Financing World GrowthDean Foust
After countless false starts, the elusive global economic recovery has arrived. No longer is the U.S. the Little Engine That Could, laboring to pull the other major economies out of recession. In Europe, thanks in part to strong exports to the U.S., most nations are aboard the expansion train, with average growth projected to hit 2.7% this year and next. And recovery is apparent even in Japan, where 6.2 trillion yen worth of tax cuts are helping to revive an economy derailed by financial and real estate problems.
Throw in continuing explosive growth among the major developing nations, plus slow but steady progress in the former communist states, and you get an expansion that could be the broadest-based in decades. "The next couple of years should be stellar--and with the help of countries that were never even on the radar screen before," says Allen L. Sinai, chief economist at Lehman Brothers Global Economic Advisers Inc.
TRIPLE DIP. Yet beneath the euphoria lies a nagging question: Is there enough capital to satisfy the tremendous demand? Combined, the global appetite seems staggering. The developing nations of Latin America and East Asia, eager to build their new market economies, are sucking in more than $140 billion annually--triple the amount of capital they absorbed in the late 1980s. Meanwhile, the formerly communist nations of Eastern and central Europe are ravenous, laboring since the fall of the Berlin Wall in 1989 to produce an attractive investment environment. According to Columbia University projections, the region could easily absorb up to $500 billion. Yet J.P. Morgan & Co. economist Susanne Gahler estimates that Eastern Europe will receive only $5.52 billion in total net direct and portfolio investments in 1995.
Even in Western Europe, a push by governments to privatize such state-owned corporations as Renault could create an additional $100 billion in capital needs in the next five years. "The world is facing an accelerating demand for capital that is unprecedented, particularly for infrastructure projects," says Winthrop H. Smith Jr., head of international operations for Merrill Lynch & Co.
Aggravating the potential squeeze is the virtual disappearance of Japanese investors from the global stage. After playing a leading role as a world financier during the 1980s, Japan remains inwardly focused on repairing its ailing financial system. While borrowing requirements from the rest of the world have doubled, to $300 billion, since 1991, the outflows of long-term capital from Japan have shrunk to just one-tenth of their 1980s peak of $137 billion, according to Merrill Lynch.
As a result, some market watchers predict that the intense competition for capital will result in higher interest rates and increased currency volatility as investment demand outstrips the global supply of excess savings. Currency swings have even prompted calls for a return to more closely regulated markets. "We've never seen more potential business in all four corners of the earth, all wanting to access the capital markets," says John M. Hennessy, chief executive of CS First Boston. "Projects that don't have high returns may be sliced off, and many of those may be in the industrial countries." Global superinvestor George Soros opines that capital will increasingly go into what he calls "the real economy" rather than financial assets.
CASH HOARDS. Interest rates are already heading north in several major economies, from the U.S.--where the Federal Reserve has ratcheted up short-term rates steadily since early this year--to Europe, where Sweden, Italy, and most recently Britain have raised their benchmark rates. With inflation at a low ebb in the industrialized nations, real 30-year interest rates in the next year could rise to 4.5%-5% in the U.S. and above 6% in Europe, predicts Lehman's Sinai--"the upper end of historical averages," he notes.
Despite the relatively high cost of borrowing, many experts dismiss any notion of a global capital shortage. European and U.S. corporations are sitting on substantial cash hoards, and the developing world is gradually becoming less dependent on industrial nations for external financing. East Asian nations such as China have savings rates of about 30% of gross domestic product vs. about 19% in the major industrial countries. As developing nations such as Brazil, China, and Russia reduce inflation, the resulting drop in prices pushes up consumers' purchasing power--so that less capital is needed to generate the same output. Lower inflation also strengthens these countries' currencies, boosting local savings and prompting wealthier investors to reimport "flight capital" from safe havens such as the U.S.
