Monday, March 16, 2020

Economic crisis? How about ‘equity mate’?

During 2009 farmers were paid $61million per month in drought assistance as part of Exceptional Circumstances Subsidies. But the public got nothing for it.

I have often said that public subsidies, even in a crisis, should always come with obligations. The simplest of all is to make the subsidy an asset swap rather than a gift—provide the cash, but take an equity stake in exchange, diluting ownership. This 'equity mate' public policy can help ensure the continuity of productive capacity during crisis periods.

Central banks provide liquidity via asset swaps to financial institutions in exceptional times. 'Equity mate' is just a way to provide cash via asset swaps to the companies that do the actual production in the economy. 

But in practice, this is not easy.

In a crisis, the value of equity falls. By taking a new equity stake when the value is low, you are providing much less cash per share while diluting an already lower equity value.

How this could work in practice is to have a “standing facility” whereby a rule about the value of equity the Treasury or Central Bank would pay is set in advance, and businesses can choose to use it up to a maximum share, of say 10% of the business value. As an example the rule could be:

For listed companies, equity comes at a price of the lower of—
  1. The middle of the price range of the two prior years, or
  2. The middle of the price range of the prior year, or
  3. The current price plus 15%.
For unlisted businesses, equity comes at a price of—
  1. The average of the marked-to-market balance sheet from the two prior years.
These rules would have to be broadly considered, but you get the idea. When equity values are rising, the price paid would be too low compared to the option of expanding cash for investment by issuing equity to private investors. Only during downturns would this kick in, when sudden declines in economic activity spook the market as a whole. Having this option in place might also dampen selling during a crisis, just like the government guarantee on bank deposits deters bank runs. 

This ‘equity mate’ injection of funds is a way to provide liquidity insurance to our productive enterprises without massively changing their incentives. A problem with drought assistance, for example, is that the expectation of future subsidies gets capitalised into the value of farmland. The insurance is free, and the incentives to invest in a way to mitigate loses from predictable rain variation are reduced. 

Buying up the nation's companies in a downturn is also just a smart investment. Buy low, sell high, make money. In the 2008-09 financial crisis, the Reserve Bank of Australia used counter-cyclical investment in currency to stabilise the dollar. It bought a lot of AUD using its USD reserves when the AUD fell to below USD0.60. In the following years, the AUD increase to above USD1, making a large profit for the Bank, which is an income for the public sector. Like this example, counter-cyclical purchases of a small public stake in a wide range of companies will provide future public revenues. 

What are your thoughts?

1 comment:

  1. Great idea Cameron, but as long as the company/farm can buy the equity back at the same price, why not just use the current market value? That way, if the value never does recover (such as climate change progressively making some farms unviable), then the government hasn't lost so much. Effectively we purchase stranded assets so people can walk away, but we don't purchase them at their pre-crisis value. The longer they choose to stick it out, losing money, the less they'll get for it. If it is a temporary crisis, they can buy back the equity. Presumably, the company would have to pay some sort of dividend if they make a profit while holding an equity loan, so there'd be an incentive to pay/buy it back. But that's a much more relaxed criterion than bank interest, which takes priority over other expenses. How would that work?

    ReplyDelete