Internal Rate of Return: A Cautionary Tale

Tempted by a project with high internal rates of return? Better check those interim cash flows again.
The McKinsey Quarterly
McKinsey & Co.
October 20, 2004

Maybe finance managers just enjoy living on the edge. What else would explain their weakness for using the internal rate of return (IRR) to assess capital projects? For decades, finance textbooks and academics have warned that typical IRR calculations build in reinvestment assumptions that make bad projects look better and good ones look great. Yet as recently as 1999, academic research found that three-quarters of CFOs always or almost always use IRR when evaluating capital projects. (John Robert Graham and Campbell R. Harvey, "The Theory and Practice of Corporate Finance: Evidence from the Field," Duke University working paper presented at the 2001 annual meeting of the American Finance Association, New Orleans.)

Our own research underlined this proclivity to risky behavior. In an informal survey of 30 executives at corporations, hedge funds, and venture capital firms, we found only 6 who were fully aware of IRR's most critical deficiencies. Our next surprise came when we reanalyzed some two dozen actual investments that one company made on the basis of attractive internal rates of return. If the IRR calculated to justify these investment decisions had been corrected for the measure's natural flaws, management's prioritization of its projects, as well as its view of their overall attractiveness, would have changed considerably.

So why do finance pros continue to do what they know they shouldn't? IRR does have its allure, offering what seems to be a straightforward comparison of, say, the 30 percent annual return of a specific project with the 8 or 18 percent rate that most people pay on their car loans or credit cards. That ease of comparison seems to outweigh what most managers view as largely technical deficiencies that create immaterial distortions in relatively isolated circumstances.

Admittedly, some of the measure's deficiencies are technical, even arcane, but the most dangerous problems with IRR are neither isolated nor immaterial, and they can have serious implications for capital budget managers. When managers decide to finance only the projects with the highest IRRs, they may be looking at the most distorted calculations — and thereby destroying shareholder value by selecting the wrong projects altogether. Companies also risk creating unrealistic expectations for themselves and for shareholders, potentially confusing investor communications and inflating managerial rewards. (As a result of an arcane mathematical problem, IRR can generate two very different values for the same project when future cash flows switch from negative to positive (or positive to negative). Also, since IRR is expressed as a percentage, it can make small projects appear more attractive than large ones, even though large projects with lower IRRs can be more attractive on an NPV basis than smaller projects with higher IRRs.) 

We believe that managers must either avoid using IRR entirely or at least make adjustments for the measure's most dangerous assumption: that interim cash flows will be reinvested at the same high rates of return.

The Trouble with IRR 
Practitioners often interpret internal rate of return as the annual equivalent return on a given investment; this easy analogy is the source of its intuitive appeal. But in fact, IRR is a true indication of a project's annual return on investment only when the project generates no interim cash flows — or when those interim cash flows really can be invested at the actual IRR.

When the calculated IRR is higher than the true reinvestment rate for interim cash flows, the measure will overestimate — sometimes very significantly — the annual equivalent return from the project. The formula assumes that the company has additional projects, with equally attractive prospects, in which to invest the interim cash flows. In this case, the calculation implicitly takes credit for these additional projects. Calculations of net present value (NPV), by contrast, generally assume only that a company can earn its cost of capital on interim cash flows, leaving any future incremental project value with those future projects.

IRR's assumptions about reinvestment can lead to major capital budget distortions. Consider a hypothetical assessment of two different, mutually exclusive projects, A and B, with identical cash flows, risk levels, and durations — as well as identical IRR values of 41 percent. Using IRR as the decision yardstick, an executive would feel confidence in being indifferent toward choosing between the two projects. However, it would be a mistake to select either project without examining the relevant reinvestment rate for interim cash flows. Suppose that Project B's interim cash flows could be redeployed only at a typical 8 percent cost of capital, while Project A's cash flows could be invested in an attractive follow-on project expected to generate a 41 percent annual return. In that case, Project A is unambiguously preferable.

Even if the interim cash flows really could be reinvested at the IRR, very few practitioners would argue that the value of future investments should be commingled with the value of the project being evaluated. Most practitioners would agree that a company's cost of capital — by definition, the return available elsewhere to its shareholders on a similarly risky investment — is a clearer and more logical rate to assume for reinvestments of interim project cash flows.

