Interest rates likely to go up in next 5 years: McKinsey study

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Business Times - 10 Dec 2010

Interest rates likely to go up in next 5 years: McKinsey study


This is due to higher investment demand and lower savings

By TEH SHI NING

(SINGAPORE) A surge in global investment demand fuelled by rapid emerging markets growth could drive interest rates upwards within the next five years, says a study by McKinsey Global Institute (MGI) released yesterday.

The infrastructure investment boom in Asia, Latin America and Africa is unlikely to be matched by an increase in global savings, as ageing populations run down savings and China rebalances and trims its savings rate.

Greater demand for capital to invest, set against a limited supply of capital from savings, will push real long-term interest rates up, possibly within the next five years as investors start to price in this longer-term shift, the report says.

But significant change will kick in by 2020, which is when MGI's researchers expect global investment demand to hit levels not seen since the post-war rebuilding of Europe and Japan.

And by 2030, they expect investment demand to surge past 25 per cent of global GDP, compared to the recent 2008 high of 23.7 per cent. Based on consensus forecasts of global growth, this means a more-than-doubled global investment of US$24 trillion in two decades' time, from just US$11 trillion today.

While the report sets no forecast on how high the cost of capital could rise in coming years, a return to the 40-year average would mean a 1.5 percentage point hike in real long-term interest rates (such as the real yield on a 10-year bond).

MGI thinks that real interest rates could 'easily surpass' this long-term average as the world adjusts to soaring investment needs. Real interest rates reflect not just the borrowing costs but also the risk premium on inflation, a premium on the rise today as loose monetary policy breeds uncertainty over future inflation, it says.

Central to the report is its observation that the 'global saving glut', said to have sent interest rates falling over the past three decades, was not caused by a hike in the world's savings rate, which in fact tumbled from 1970 through to 2002.

Instead, it resulted more from falling capital demand as global investment rates sank after post-war rebuilding and in line with slower global GDP growth.

It explains why upward pressure on interest rates is expected soon, with the global savings rate set to fall and investment demand now on a sharp upswing.

The mix of this surge in global investment demand will shift as the emerging markets grow.

MGI projects investment in infrastructure and residential real estate to come to about US$4 trillion and US$5 trillion respectively and US$15 trillion in other productive assets in 2030, should global growth stick to consensus forecasts.

Businesses, financial institutions, consumers, investors and government policymakers will all have to 'adapt to a world in which capital is more costly and less plentiful, and in which more than half the world's savings and investment occurs in emerging markets', says MGI, the business and economics research arm of consulting firm McKinsey.

Costlier capital will mean that companies need to recognise that higher output per dollar invested and having access to direct financing give them a competitive advantage over rivals. Large companies may increasingly raise funds in debt markets, as they are less costly than bank loans, while more mid-sized ones may too seek access to capital markets.

Higher real interest rates could make commercial and retail banking, overshadowed in recent years, more attractive to financial institutions, while investors could in the longer run shift from equities and alternative investments back to fixed-income instruments and deposits.

Rising interest rates mean short-run losses for bondholders, but in the long term still generate better returns from fixed income investments than during the years of cheap capital, the report says.

MGI's researchers also suggest that governments of mature economies rebalance and find ways to promote savings and domestic investment while reducing reliance on consumption. Governments of emerging markets, meanwhile, ought to deepen and stabilise financial markets to channel funds into productive investments, they say.

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