LIVING IN UNCERTAIN TIMES

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By Howard Kung

People across the decades have perhaps believed themselves to be living in an age of uncertainty, yet such a label would seem to attach itself naturally to the period through which we are passing.
Geopolitical storm clouds, not least in revived East-West tension, combined with the long shadow cast by the financial crisis create a gloomy outlook.

Uncertainty has significant effects on corporate investment, which, in turn, impacts on the level of economic growth. The more uncertain the future economic climate, the less willing firms are to put their capital at risk.

This topic is vast and can seem almost amorphous. To make the task seem less daunting let’s concentrate on the well-known macroeconomic effects of uncertainty through a microeconomic route. In other words, I will approach the question of the effects of uncertainty on corporate investment through a narrow, but revealing, prism.

The redeployability of assets

How easily would a company, having invested in assets such as machinery equipment, be able to sell them to another firm should an external shock force them to do so? And should it sell to a firm in the same line of business as the vendor or a quite different sector?

You may expect that a business able to buy and sell assets with ease may be more willing to invest in such assets than one likely to invest in less liquid and less redeployable assets. These are indeed my findings. And the redeployability of a firm’s assets has widespread implications beyond the immediate investment decision to include the capital structure of the business in question.

More of that in a moment.

First, let’s have a look at the secondary market for corporate assets. In aggregate, this market is worth more than US$100 billion in a typical year. This market performs a number of valuable functions, allowing idle plant and other equipment to be reactivated, to general economic benefit. For instance, providing a lower-cost route through which expanding companies can acquire the assets they need, and improving the creditors’ returns of insolvent businesses.

But while this is an active market, not all industries are equal in terms of finding ready buyers for surplus assets. Far from it.

Using data from the Bureau of Economic Analysis and the Compustat database, I have identified the 10 manufacturing industries with the most redeployable assets – and importantly, the 10 whose assets are the least redeployable.

What the results boil down to is the relative ease with which an investment decision can be reversed. When we talk about this reversibility in terms of the stock market, we refer to it as liquidity. The principle is the same here. As with a company share, we question the likelihood that an investment decision can reach something close to the original purchase price.

The difference between the purchase price and the resale price – otherwise known as a wedge between purchase and liquidation values – is a key measure of investment irreversibility.

Such irreversibility would not normally be a barrier to investment, otherwise the assets in some of the industrial locations, such as textile mills and aerospace plants, would long since have worn out. We should instead focus on the combined effect of this illiquidity in periods of heightened uncertainty.

The real impact of uncertain times

In a moment, we’ll look at two specific such periods, the 1990–1991 First Gulf War, which followed Iraq’s invasion of Kuwait, and the terrorist attacks on New York and Washington in September 2001. But first, a general outline of the interaction between low redeployability of assets and heightened uncertainty.

Costly capital reversibility creates a direct incentive for firms to delay investment at a time of uncertainty because of its possible impact. Irreversibility tend to cause lower resale values, thus selling those assets offers less protection against negative outcomes than if the assets were more easily redeployable.

So, even when expected investment opportunities remain unchanged, an increase in uncertainty regarding the likely pay-off from investments is likely to lead to more firms whose assets are not easily redeployable, delaying investment decisions.

Put another way, because these firms’ assets offer fewer safeguards against possible economic shocks, the irreversible firms are, in effect, buying extra protection by delaying investment decisions.

Focusing specifically on the First Gulf War and the events of September 2001, I found that, perhaps not surprisingly, there was a marked increase in uncertainty regarding the outlook for consumer demand and, consequently, for the profitability needed to make new investments viable.

In both cases, I found a direct relationship between the redeployability of assets and the subsequent levels of capital expenditure. Investment levels went down in both the First Gulf War and September 11 case studies among those firms with the least redeployable assets, relative to those with the most easily reversible assets.

The ability to redeploy assets is also, as mentioned earlier, an influence on the capital structure of businesses. Assets that are relatively easy to redeploy offer protection not only to the company concerned, but also to its creditors. This expresses itself in two ways.

1. The creditors of a business rich in reversible assets will tend to feel happier about waiting to be repaid. Debt maturities for such businesses tend to be longer

2. This protection tends to make creditors more willing to extend generous credit lines than would have been the case with a firm with irreversible assets.

To sum up, heightened uncertainty has a disproportionate effect on the investment plans of firms whose assets can less easily be redeployed to another business, thus could be expected to find a ready market. In general, the more specialised the assets concerned – such as the machinery used in the manufacturing industry – the harder they are to redeploy.

As a reminder, the secondary market for corporate assets is a narrow prism through which to view the huge topic of the effect of uncertainty on business and the economy. But my findings support the argument of policymakers and academics that uncertainty has a negative impact. It can significantly reduce investment in the sectors whose assets are hardest to redeploy, and this effect, in turn, will ultimately reduce the rate of economic growth.

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