Should entrepreneurs take advantage of the generous lending made available by central banks? Should they look to expand current operations? Or, should they invest in new lines of business? These are some pertinent questions asked by entrepreneurs in the new policy environment.
Easy credit is an example of an incentive thrown by policy rather than by the markets. In uncertain times, taking up long term projects should be best avoided.
Risks are high due to the long time taken in converting inputs to products. During this time consumer behavior change is likely. Consumer desire diminishes due to the availability of substitutes or price mismatch. Macroeconomic risks also play out during this time.
Interest-rate sensitive businesses such as steel or auto are risky businesses. The plant factories are complex, take time to set up and expenditure heavy. Due to their long distribution structure inventory risks are high.
Changes in consumer demand create a bullwhip like an effect through the value chain. An unattractive product - either due to change in tastes or bad pricing - causes losses. The factories end up with large inventories they need to write-off.
The easy credit conditions created through deliberate policy actions are risky. Entrepreneurs are falsely induced by low-interest rates.
The future actions of the central bank may not be in the best interest of the entrepreneur. What guides the central bank are variables like price-level, exchange rates, etc. If prices rise central banks won't hesitate to withdraw the easy credit conditions. A fall in exchange rates could trigger a rise in interest rates. A frothy housing market could, likewise, cause tighter credit markets.
Entrepreneurs shouldn't assume credit conditions to remain synchronous with their business plans.
But for the above risks, long term projects may be otherwise attractive. Especially from an IRR and profit-pool perspective. The easy credit only exacerbates the attractiveness of these projects.
In these fleeting times, it's best to stay short. Entrepreneurs who desire to borrow could start with small, working capital loans. These loans liquidate in short intervals such as six months to a year. This allows the borrower to always check his business viability. Retail businesses have the advantage of being closer to the consumer. They rotate inventories in small intervals of time. Shifts in consumer tastes are soon or later take into account.
Governments across the world are making direct transfer payments to consumer wallets. Consumers spend these monies for buying food, clothing, and several discretionary items. An entrepreneur who runs a retail business must keep his ear close to the ground. He usually knows when these monies come and go. He alters his inventory plans inline. This entrepreneurial task is at least within his area of competence. He doesn't have to predict credit market conditions because he is not a heavy borrower.
A financial investor investing in equity or fixed income faces several risks. A government running deficits accesses credit markets to make ends meet. This causes the crowding-out of entrepreneurs. Commentators discount this crowding out citing low entrepreneurial appetite even otherwise.
A clear-thinking view is absent in the light of central bank activities. For instance, through open market operations, central banks pump liquidity into markets. They buy short-end treasury papers, thereby sending liquidity to markets. These are processes that interfere in the free markets.
Left to its own, the loanable funds market would arrive at a 'market rate of interest'. Constant sucking out and pumping in liquidity creates economic risks. Entrepreneurs misunderstand these lower interest rates, that are otherwise unsustainable. The profitability of projects goes out of whack with frequent policy-induced rate changes.
Sometimes, these macro-economic risks get priced in the interest rates on offer. In its role as the arranger for government finance, the central bank manages to keep its interest rate low. This doesn't go unnoticed. The suppressed risks appear in the form of a high-interest rate for the private borrower. In fixed income markets, this goes by the term 'credit-risk premium'. Generally, credit risk premiums are idiosyncratic risks. They are borrower specific. But in these unusual times, credit risk premiums could signal other factors.
The deficits and the suppression of rates impose 'risk externalities' on everyone else. It is a form of 'risk-spreading' across space and time. These risks materialize someday in the future. This happens in the form of big, lumpy events such as continuous fall in exchange rates. Or, as a rapid rise in interest rates by the central bank prompted by price rises. Price rise and sudden change in interest rates upset producer and consumer's plans. Producers have to contend with lower real profits. And, consumer with lower real wages.
The elevated credit risk premium encrypts risk-externatilities, ex-ante.
The bitter-pill of a slowing economy reminds the aftermath of previous credit binges. In good times credit-money growth outran nominal GDP growth by a scale of two to three times. This culminated in the creation of bad assets. The increased borrowing costs now serve as a warning for the risks that lie ahead.
In the equity markets, several stocks trade at valuations that masquerade as 'value-stocks'. Gullible stock pickers absorb these risk-externalities as losses in their portfolios.
Whether these high risk-premiums compensate a risk-taking investor enough is a separate question. As the legendary investor Howard Marks puts - risk means more things can happen than will happen. Unlike the risk of changing consumer behavior, risk-externalities are usually imperceptible. Few are familiar with market cycles, risk-externalities, and out-whack structure of interest rates. Names such as Warren Buffett and a few prudent, large business houses come to mind. It's a different matter that financial products allow profiting from such events. The vast majority can't discern these risks and lose wealth in these events.
Governments are cognizant of the ill effects of deficits. It's political compulsions that drive deficits. With some help from commentators, it hides or postpones the consequences of debt. There is usually an attempt is to trivialize the extent of deficits and debts. Some float theories such as deficits-don't-matter or that it has a neutral-effect. The commonplace method of trivializing is to express debt as a percentage of nominal GDP. All these are book-keeping shenanigans - of the sovereign variety one would say!
Deficits levels being high or low is a never-ending argument. A clearer method is as follows. Is there a growing trend in government funding as a percentage of business funding?
For definition sake, government funding means treasury, public-sector, and any off-balance sheet borrowing. It's prudent to include unfunded liabilities. But those don't impact the loanable funds market, in any case. And, private funding includes credit and equity issuance.
That, entrepreneurs, are better wealth creators than government agencies is axiomatic understanding. They perform a better role in coordinating, signaling, and producing goods and services. They are better 'behaved' borrowers in the loanable funds market. On the supply side, creditors earn a fair interest when markets are not suppressed.
A growing trend in government funding as a ratio of private funding is worth worrying about. The answer to sustainable economic growth lie in which borrower-type plays a greater role. The risk-free nature of a sovereign issue masks the risk-spreading that it entails. The huge costs are evident in the form of failed projects, high prices, and lack of genuine credit in general.
Entrepreneurs must exercise caution as governments expand budgets and central banks manipulate markets. A longer-term view, but short term execution plan help preserve capital. Taking cognizance of the behavior of credit markets is important. Mere single-project focus alone is insufficient. Acting on plans spurred by changes in the availability of funding alone is risky. Past cycles have valuable lessons to teach.