When the cost of capital is used, a project's true annual equivalent yield can fall significantly — again, especially so with projects that posted high initial IRRs. Of course, when executives review projects with IRRs that are close to a company's cost of capital, the IRR is less distorted by the reinvestment-rate assumption. But when they evaluate projects that claim IRRs of 10 percent or more above their company's cost of capital, these may well be significantly distorted. Ironically, unadjusted IRRs are particularly treacherous because the reinvestment-rate distortion is most egregious precisely when managers tend to think their projects are most attractive. And since this amplification is not felt evenly across all projects, managers can't simply correct for it by adjusting every IRR by a standard amount. (The amplification effect grows as a project's fundamental health improves, as measured by NPV, and it varies depending on the unique timing of a project's cash flows.)

How large is the potential impact of a flawed reinvestment-rate assumption? Managers at one large industrial company approved 23 major capital projects over five years on the basis of IRRs that averaged 77 percent. Recently, however, when we conducted an analysis with the reinvestment rate adjusted to the company's cost of capital, the true average return fell to just 16 percent. The order of the most attractive projects also changed considerably. The top-ranked project based on IRR dropped to the tenth-most-attractive project. Most striking, the company's highest-rated projects — showing IRRs of 800, 150, and 130 percent — dropped to just 15, 23, and 22 percent, respectively, once a realistic reinvestment rate was considered. Unfortunately, these investment decisions had already been made. Of course, IRRs this extreme are somewhat unusual. Yet even if a project's IRR drops from 25 percent to 15 percent, the impact is considerable.

What to Do? 
The most straightforward way to avoid problems with IRR is to avoid it altogether. Yet given its widespread use, it is unlikely to be replaced easily. Executives should at the very least use a modified internal rate of return. While not perfect, MIRR at least allows users to set more realistic interim reinvestment rates and therefore to calculate a true annual equivalent yield. Even then, we recommend that all executives who review projects claiming an attractive IRR should ask the following two questions. 

1. What are the assumed interim-reinvestment rates? In the vast majority of cases, an assumption that interim flows can be reinvested at high rates is at best overoptimistic and at worst flat wrong. Particularly when sponsors sell their projects as "unique" or "the opportunity of a lifetime," another opportunity of similar attractiveness probably does not exist; thus interim flows won't be reinvested at sufficiently high rates. For this reason, the best assumption — and one used by a proper discounted cash-flow analysis — is that interim flows can be reinvested at the company's cost of capital. 

2. Are interim cash flows biased toward the start or the end of the project? Unless the interim reinvestment rate is correct (in other words, a true reinvestment rate rather than the calculated IRR), the IRR distortion will be greater when interim cash flows occur sooner. This concept may seem counterintuitive, since typically we would prefer to have cash sooner rather than later. The simple reason for the problem is that the gap between the actual reinvestment rate and the assumed IRR exists for a longer period of time, so the impact of the distortion accumulates. (Interestingly, given two projects with identical IRRs, a project with a single "bullet" cash flow at the end of the investment period would be preferable to a project with interim cash flows. The reason: a lack of interim cash flows completely immunizes a project from the reinvestment-rate risk.)

Despite flaws that can lead to poor investment decisions, IRR will likely continue to be used widely during capital-budgeting discussions because of its strong intuitive appeal. Executives should at least cast a skeptical eye at IRR measures before making investment decisions.

The authors, John C. Kelleher and Justin J. MacCormack, are consultants in McKinsey's Toronto office. They wish to thank Rob McNish for his assistance in developing this article.


Global oil industry in figures

Oil industry images

The importance of oil to global economies has been brought into focus as prices reach $100 a barrel.

Follow the links for a snapshot of the industry and how reserves, consumption and trade differ around the world.


reserves graph

The Middle East remains the biggest player in oil.

The region dwarfs the rest of the world, when it comes to reserves, ensuring its prominence on the global political stage. Saudi Arabia alone possesses 21.9% of the world's proved reserves.

The North Sea and Canada still have substantial reserves.

No-one knows how long the world's oil reserves will last, but even the oil industry suspects the world "peak" is now approaching.

It says it has 40 years of proven reserves at the moment - but it also said that 30 years ago.

In fact, the estimate has actually increased in recent years as production has fallen. Cutting consumption would prolong oil's life.


daily consumption graph

Demand is at an all-time high, fuelled by the continued economic expansion of the economies of China and India.

China overtook Japan as the world's second-largest consumer of oil in 2003 and is closing in on the US, with demand for oil growing at about 15% a year.

Western Europe and Japan are heavily dependent on oil imports as production cannot meet massive domestic demand.

The gas-guzzling US is the world's largest per-capita oil consumer but produces much of its requirements itself.

