by Robert N. McCauley, Steven A. Zimmer
*Robert N. McCauley is Research Officer and Senior Economist, International Finance Department, and Steven A. Zimmer is Senior Economist, International Capital Markets staff, Federal Reserve Bank of New York.
1 See footnote at end of text.
A relatively high cost of capital burdens U.S. industry and banks alike. The effects of high capital costs on capital formation in the United States are hard to demonstrate, but are believed to be important, especially in research-intensive high technology industries. The inflow of foreign direct investment into the United States in the late 1970s and the 1980s fits with a cost-of-capital interpretation. Cost-of-capital differences assert themselves with particular force in competition in wholesale banking. How foreign banks will respond to the effect Of recession on the cash flows of U. S. corporations is important, because a high cost of capital has shrunk U.S. banks' market share.
IT IS EASY to come away from a reading of the growing body of work comparing capital costs across countries with a question as to the possible consequences. Pairs of analysts perform research on the subject as if the exertion requires a team in harness.(1) The teams seem to arrive at estimates of the cost of capital not just lathered but also winded by the long run of calculations.
Comparing cost of capital across countries elbowed its way onto economists' research agenda from the outside, as it were, from business. Most economists who work on cost of capital are tax experts whose faith in the equalization of all prices of interest across all markets is undisturbed by any attempt at measurements.(2) The convenient consequence of his faith is that tax wedges remain the only matter of interest.
The Semiconductor Industry Association commissioned a study in 1980 of capital costs in Japan and the United States. Concern over the ease with which Japanese firms were making the massive investments required for the next generation of chips motivated the investigation. Later, as the U.S. deficit in international trade widened, so did interest in cost of capital. The flaws of the Semiconductor Industry Association's report and a later pass on the subject by the Commerce Department(3) drew economists to the project. To this day, cost of capital comparisons get more attention at gatherings of the American Electronics Association than at gatherings of the American Economic Association.
WHY CAPITAL COSTS MATTER
Capital costs influence two kinds of investment. First, capital formation depends on capital costs, which may be thought of as setting the required payback period for investment projects. Capital costs also shape direct investment flows.
Capital Formation
Capital costs matter to the level of investment in an economy, and the level of investment per worker matters for the growth of productivity and therefore living standards. On the latter connection the evidence is fairly impressive: the strength of investment spending bids fair to explain cross-country differences in productivity.(4) On the connection between capital costs and investment, most macro-economists will readily admit that capital costs do not add much to a simple accelerator model of investment in explaining investment over time in a given country.(5)
The cost of capital as we measure it bears a striking relation to investment performance of the United States, Japan, Germany, and Britain (Charts 1 and 2).(6) The juxtaposition raises the question of whether it is fair to test the efficacy of cost of capital in the usual fashion. The time series evidence on investment from single countries is unsurprisingly dominated by the business cycle, which may obscure the effect of cost of capital.
The cost of capital advantage enjoyed by Germany and Japan arose from quite different sources. Germany's short-term and long-term interest rates were not all that different in real terms from those of the United States in the 1980s, but German corporations relied almost entirely on cheaper short-term debt. German companies got away with not paying the premium for long-term liabilities by virtue of closer links between industry and banks on the one hand and the strong commitment of the Bundesbank to price stability on the other hand. Corporate Germany, however, has not been well-served by this mix of debt since the breaching of the Berlin Wall. Japanese firms, by contrast, derived their advantage in the 1980s from the run-up of equity prices on the Tokyo exchange.
On its face, the rise in the share of Japan's domestic product devoted to investment, to 29 percent in 1989 from the low 20s, cannot be separated from the run-up in the Tokyo stock market. if the rise in equity prices represented a bubble, rational or otherwise, it was nevertheless a bubble from which corporate Japan could and did remove cash, largely by the sale of call options embodied in Euro-bonds with warrants and convertible bonds. That the investment rate in the Japanese economy rose again in 1990 in spite of the disorderly retreat of the Tokyo Stock Exchange suggests the importance of lags and liquidity effects rather than the unimportance of the cost of equity.
The composition of investment in the United States in the 1980s may also reflect capital costs. Gross investment held to its postwar norm in the 1980s, but the shortening of the average life of U. S. equipment investment dragged net investment below its norm. The shift in the mix of investment may well reflect that the cost of capital disadvantage is accentuated for long-lived projects.
Direct investment in the United States
Twenty years ago Bob Aliber argued that the predominant home country for foreign direct investment draws on a cost-of-capital advantage. If in the 1950s and 1960s the New York Stock Exchange capitalized a given stream of earnings at a higher multiple than the London, Frankfurt, Paris or Tokyo stock exchanges, then U.S. multinationals could outbid British, German, French or Japanese companies for corporate assets abroad.(7) This view does not provide an account of the two-way flow characteristic of foreign direct investment; oil companies marketing in each other's back yard is better understood in terms of industrial organization.(8) As an account of the shifting balance of foreign direct investment, however, Aliber's hypothesis has aged reasonably well. Foreign acquisitions in the United States rose sharply in the late 1970s when, as a result of the confounding effects of inflation, U.S. firms' cost of equity moved irregularly above that of major foreign competitors (Chart 3).
From the mid-1980s, foreign acquirers brought a significant cost of equity advantage to the bidding contests for U.S. corporate assets. By the end of the decade, as foreign firms accounted for as much as a third of the deals by value, Congress legislated new restrictions on foreign acquisitions. The country composition of the foreign acquisitions shifted toward Japan, which made sense in light of the low cost of equity there. That British firms managed to increase their wonted share of acquisitions in the United States was a little puzzling, and a deal-by-deal comparison of the price-earnings ratios of U. K. acquirer and U.S. target does not suggest that the British firms were creating equity value by relocating earnings from New York to London; indeed, in 1988 and 1989 the target's exit multiple was generally higher than the acquirer's price-earning's multiple.(9) Overall, however, both the timing of the United States' receipt of a disproportionate share of the world's direct investment and the sources by country accord with Aliber's hypothesis.
Competition in Banking
A corollary of the cost of capital interpretation of direct investment is that businesses that rely heavily on equity should show an exaggerated effect of international differences in fundamental stock market valuations. This corollary is borne out by a comparison of competitive outcomes in industry and banking.
In industry, foreign acquisitions are raising the share of U.S. manufacturing assets or employment under the control of foreign firms, although the growth is slower than one might expect because of divestments by foreign firms that found it easier to acquire than run firms in the United States. Much of the recent near-doubling of the share of U.S. gross national product accounted for by foreign-owned firms - from 2.3 percent in 1977 to 4.3 percent in 1987 - actually occurred in the late 1970s.(10) Still, only in the rare cases such as the chemical industry have foreign firms reached a one-third market share.(11) And U.S. manufacturing and commercial firms are not retrenching their foreign operations.(12)
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