A lot of things are very different today in the world of finance. However, what has prompted me to write today is the imminent demise in the developed world of something which was at the very foundation of the course on ‘Financial Management’ I studied during my Masters- the concept of the risk free interest rate.
The risk free interest rate is basic opportunity cost. It is traditionally taken as the yield of a long term sovereign bond or some other such asset which is guaranteed by the government. The concept is somewhat ideal as sovereign defaults do happen but it is definitely true that sovereign bonds of first world countries have a good credit history.
The developed world is now a place of either Zero Interest Rate Policy (ZIRP) or Negative Interest Rate Policy (NIRP). In a world having inflation, both policies mean that a person buying a risk free asset would lose money over time. While ZIRP makes its way felt through creeping inflation, NIRP is more direct as a direct debit on your bank account. Effectively though the message is clear, there is no risk free asset that delivers a return. No FD in a sovereign bank or long term sovereign bond that preserves your capital. Even to preserve capital, investors would need to take risk.
The removal of risk free interest rate has far reaching implications, especially on cost of equity. Taking an example, let’s assume that the 10 year Government bond is the risk free interest rate in India. Currently, its yield is approximately 7.5% and an investor’s equity risk premium is also 8%. This means that the cost of equity is 15.5%.
However, in ZIRP, the cost of equity would just be the risk of investing in equity, the equity risk premium i.e 8%. Thus theoretically, it also means a lower expected return from equity.
It is a terrible situation to be in; the inflation indicators are benign in most of the world but the truth is that food, housing, medical bills and education are getting more expensive year on year almost everywhere. If one has to spend in the future on any of these things, one has to save and this means that getting a return is important. However, with no risk free asset, one is literally forced to dabble in the markets. Thus with more demand, equity asset prices go up.
That is theory. In real life too, the US markets have enjoyed a speculative rally fuelled by debt. However, something is seriously wrong when the Dow and S&P 500 reach lifetime highs without any meaningful increase in economic indicators and investors have to bet our life’s savings on the hope that this continues because they simply have nowhere else to go. This is bad because if there are no savings, one can only borrow. Borrowing is based on the premise that one would earn more in the future. Is that really guaranteed when wages have been stagnating in the developed world for decades? Don’t take my word for it, read Michael Lewis’ ‘Liar’s Poker’ that mentions starting 1980s salaries in the USA in Wall Street and it is difficult to believe how little the salaries have changed even in nominal terms. Yet, cars, houses and tuition are phenomenally more expensive now than then.
How do central banks tackle the crisis? They try to remove the ‘risk’ from the equity risk premium by playing to the market. Witness the efforts of the central banks of China, Japan, the Euro zone and of course the US. It is working so far: basic concepts of Financial Management be damned.
I sincerely hope that the rate easing cycle in India never reaches ZIRP in my lifetime but I am afraid the odds are against me.