Producers in the Middle East, where oil costs so little, are also heavy users. Poorer countries consume much less per head.

Consumption per capita graph


trade flows graph

The Middle East is the biggest oil producer, currently providing nearly one-third of the world's total.

Europe and Eurasia (mainly Russia and the UK) and North America are also big producers. The difference is, nearly all the Middle East oil is for export while Europe and the US do not produce enough to meet their own needs.

bar chart shows petrol pump prices
The weaker dollar has been driving up oil prices as investors have been using the commodity as an alternative to holding dollars.

Oil prices nearly doubled in value during 2007, but prices have still not reached a record high if inflation is taken into account.

Adjusting for inflation, US light crude's record peak of $101.70 came in 1980 against a backdrop of war between Iraq and Iran.


‘This is truly a mess, a very big one’

KUALA LUMPUR, Aug 28 — A grand alliance between two of Southeast Asia's wealthiest tycoons, Malaysian T. Ananda Krishnan and Indonesian James Riady, has collapsed into an acrimonious face-off that could lock their businesses in a bitter legal battle.

In Indonesia, a joint venture into a pay-TV business has turned hostile. Allegations of embezzlement and fraud, including charges that unauthorised payments were made to an unnamed family member of former Malaysian premier Tun Dr Mahathir Mohamad, have been levelled.

Relations worsened to the point that at least three employees of Ananda's business units in Jakarta had to flee Indonesia for fear of arrest by the police.

In Singapore, the months-long feuding over how to manage property and hotel company Overseas Union Enterprise (OUE), which Ananda and Riady control jointly, has forced the two parties to the arbitration table to resolve differences.

A senior executive of Ananda's business empire, which includes the satellite TV network Astro and cellular phone company Maxis, admitted that the businessman's corporate alliance with the Riadys was in trouble. “The issues are being worked out, but we are also pursuing legal remedies,” said the executive who asked not to be named.

Riady, who owns the conglomerate Lippo Group, did not respond to queries.

A spokesman for Lippo in Singapore said the company could not comment as the dispute is in arbitration.

“This is truly a mess, a very big one,” said a chief executive of a Malaysian bank which has dealings with the two groups and is closely tracking the situation. “Both sides made wrong moves and the whole issue boils down to the loss of face. There are not going to be any winners here,” he added.

Loss of face aside, the collapse of the four-year business partnership shows how inter-regional corporate alliances are hard to forge in Southeast Asia because companies and governments are reluctant to yield their markets to outside competition.

When partnerships unravel or domestic political problems crop up, nationalistic sentiments are whipped up. In the process, foreign investors can often find themselves on the wrong side of the law, as Singapore groups like Temasek have discovered in their investments in the telecommunications sector in Indonesia and Thailand in recent years.

The following account of the crumbling business ties between Ananda and Riady is based on interviews with bankers, government officials and corporate executives in Singapore, Malaysia and Indonesia, who requested anonymity.

The partnership began in early 2005 when both groups agreed to set up a joint venture to operate a pay-TV business in Indonesia through a Lippo subsidiary, PT Direct Vision (PTDV). The subsidiary owned a multimedia licence awarded by the Indonesian government.

The pay-TV tie-up quickly led to other corporate pacts.

In April 2005, Ananda-controlled Maxis paid US$100 million (RM330 million) to acquire a controlling 51 per cent interest in Lippo's wholly owned cellular telephone company Natrindo.

But rolling out the pay-TV and cellular businesses was not easy in Indonesia's heavily regulated business environment.

The joint venture also came under resistance from other Indonesian telcos and pay-TV players that did not want competition from the new Riady-Ananda start-ups.

At the time, bankers say that Astro and Maxis executives would privately gripe that the Riadys, who wielded immense clout during the Suharto years, had lost their political muscle to get things done under the new regime.

“The view among the Malaysians was that the Riadys had not been able to ensure the status of the licences that they had obtained from the Indonesian authorities,” said a senior Malaysian banker familiar with the situation.

But that did not deter Ananda and Riady from forging new business tie-ups.

In May 2006, Ananda's privately-held holding company Usaha Tegas and Lippo paid S$1.8 billion (RM4.4 billion) to take control of Singapore's premier property and hotel company, OUE, from United Overseas Bank.

It was Ananda's first major investment in Singapore and at the time both parties trumpeted the acquisition of the highly prized OUE as a major corporate coup in the island's robust property sector.

