The RBA today published a paper on business investment decisions and their relationship to interest rate settings. They are clearly trying to understand why, when interest rates are in absolute terms low, business investment is still flat. Indeed in real terms, non-mining business investment in Australia has been little changed for several years.
“Firms typically evaluate investment opportunities by calculating expected rates of return and the payback period (the time taken to recoup the capital outlay). Liaison and survey evidence indicate that Australian firms tend to require expected returns on capital expenditure to exceed high ‘hurdle rates’ of return that are often well above the cost of capital and do not change very often. In addition, many firms require the investment outlay to be recouped within a few years, requiring even greater implied rates of return. As a consequence, the capital expenditure decisions of many Australian firms are not directly sensitive to changes in interest rates. Furthermore, although both the hurdle rate of return and the payback period offer an objective decision rule on which to base expenditure decisions, the overall decision process is often highly subjective, so that ‘animal spirits’ can play a significant role.”
“Analysis of the investment decision process helps to explain the subdued growth of non-mining business investment. First, there is some evidence of a tightening in investment criteria since the global financial crisis. For example, some firms have reduced their maximum payback period, suggesting implied discount rates for investment decisions may have increased even as long-term interest rates declined.
Second, identifying investment opportunities with returns exceeding the typical hurdle rate of around 15 per cent may be difficult for many firms given their expectations for the growth of their sales.
It is clear from discussions with liaison contacts that the overall decision process is highly subjective, which in turn allows ‘animal spirits’ to play a role. As noted, firms frequently reject investment decisions that satisfy self-imposed quantitative criteria on other grounds, such as concerns about the economic outlook, the availability of capital within the company, or shareholders’ preferences. Some managers have noted that they have taken a more cautious approach to capital expenditure since the financial crisis, either because there is more uncertainty about the future or they are more averse to taking risks. As a consequence, firms with a range of opportunities may only be willing to pursue the most profitable projects in the current economic environment.
Although changes in interest rates may not have a direct effect on investment decisions for many firms, interest rates will still have a powerful indirect influence on firms’ investment decisions. For example, a reduction in interest rates may improve firms’ cash flows through reductions in interest payments, freeing up cash for other purposes. More broadly, interest rates affect economic activity via a number of channels, including the saving and spending behaviour of households, the supply of credit, asset prices and the exchange rate, all of which affect the level of aggregate demand.
“Detailed discussions with managers and survey evidence indicate that the lack of direct interest rate sensitivity partly arises because Australian firms typically use effective discount rates that are high and sticky to evaluate capital expenditure opportunities. This reflects the use of hurdle rates that are considerably higher than the weighted average cost of capital and are adjusted infrequently, or a requirement that any outlay must be expected to be recouped within a few years”.
We think it may have something to do with the hurdle rate to assess projects, but it has more to do with levels of confidence. Many firms are still in hunker down and survive mode, not one which is conducive to encourage investment for future growth. Lack of demand of course becomes self-fulfilling.