Indeed, what distinguishes the current global recovery from past expansions is the remarkably unhindered flow of investment funds circling the globe in search of the best return. Investors are putting together deals that would have been unthinkable just a few years ago. Some examples:
-- Bankers are lending to borrowers that haven't achieved investment-grade status by tying the financing to specific projects or revenue sources. In June, for instance, Salomon Brothers Inc. raised $50 million for Aeromexico in a private placement of five-year bonds se-curitized by the Mexican airline's dollar-denominated ticket receivables. Similarly, in July, the National Commercial Bank (Jamaica) Ltd. borrowed $65 million in a debt issue backed by credit-card receivables.
-- The mutual-fund industry, that bastion of democratized capital, is planting flags in previously untapped markets. On Sept. 15, Franklin Resources Inc. launched the $98 million Templeton Vietnam Opportunities Fund Inc.--the fourth Vietnam fund now trading. Combined, investors have pumped more than $240 million into a country that still doesn't have an organized stock exchange.
-- With the help of experienced capitalists, new free-market economies are rapidly developing their own capital markets. In a room near Moscow's Gorky Park, traders gather for two hours each day to buy and sell three- and six-month Russian securities auctioned by the government--already a $2.75 billion market. Buoyed by the success of these auctions and by the nation's recent progress in taming hyperinflation, the Russian central bank will soon begin selling one-year bills out of its regional offices at preset prices.
Worldwide, the pool of funds racing around the globe is growing. Around $1.5 trillion is now held in dedicated international-equity portfolios. A further $50 billion to $100 billion resides in discretionary accounts run by hedge-fund managers who just this year jumped in and out of such volatile investments as Chinese government bonds, Brazilian coffee futures, and Turkish stocks.
Even U.S. and European pension funds, traditionally cautious investors, are eyeing exotic shores. Overseas opportunities are expected to play a growing role in meeting their steep funding obligations in coming years as returns from developing-country investments surpass those closer to home. John Webster, a partner at consultant Greenwich Associates, expects U.S. pension managers to boost their share of foreign assets from 8% to 12% by 1996.
Likewise, insurance funds' interest in international investing should increase as more developing nations secure "investment-grade" status from at least half of the four major U.S. rating agencies, a requirement set by the National Association of Insurance Commissioners. John F.H. Purcell, Salomon's managing director of emerging markets research, predicts that Mexico, India, and Hungary could all secure investment-grade ratings from two agencies as soon as next year, which will attract new investors. "As soon as the NAIC restrictions are lifted in more countries, insurance companies are going to become big players in developing markets," predicts Purcell.
If the competition for capital proves too rough despite these new sources of funds, governments may be largely to blame. Years of profligate public spending in the major economies, together with declines in private savings rates, have driven government debt levels to historic highs. Yet there are few signs that nations' borrowing needs will diminish significantly, even if the global boom increases tax revenues. The rigid social mandates of most Western European governments should conspire to keep the 1995 deficits for the Continent at a stubbornly high 5% of gross domestic product, vs. 1.8% in the U.S.
Those high deficits are already creating anxiety in the markets. Interest-rate spreads on 10-year bonds issued by highly rated countries, such as Germany, and lower-rated ones, such as Italy, have widened to more than 4.5 percentage points. European governments have begun delaying debt issues and pushing back funding schedules; Germany and Spain, for instance, shelved bond issues this summer. That only heightens the likelihood of a logjam next year, when corporate borrowing is expected to pick up. Some European financiers are even beginning to fret that higher rates could cut short the Continent's nascent expansion. "I think we can sustain recovery with real interest rates in the ranges they are today, but not much more," says Andre Levy-Lang, management board chairman at Compagnie Financire de Paribas, one of France's largest investment banks.
Of course, the scramble for capital spells opportunity for Levy-Lang and other money merchants, who are working overtime to satisfy the global demand. The current wave is bringing many developing-nation borrowers back into the markets for the first time in years. The governments of Hungary, India, and the Czech Republic all recently returned to the Eurobond market for the first time since 1989, and South Africa is preparing its reentry. "There seems to be more willingness to take speculative-grade debt in the Eurobond market," says George Dallas, managing director of Standard & Poor's Corp.'s European operations.
