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December 29, 2011, Thursday

Will debt eclipse equity by 2020?

Debt versus equity financing is a major question facing companies. Debt versus equity investing, on the other hand, is a major question facing savers. Companies in their financing and savers in their investing face several advantages and disadvantages of debt and equity as the two basic alternative sources and destinations of financial capital. The advantages and disadvantages depend on company and investor characteristics as well as capital market conditions.

In developed economies (DEs), relative to emerging economies (EEs), equity is dominant over debt due to the more sophisticated equity markets. DEs not only grow more slowly than EEs, but also have older populations. Global wealth has been shifting toward EEs, where most financial assets are kept in bank deposits, reflecting underdeveloped capital markets that limit portfolio diversification. Older investors, especially retirees, in DEs prefer, compared to younger ones, investing in debt to equity. Even the younger investors have been losing their appetite for equities due to last decade's volatile equity prices and poor equity returns, frequent corporate and financial scandals, transition from defined-benefit to defined-contribution retirement plans and the growing interest of institutional and wealthy individual investors, seeking higher returns, in alternative assets. If these trends persist, equities will likely play a smaller future role in global capital markets. This raises questions about not only how cheaply and readily companies will fund themselves and how closely and regularly investors will hit their targets but also how rapid and sustained economic growth will be.

Against this background, the McKinsey Global Institute (MGI), the business and economics research unit of consulting firm McKinsey & Company, published a timely 108-page report titled “The Emerging Equity Gap: Growth and Stability in the New Investor Landscape.” The MGI report defines financial assets as publicly listed equities, corporate and government bonds, other fixed-income securities and cash and bank deposits as well as alternative assets, such as hedge funds and private equity funds. According to the report, in 2010 global financial assets totaled $198 trillion, with EEs accounting for 21 percent of the total, up from 7 percent in 2000. Among EEs, China was dominant, accounting for 10 percent of global financial assets, up from 3 percent in 2000. It was also the world's third-largest owner of financial assets after the US and Japan. Of the global financial assets 28 percent were invested in equities in 2010. Only 15 percent of the EE household portfolios were invested in equities, compared to 42 percent in the US, which accounted for almost a third of global financial assets.

The MGI report forecasts in its base case scenario, making several debatable assumptions, that global financial assets will increase to $371 trillion in 2020, with the EEs' share jumping to at least 30 percent, but the share of global financial assets invested in equities falling to 22 percent. Given our inability to forecast precisely even very short-term financial events, we should be skeptical about the report's overly precise numerical projections for 2020, regarding them as merely indicative.

The report projects, using a sample of 10 DEs and eight EEs (including Turkey), an “equity gap” (the difference between the incremental amount of equities companies will want to supply, $37.4 trillion, and the incremental amount investors will wish to demand, $ 25.1 trillion) of $12.3 trillion, located mostly in EEs, by 2020. Of course, such a gap, which the report claims would disappear only by the tripling of demand for equities in EEs, is notional since actual supply would equal actual demand. Then investors would receive a rising risk premium for equities through lower equity prices or higher dividend yields. That would mean for companies higher cost of equity, shifting the balance from equity to debt, owed to either banks or capital markets. The greater leverage, as was the case in the recent global financial crisis, could be highly destabilizing. Economic growth that relies more heavily on debt financing might be slower and less stable.

The MGI report forecasts that in Turkey the ratio of total financial assets to gross domestic product (GDP) will rise from 75 percent to 89 percent between 2010 and 2020, with the ratio of total stock market capitalization to GDP rising from 42 percent to 50 percent. With the increase in equity required by companies at $0.6 trillion but the increase in investor demand for equities at $0.4 trillion, Turkey is forecast to face an “equity gap” of $0.2 trillion. The report suggests that Turkey, like other EEs, can help close this gap by making its equity markets more accessible and attractive to foreign investors, who would have to overcome their home bias.

Higher incomes by themselves will not foster a vigorous equity investing culture among Turkish investors. To make equity investing safer, more transparent and accessible, the government, besides incentivizing Turks to save more, must strengthen the legal and regulatory institutions and infrastructure, backed by more vigilant oversight to prevent equity market abuses and corporate fraud. That should be an essential part of realizing Turkey's financial development potential, the subject of my last column.

I wish all my readers a prosperous new year.

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