In the meantime, Astro pushed ahead with building its pay-TV business through the Lippo-controlled PT Direct Vision despite numerous unresolved issues over the planned joint-venture agreement. Astro employees were seconded to head PTDV, which is currently ranked as Indonesia's second-largest pay-TV operator with 150,000 customers.

In April 2007, Ananda's Maxis bought out Lippo's remaining 44 per cent interest in Natrindo for US$124 million.

It would be a deal that would cause irreparable damage to the alliance.

Two months after concluding the buyout of Natrindo, Ananda entered into one of the region's biggest corporate transactions with Saudi Telecom, Saudi Arabia's largest telecommunications firm.

He sold a 25 per cent interest in Maxis and another 51 per cent in Natrindo for a whopping US$3.05 billion.

The deal stoked anger in the Riady camp. The Indonesians felt that Ananda had already lined up Saudi Telecom as a potential business partner before he concluded the deal to acquire Lippo's remaining interest in Natrindo and in the process deprived the Indonesian group the chance to profit from the Saudi deal.

“The Riadys felt it represented a huge loss of face,” said a Jakarta business consultant who knows the Lippo group well.

But Maxis executives say that negotiations with Saudi Telecom began only after the deal with Lippo was concluded.

Relations between the two partners deteriorated rapidly.

Lippo then informed Astro that it wanted a non-negotiable sum of US$250 million to sell its interest in PTDV, a demand which the Malaysian group rejected.

The OUE joint venture also began to unravel.

While both parties held roughly equal stakes in the company, close associates of Ananda claim that the Malaysians were deprived of any real sway in the company's management.

Within months, Astro and Maxis executives say that Ananda's operations came under intense pressure.

In August last year, a police report was lodged at the Jakarta police headquarters against one Astro employee seconded to PTDV for alleged embezzlement by a director of a Lippo-affiliated company called PT Ayunda Prima Mitra. The director allegedly made payments to a family member of Dr Mahathir.

The allegations contained in the police report, which Astro insists are frivolous, prompted the Malaysian company to immediately fly Sean Dent, who was seconded as chief financial officer in PTDV, out of Jakarta. Dent continues to perform his duties for the pay-TV company from outside Indonesia.

Malaysian police say that the Indonesian police then requested the Interpol division in Malaysia to arrange for them to interview Ralph Marshall, Ananda's chief corporate lieutenant, over the allegations of embezzlement at PT Direct Vision.

Astro executives say that the company had informed the police that its employees, including Marshall, were not aware of any alleged criminal acts in the Indonesian pay-TV company.

So far, no further action has been taken by the police in Malaysia or Indonesia.

In late May this year, another police report was lodged against Astro executives seconded to PTDV, including the Indonesian company's president director Nelia Molato, alleging embezzlement and money laundering.

Sources in Astro say that shortly after the police report was filed, the company was informed that several of its several of its executives had been listed on a travel ban to Indonesia, including Marshall, Dent and senior technical advisor Michael Chan.

The three now perform their duties from outside Indonesia, including Molato, who left Jakarta in mid-June.

With little chance of both parties reaching an amicable situation, senior bankers familiar with the situation say that Ananda is seriously considering legal remedies to resolve his troubles with the Riadys.

Astro has also decided that it will cease its licensing pact with PT Direct Vision when its agreement lapses later this month.

That will mean 150,000 unhappy pay-TV subscribers in Indonesia because Astro will cease to deliver programming to PTDV. The Malaysian company also plans to initiate legal proceedings to demand for roughly US$250 million as compensation from the Lippo Group for funds and technical services to PTDV in rolling out its pay-TV business. — Straits Times Singapore

Anwar’s popularity adds to ruling party’s fear and loathing

KUALA LUMPUR, Aug 28 — Former Deputy Prime Minister Datuk Seri Anwar Ibrahim won a crucial by-election for the parliamentary seat of Pemantang Pauh on Tuesday.

That Anwar was going to win was never in doubt. He was first elected to the seat in the early 1980s and his wife became MP when he was jailed in 1998.

Last month, she resigned from the seat so Anwar could get back into Parliament. What was unexpected was the huge margin of victory. Anwar's wife won the seat in the March general election with slightly more than a 13,000-vote majority.

Many had expected Anwar to win by about 10,000 votes rather than the nearly 16,000 votes he took on Tuesday. The ruling Barisan Nasional coalition poured everything it had into the campaign.

Led by the Deputy Prime Minister, Datuk Seri Najib Razak, the BN promised nearly RM60 million worth of development. Almost every minister visited the constituency offering more goodies if Anwar was defeated.