Bankers are also taking imaginative risks with developing nations that don't qualify as borrowers based on traditional standards. Financing techniques that were once confined to industrialized nations, such as securitizations and asset-backed financings, are increasingly becoming de rigueur elsewhere. For example, the Hungarian government recently signed a $350 million contract with a French-led foreign investment group to build the largest toll-road project in Eastern Europe.
Another trend is taking shape in countries with new or small stock markets. With foreign funds sometimes overwhelming the equity markets of developing nations--witness Latin America last year--investors are seeking stakes in private companies that may go public in the future. In Eastern Europe, where the equity markets remain small and illiquid, several firms are launching venture-capital funds to hunt for unlisted small and midsize companies. After establishing the first--and only--Polish mutual fund, Boston-based Pioneer Group Inc. is organizing a $50 million institutional venture fund designed to take private stakes in companies in Poland.
Likewise, Central Europe Trust, a London-based advisory firm, aims to raise up to $200 million for a family of development capital funds that will target small companies in Poland, Hungary, the Czech Republic, and Slovakia. "We want to avoid overpriced stocks that are at the mercy of the wall of money from huge Western investment houses," says Tom Lampl, managing director of Central Europe Trust.
Still, the need among developing nations for infrastructure, from ports to power plants, is immense: Some estimates put the total tab for the next decade at $1 trillion. That could overwhelm the bond markets, particularly for countries that are years from reaching investment-grade status. "You can't pay for a power plant with the seven- or eight-year financing most banks offer," says Anthony R.H. Bottrill, deputy managing director of the Washington-based Institute of International Finance.
BENCHMARK. So financiers must find ways to help developing nations build bond markets that stretch maturities. The World Bank recently provided an unusual "put option" that guarantees investors the full return of principal at maturity of a 15-year bond issued by a Philippine utility, National Power Corp. With this guarantee in hand, Morgan Stanley & Co. and Salomon Brothers was able to raise $100 million at a rate close to that of another National Power obligation, a 10-year note backed by the Philippine government. "You establish a benchmark so markets can start making their own judgments," says Gary L. Perlin, the World Bank's director of financial-sector development.
The pace at which capitalism has rolled through developing economies is breathtaking. It's easy to forget that as recently as a decade ago, only 1 billion of the world's citizens were playing by capitalist rules. Today, three times that number have been brought into the game. No wonder there's an unprecedented demand for money. But with optimism spreading about the prospects for the global economy and creative solutions taking hold for overcoming investment barriers, lenders and borrowers from London to Lima are finding that they can do business with each other.
AS WORLD ECONOMIES RECOVER... Annual GDP growth rates, in percent 1993 1994* 1995* EUROPE -0.5% 2.7% 2.7% U.S. 3.0 2.6 3.1 JAPAN 0.1 0.8 1.1 NON-JAPAN ASIA NA 10.7 8.8 LATIN AMERICA NA 12.8 12.6 DATA: MORGAN STANLEY & CO. *Estimates ...INTEREST RATES CREEP UP... Short- and long-term yields, in percent Maturity Sept. `94 Feb. '95* Sept. '95* U.S. 3-month 4.89% 5.50% 6.00% 10-year 7.23 8.00 7.75 BRITAIN 3-month 5.38 5.90 6.40 10-year 8.51 8.40 8.50 GERMANY 3-month 4.93 4.60 4.60 10-year 7.05 6.90 7.00 JAPAN 3-month 2.34 2.70 3.30 10-year 4.65 5.00 5.10 DATA: MERRILL LYNCH & CO. *Estimates ...EVEN WITH MODEST INFLATION Consumer prices, percent change 1993 1994* 1995* EUROPE 3.1% 3.0% 3.2% U.S. 3.0 2.7 3.2 JAPAN 1.3 0.6 0.7 DATA: CS ECONOMIC RESEARCH *Estimates