time being, they will limit their involvement mainly to financing their own export sales or testing the waters through small-scale ventures with local partners. These are positive developments but they do not inject large amounts of financial capital.

Finally, there are the Western governments themselves, Japan included. Governments in many industrial countries face intractable budgetary problems: They are inhibited from forcefully expanding their own official lending, except where it accrues to the direct benefit of domestic producers. While this is an important exception, it is unlikely to become a major force for generating large-scale capital flows. The reason is that in the short term the budgetary problem will not fade quickly, and it may in fact get worse before it gets better. In any event, it is this combination of lending constraints on private institutions and governments alike that will substantially limit upward pressure on real interest rates stemming from marginal demanders of credit.

Equity Capital's Greater Role

The Achilles' heel of the past resource transfers to Eastern Europe and most developing countries was that the financing took the form of debt, with lending margins that were little different from those available on loans to corporations of high credit quality but with risks that were equity-like in virtually every one of those countries. Hence, it is simple logic that future financial resource transfers must take the form of equity-related instruments, and that means yields to permanent investors must be equity-like, as well.

There is a certain naivete among a large number of otherwise informed people about what a true hurdle rate of return on equity investments expected by risk-taking private investors is. These returns are in no way proxied by the long-term rate of return on domestic equities of established corporations - roughly 12% per annum over the past half century in the U.S., for example. Those are average returns for going concerns with long records of earnings, dividends, and legal stability. For new ventures in the U.S., investors demand far higher returns - 30%, 40%, or 50% a year, compounded. It is far from obvious that promoters of investment opportunities in Eastern Europe, for example, are willing to contemplate providing these kinds of returns to their equity investors. But if not, they will largely fail to attract the funding.

The Large Investor

By process of elimination, the main untapped source of financing for the developing countries and the emerging economies of Eastern Europe and the former Soviet republics is the risk-taking equity investor. Realistically, this cannot be the retail investor, who has little or no interest in investing anywhere but at home. Therefore, it can only be the large institutional equity investors from the industrial countries - corporate pension funds, other retirement funds, investment companies and other specialized financial enterprises, and insurance companies - that must be attracted to unconventional equity investments. That will require time and fundamental change by those countries that would like to see a sizeable transfusion of foreign capital to speed their economic development, and some important changes in the industrial world as well. I have in mind the following:

First, there needs to be moderate economic recovery in the industrial countries that are now in or near recession, and continued moderate expansion in the rest. Too rapid a rebound, rightly or wrongly, will incite inflationary concerns; interest rates will be pushed up by the financial markets, and the relative attractiveness of foreign investment will diminish.

Second, there needs to be a pronounced change in the composition of expenditures in many countries. Most important, military spending needs to be de-emphasized globally. Reductions in military spending are required to help achieve budgetary balance, certainly in the U.S. as well as in the former Soviet republics. But it is equally important from a broader economic perspective. The resources, both human and physical, that are devoted to weaponry need to be made available to the civilian sector, where they can help enterprises achieve higher rates of return on capital.

Third, there needs to be a continuing process of rehabilitating the financial health of deposit institutions. This includes regulatory reform, and capital infusions into marginally capitalized banks. It also would be helpful to have a continuation of a positively sloped yield curve, which provides opportunities for banks to increase their earnings by taking modest interest rate risks rather than having to absorb additional credit risk.

Fourth, recipient countries have a lot of work to do in making the transition to a market-based economy. This includes establishing a reliable legal system, including a reasonable bankruptcy law, dependable and transparent accounting standards, adequate protections of the right of an equity investor to sell his position or repatriate dividends, and a host of supportive regulatory codes.

Global Economic Implications

Relative capital scarcity will be an enduring feature of the 1990s. It will no doubt restrain economic growth potential in certain countries and regions. But in subtle ways it will also provide benefits to the world economy. That is because an atmosphere of capital scarcity will evoke a number of constructive responses by business enterprises in industrial countries and industrializing countries alike.

These reactions can usefully be encapsulated by the term "capital frugality." We are already aware of this instinct in the management of capital by the better companies. Whether it takes the form of just-in-time inventory control or zero-based capital budgeting or joint design-production engineering, it is evident that, in manufacturing their products, highly profitable enterprises seek to deploy as little capital as possible but embody the most advanced technology available. In the 1990s, that impulse to conserve on the use of capital will spread globally; it may become a hallmark of every well-run enterprise, regardless of nationality. Its absence will serve to frighten off potential investors as surely as a debt-sodden balance sheet. Skepticism over whether the newly formed republics will quickly adopt an attitude of capital frugality is an important impediment to private flows of financial resources to them.

Along with manufacturing and commercial enterprises, financial intermediaries, both private and official, are coming to appreciate that wasteful use of the capital they provide hurts economic performance and magnifies the risks in lending and investing. They will insist on enforceable controls over how the money they provide will be used. Less waste in the deployment of capital and more care in its use actually lessens credit burdens, because enterprises will then have a greater chance of realizing sufficient rates of return to service debt and maintain dividends to investors. In the end, lending and investing institutions will be more likely to get paid back.

More Disciplined Analysis

Finally, an atmosphere of capital scarcity will force the world's credit system onto a sounder footing. There will be less abuse of the credit structure when credit is harder to come by and the tolerance for financing marginal ventures is reduced. This will be a dramatic change from the decade we have just finished, which was soiled by excessive debt creation, shabby credit evaluation, and an attitude that anything could be financed, however dubious its economic fundamentals. Credit allocation will be based more on disciplined analysis and objective evaluation of creditworthiness than on what the levels of fees are and how much the financial intermediary can take out of the deal for itself. As is true in so much of life, moderation in credit creation will breed healthier businesses and a healthier global financial system.

Henry Kaufman is President of Henry Kaufman & Co. Inc., a firm established in April 1988, specializing in investment management and economic and financial consulting. For the previous 26 years, he was with Salomon Brothers Inc., where he was Managing Director, member of the Executive Committee, and in charge of the firm's four research departments. Before joining Salomon Brothers, Dr. Kaufman was in commercial banking and served as an economist at the Federal Reserve Bank of New York.
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Author:Kaufman, Henry
Publication:Directors & Boards
Date:Jan 1, 1993
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