The BN has spent millions in trying to discredit Anwar, using the mainstream media and giant video screens spread all over the constituency, to remind voters that Anwar is under criminal indictment for sodomy. Sodomy is a serious offence under Islam and more than 60 per cent of Pemantang Pauh's voters are Malay Muslims.

The BN showed a tape of Anwar's accuser swearing on the Quran that he was sodomised by Anwar. Malay voters were told also that Anwar was a race traitor.

Anwar champions the removal of the New Economic Policy, or NEP. Under the guise of affirmative action, this policy discriminates against the non-Malay population in all areas of political and economic life. Special scholarships, bank loans, contracts and even a university were established exclusively for the Malays.

While it was initially popular among the Malay population and deeply resented by non-Malays, in recent years, the younger, better educated, Malays have become critics of the NEP.

It is a known fact that the NEP has enriched only those with link to Umno, the ruling party, and that poorer Malays have benefited much less. Some Malays who supported opposition parties were even denied access to the NEP.

Younger Malays are starting to realise that the NEP, far from helping them, is actually a tool for Umno to manipulate and buy its political support from the Malay community.

The culture of corruption created by the NEP has reached the plateau that a large segment of the Malay community has decided that the only way to get rid of the corruption is to get rid of the NEP and Umno.

They also want an end to racial politics in Malaysia pioneered by the BN, and Umno in particular. Umno's ideology of ''Ketuanan Melayu'' or Malay supremacy has meant open and blatant racial discrimination against the non-Malay population.

One senior Chinese minister described Umno's relationship with its non-Malay parties in the BN parties as akin to a ''master-slave'' relationship. Race relations are now much worse after 50 years of independence.

Anwar has promised to replace the NEP with the Malaysian Economic Policy, or MEP, which does not have racial criteria. The overwhelmingly majority of the younger population sees this as the only real long-term solution to racial polarisation.

Anwar has promised that he will engineer the defection of about 30 MPs from the BN by the middle of September, and he will take over as prime minister then. There is every reason to believe that Anwar is capable of doing this, although the BN will still try to do its best to stop him.

The BN will do its best to make sure that Anwar is convicted of sodomy. It does not matter that more than 80 per cent of the population thinks that the sodomy allegations are politically motivated.

The only political game Malaysia now, at least among Umno, is to stop Anwar. The security apparatus will also be used against Anwar's allies.

Several leaders in Anwar's parties have been arrested for corruption, and bloggers who are sympathetic to Anwar are being sued for defamation and publishing false reports on the Internet.

The Government is also expected to pass laws that restrict political chatter on the Internet, and crack down harder on civil society groups.

The BN is still a powerful political machine and when it is threatened, it moves back to its authoritarian mode. There is every reason to believe that there will be mass arrests under the Internal Security Act to stop Anwar from becoming prime minister.

There are too many vested interests that will stop at nothing to make sure that their corruption and past misdeeds are not exposed by Anwar's new administration.

They have every reason to fear the consequences of an Anwar ascendancy. When Anwar's party took power in several states after the March general election, they exposed shady land deals and government contracts worth millions.

A Morgan Stanley report published a few years ago says that corruption has cost Malaysia the equivalent of more than US$110 billion (RM360 billion) in the past 30 years.

The NEP was promulgated about 30 years ago and it was only after the NEP came into being that ''money politics'' became synonymous with Umno.

If Anwar eventually becomes prime minister, it will be one of Asia's most remarkable political comeback tales.

The closest one to it is that of Kim Dae Jung. Sometimes called the Nelson Mandela of Asia, Kim was nearly killed by South Korea's intelligence service in the 1970s, imprisoned, put under house arrest, sentenced to death for sedition and banned from politics.

Kim managed to overcome all these obstacles before becoming South Korea's president from 1998 to 2003.

- Canberra Times



A Turbulence Week

Yesterday as i was on my way to a friend's new house in Keramat- actually he just bought a condo unit there for business purpose- suprisantly a call came through. It was from my great Mentor in land downunder - asking how's thing in Malaysia? (as if he doesnt know yet... :P) he said expect a turbulence week ahead in our Malaysian politics starting this Monday. DSAI & Kak.Wan are in Madinah performing Umrah & attending some business there. So i expect balls will start roll on Tuesday on wards.. i suppose, sigh! I kept asking him, when is it? as people on the street have been clamouring for DSAI to lead our nation... for better or worse. Current PM's govt has too much crap already. 

