We can agree that hurdle rates do seem too high. One oft-quoted survey suggests most countries clustered around hurdle rates between 12 per cent and 15 per cent, well above current interest rates regardless of the country.
Interestingly, hurdle rates don’t seem to move much over time. This clustering, and inertia, in hurdle rates raises important questions. If hurdle rates don’t move very much, how can they be a significant driver of something as variable as investment? And how can they contribute to the variability in investment across countries when they are quite similar across those same countries?
The gap with current interest rates in virtually all countries is very wide at present, but it has always been wide. Certainly it is wider than normal, but the existence of a large gap shouldn’t surprise us.
Japan’s hurdle rate is reported at 11.5 per cent and its interest rates moved below 1 per cent in 1995. Maybe other countries are being too impatient in expecting their hurdle rates to have fallen materially as interest rates have come down. This suggests we need to look elsewhere for an investment spark.
At a macro level, tighter capacity use is required because it drives the need for investment in the first place. A company is most likely to invest when it is running production at full capacity and still faces excess demand.
In the US capacity use tracked above 80 per cent for a run of years before the global financial crisis. It hasn’t recovered to that level since.
It’s a similar story in Australia. Capacity use peaked in 2007 at 85 per cent and hasn’t exceeded that level since. Korea and a range of other economies show the same pattern.
Let’s also consider the financing of investment. A firm’s ability to pay for investment might best be proxied by growth in company profits. Outside the US, developed market company profits peaked at 3.8 per cent of gross domestic product in 2008.
The US tech sector has performed very strongly, but outside that sector profit margins are below 2007 levels. In Australia non-mining company profits are currently growing at not much above zero.
Only for two brief periods since the financial crisis have non-mining company profits grown at double-digit rates. The upshot is there is no apparent need for investment to add to capacity, but even if there were, firms don’t have the obvious profit growth to pay for it.