chapter  11
17 Pages

Anti- inflationary policy and financial fragility: a microeconomic analysis case study of Mexico, 1990–2004

ByIGNACIO PERROTINI - HERNÁNDEZ ,

Given the term structure of interest rates, rl, . . . rn, the supply price of capital investment will be:

(11.2)

Where Ki and Yi denote capital and income flows in period i respectively. Assuming Q1 = Q2 = . . . = Qn, the capitalisation rate can be expressed as:

(11.3)

where expected returns (Qn) are determined by the future price of produced goods, the volume of sales, input costs and firms’ financial costs. Minsky uses Keynes’s (1936) concept of capitalisation of investment returns to determine the demand price of capital assets (PKi), which depends on the parameter of capitalisation of quasi-rents (bi)

(11.4)

The rate of capitalisation crucially depends on the monetary and financial conditions of the economy, that is, on the capitalisation rate of the loan borrowed to finance investment. Therefore, the price of liabilities, determined in the debt market, bear an influence on that of capital assets. Thus, the rate of capitalisation of Qn also depends on the level of uncertainty prevailing in financial markets. Then, ‘the capitalisation rate of capital assets is some ratio, 0 < μ < 1, of the capitalisation rate of money loans’ (Minsky, 1975: 102). Let μ denote financial uncertainty and bL the capitalisation rate of the bank loan or the financial liability of firms, then:

(11.5)

and

(11.6)

The rate of capitalisation of quasi-rents depends on the performance of the financial market, whereas the capitalisation rate of the loan used to finance investment hinges on the central bank’s monetary policy (the money supply). Since firms

get loans in order to finance capital asset positions, the rate of interest becomes a key variable in the process of capitalisation of Qn. In sum, there is a negative relationship between the monetary rate of interest and b. Hence the effect of monetary policy on investment through the effect of the interest rate on the parameter of capitalisation:

(11.7)

Equation (11.5) is an unstable function – this is a ‘fundamental fact’ (Minsky, 1975) – because the monetary and financial conditions of the economy may affect Pki through the effect of the interest rate on expected quasi-rents. The central bank can affect the balance sheet of those firms that have been undertaking debt in the credit markets with the aim of financing fixed capital asset positions. The relationship between r and bi depends on the market assessment of the probability distribution of actually getting a certain and assured stream of income flows, Qi, vis-à-vis the probability of getting it at a fluctuating market rate of return, Qn, plagued by uncertainty. Investment, then, is determined by the discrepancy between the demand price and the supply price, while the adjustment process induces instability. As for the financial structure approach, Minsky (1982) focuses on the methods used by enterprises to finance investment. Potential sources are: (1) cash and financial assets, (2) internal finance (after-tax and dividends profits) and (3) external finance (loans and equity issuance). Investors consider these different methods of finance and must include the financial cost of capital,1 apart from wage and input costs, in the supply price of produced goods. Investors are bound to forecast their future income streams and the specific conditions which will prevail in the financial markets, as fixed capital investment is a long-term action, while the means available to finance investment positions are short term in nature. Minsky’s financial fragility hypothesis states that there exists an inherent tendency for the economy to become financially fragile as a result of the negative influence of financial variables on firms’ capital structure throughout the business cycle. He then goes on to establish a taxonomy of financial structures according to firms’ balance sheets in terms of flows of income and liabilities and debt payments. Thus, income sources, revenue flows from operations plus new debt (D), equal expenditure streams – investment (I ) plus payment commitments on debt (V ):

(11.8)

If R < 0, the firm will face a loss; if D < 0, the firm will be repaying its debt, and V < 0 makes the firm a net creditor. The net wealth of a firm (W) is measured as:

(11.9)

where A denotes total assets and B is the value of its outstanding debt. W increases when investment is increased and/or debt gets reduced. A firm becomes

insolvent and goes bankrupt when W ≤ 0 and its creditors are unable to rescue the capital involved in the unit. A firm is said to hold hedge finance when its cash income flows from operation are expected to be larger than its payment commitments on debts. A hedge firm can be troubled whenever R gets reduced during downswing periods and/ or V increases in a credit crisis. A firm can be characterised as speculative if R ≥ V and R < V + I, which implies D ≥ 0, though D < I. Typically, speculative firms run financial deficits during expansion periods when they engage in investment opportunities that exceed their internal financial capacity. In this case W increases, and the rate of return on investment determines whether a speculative unit survives or goes out of business. In addition, Minsky defines as Ponzi finance a firm that meets its cash payment commitments on debt by augmenting the amount of debt outstanding. In this situation, R < V and D > I. While the credit profile of a Ponzi unit depends on its ability to persuade creditors that its income streams will increase in the near future, the increment in the outstanding debt will make it harder for the former to find voluntary lenders. By and large, business enterprises depend on expectations about future interest rates and financial market conditions. The latter can force hedge firms alternatively into speculative and Ponzi financing. Unless effective demand (sales) rises and/or the interest rate falls, the probability of a firm falling into Ponzi financing will arise.2 The financial structure of firms changes along the business cycle, usually from hedge to Ponzi finance; hence macroeconomic instability. Foley (2003), following Minsky, suggests a typology in terms of the growth rate of firms’ assets (A) and liabilities (B) and the rate of returns on assets: g = I/A is the growth rate of assets, r* = R/A is the rate of return and i* = V/B is the interest payments to debt ratio. A particular combination of i*, r* and g sets the stage for financial fragility of firms (see Table 11.1). The modus operandi of financial fragility can be summarised as follows (cf. Minsky, 1982, 1986; Wolfson, 1989):

1 Expected returns (0E) depend on expected income flows of sales, which in turn depend on effective demand. The actual flow of returns (0R) validate the amount of outstanding debt securities. 0E induces fluctuations in the rate of capital investment.