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Jul 5, 2023Liked by Joachim Klement

Nice piece. A central tenet of the argument regarding the 5% scenario seems to be, as you say: “If interest rates remain at 5%, about half the money that is typically invested in new projects would need to be diverted to service existing debt.”

Investment and capital budgeting is typically based on project NPVs. NPVs are typically based on long term costs of capital, which aren’t so volatile and use more normalised risk free rates. Investment that can’t be funded internally gets funded via new debt, equity or hybrid. Hence what do you see as the mechanism by which the volume of investment halves?

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It is the same mechanism but with a smoothed discount rate to calculate the NPV of projects. Pablo Fernandez has a beautiful annual survey of the discount rates analysts use for their DCF models (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4407839). I suspect companies use a similar approach to calculate the NPV of their projects. Looking the discount rates used you can see that the nominal risk free rate is a smoothed 10-year government bond yield.

So, if short term rates stay at 5% for a long time, the 10-year bond yields will rise to 5% or above over time, which in turn increases the risk-free rate used in NPV calculations. And since even small changes to discount rates have large effects on the NPV, many projects will quickly become unprofitable...

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In a system characterized by the transition from capitalism to creditism, as defined by Richard Duncan, raising interest rates becomes a significant challenge. This issue is exemplified by a current situation in China. When the system faced a halt due to the collapse of the real estate bubble, local entities adopted a strategy similar to that seen in the Western world, using off-balance-sheet financial vehicles known as Local Government Funding Vehicles (LGFV). Initially intended for infrastructure development, these vehicles resorted to borrowing from state banks at favorable interest rates in order to acquire land and maintain a steady flow of funds to municipalities.

Currently, major Chinese state banks are undertaking the process of restructuring the debt of these financial vehicles, considering them to have a higher creditworthiness. I found some number online: loans with longer durations of 25 years, instead of the typical ten, are being granted, and the first four years of the loan do not require interest payments. Additionally, formal restructuring measures have been implemented, such as the case in the financially struggling province of Guizhou, which announced an extension of debt to off-balance-sheet banks for 20 years and a suspension of capital repayments for the next ten years.

In February of the 2023, the International Monetary Fund estimated that the hidden debt of these funding vehicles had reached 66 trillion yuan (around 9.1 trillion dollars) by the end of 2022, compared to 40 trillion yuan in 2019. This indirectly confirms the disbursed funds during the pandemic and the stagnation experienced in the real estate market.

Consequently, Beijing is compelled to rely on its financial strength, represented by state-owned banks, to prevent a chain of failures that could undermine the consensus and stability of the regime.

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Many thanks for the comments and Fernandez paper. I used to read him religiously at UBS.

Reminding myself of your original comment: "If interest rates remain at 5%, about half the money that is typically invested in new projects would need to be diverted to service existing debt. If interest rates go to 10% investment growth would practically be reduced to zero"

So you're attributing the investment impact to NPV effects from discount rate changes rather than free cash flow, which I think makes more sense.

The impact very much depends on the numerator (expected cash flows) and how many projects are at the margin of NPV positive. If 50% of projects were juicy enough (IRRs comfortably above cost of equity) then they'd still be NPV positive and undertaken with a 200bp rise in COE.

I've sent you a LInkedin request. Wld be great to connect.

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