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Currently we have two separate crises the problems in the financial sector and the slowdown in the non-financial economy. The question most frequently asked by investors and businessmen trying to peer into the future is whether the worst of the financial crisis is behind us not if it is over, but if we are over the hump.
If that is the case, we can focus on the recession and how best to tackle it, and given that we have had recessions before this is not all that scary. But if there is a serious chance the financial crisis could erupt again into something even worse that prospect is altogether more frightening.
US Federal Reserve chairman Ben Bernanke was in London yesterday to deliver the Stamp memorial lecture at the London School of Economics. What he said in answer to a question afterwards has a bearing on this key question.
Confidence has been shattered by the financial meltdown, he said. He hopes that by late 2009 he implied by the third quarter we will see a stabilisation in financial markets that will allow them to begin to function more normally. Financial-market stability would help restore confidence worldwide.
So his message would seem to be that while we are not out of the financial woods yet, at least we seem to have found the path.
A guessing game for the regulator
Now that businesses are focused on survival, one hears a lot less about the cost of capital than was the case a year or so back. In those halcyon days, it was very much part of the shareholder-value mantra management had to deliver returns to its shareholders that were greater than the cost of capital and, as debt was generally cheaper than equity, part of creating value was to have an efficient balance sheet. And that meant loading up the business with as much debt as it could bear.
The availability of capital, not its cost, is the preoccupation now, but this is not true everywhere. Indeed, it has thrown up a potentially serious problem in highly-regulated sectors of the economy the water industry, for example, where the amount the business is allowed to charge for its services is calculated to give it a reasonable return over the weighted average cost of capital on its regulated asset base.
The problem taxing finance directors such as Severn Trent's Mike McKeon, and the industry regulator, is how to calculate the cost of capital when the capital market is as dislocated as it now is. The problem cannot be shelved because the industry has begun its five-yearly price-setting debate, with the verdict due in November.
So the discussions between regulator and industry, which will focus on the permitted rates of return on allowable investment, will be conducted in an atmosphere where no one knows what they are talking about or, to put that slightly less contentiously, where the central building-block of the business model is an unknown. If they don't know what capital costs, they cannot know what the rate of return will be.
In theory, the risk-free real rate of return as measured by long-term gilts should approximate to the economy's long-term growth rate, about 2.5%. Market disruption, and the distortions caused by pension funds and others ditching equities for bonds, mean it is currently significantly lower while spreads have become much wider. And that assumes a corporate can access to the market currently a preserve of the highest rated.
This has also made it harder to calculate the equity risk premium, so there is considerable debate about the true cost of a business's capital. And this is more than a semantic issue because water-company investment is very much driven by Government, with obligations of quality, leakage and security of supply very much imposed as a condition of keeping their licence.
These obligations will not go away, and the industry will have to live for five years within the regime set as a result of the current negotiations. So if the chosen cost of capital is wrong, the industry has to live with the consequences near-bankruptcy if too penal or a shareholder bonanza if too generous. Pity the poor regulator, who somehow must decide next autumn where rates are then, and where they are likely to go thereafter.