Oh ya, back to my friend story. The condo he bought is indeed very nice - 1800 sq ft unit - it is very spacious and location is good too. The only worry for him, our state of economies... KLCI has not been performing well since the last election, with the impending turbulence week im sure alot of people are happy to just sit and watch... at local front, the inflation soon is going to skyrocketing. thanks to sudden increase of oil prices by the Govt.  duh.. how DSAI is going to inherit this kind of mess? ... well, as he put it clearly last week in Shah Alam, let's SAVE MALAYSIA!

Let's do it Dato' Seri

The long hangover

America's economy is in recession. Don't expect a quick recovery 

If the IMF is right, weakness will last longer this time. America's new president will be elected against the backdrop of a shrinking economy and on taking office will face months of economic malaise.


IT MAY not be official but it is increasingly obvious: America's economy has slipped into recession. The latest labour-market figures—a jump in the unemployment rate to 5.1% and the loss of 98,000 private-sector jobs in March, the fourth consecutive month of decline—point to a shrinking economy. So do surveys of manufacturing and services. So does Ben Bernanke, chairman of the Federal Reserve. On April 2nd he told a congressional committee that output was unlikely to “grow much, if at all, over the first half of 2008 and could even contract slightly.”

The official judges of American downturns—a group of academics at the National Bureau of Economic Research (NBER)—define a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production and wholesale-retail sales.” (Contrary to popular belief, recession does not require two consecutive quarters of falling output.) Though the NBER's wonks will not pronounce for many months, their criteria look increasingly likely to be met. 

The question now is: what kind of recession will this be? Shallow or deep; short or long? So far, it seems remarkably gentle, given that many think America is suffering its worst financial shock since the Great Depression. Since December the economy has shed an average of almost 80,000 jobs a month. In most recessions a rate of 150,000-200,000 is normal.

To be sure, this downturn has only just started. The labour market will surely worsen as firms cut back in the face of weaker consumer spending. But a buoyant world economy is still boosting American exports; a fiscal stimulus is on the way; real interest rates are around zero and likely to fall further; and, with the rescue of Bear Stearns, the Fed has given an implicit guarantee to Wall Street. So few forecasters expect outright slump. A liberal enough loosening of fiscal and monetary policy can stop recession turning into depression, and American policymakers have left little doubt that they will use their recession-fighting weaponry freely.

More controversial is the question of how long the weakness will last. Not very, Mr Bernanke told Congress. Growth will strengthen in the second half of the year, nourished by lower interest rates and the fiscal package. In 2009, he suggested, the economy would be growing “at or a little above” its trend rate, which the Fed is thought to put at around 2.5%. Many investors seem to agree that the downturn will be short as well as shallow. Share prices have recovered since the Bear Stearns rescue, even as economic statistics have been gloomy. The S&P 500 stockmarket index is around 5% higher than it was a couple of weeks ago and is still only 13% below its all-time high. 

Others are more pessimistic. In its latest World Economic Outlook, published on April 9th, the IMF slashed its forecasts for America's economy both this year and next. It now expects GDP to shrink in every quarter of this year. By the fourth quarter the economy will be 0.7% smaller than a year before. (Only three months ago the fund expected a rise of 0.9%.) Nor does the IMF expect 2009 to be much better: GDP will grow, but at well below its trend rate.

Such a dramatic divergence of official economic opinion is rare. And it matters. Recent recessions, as defined by the NBER, have been both short and shallow: those of 1990-91 and 2001 each lasted eight months, below the post-war average of ten. If the Fed is right, the 2008 recession may be shorter and shallower still. That would be remarkable, given the extent of the housing bust and credit turmoil.

If the IMF is right, weakness will last longer this time. America's new president will be elected against the backdrop of a shrinking economy and on taking office will face months of economic malaise. That in turn will imply bigger budget deficits, and redefine next year's big domestic policy debates: whether to roll back George Bush's tax cuts for the wealthy, for instance, and how ambitiously to reform health care. It could fuel protectionist and populist sentiment, particularly since Americans are already unusually fed up. A new CBS/New York Times poll finds that eight out of ten people think the country is “on the wrong track”, the most since the question was first asked in 1991.

The hangover's duration will depend on many things, from the strength of foreign economies to the degree to which American firms cut jobs and investment. But top of the list, given the recession's origins in the property bust and the credit crunch, are the fate of the housing market and the resilience of consumer spending. On both counts, the odds are against catastrophe but on a lasting headache. 

By many measures the news from housing is still getting grimmer. Housing starts are at less than half their peak, and builders are continuing to cut back. Although this has begun to reduce the stock of unsold new homes, the frailty of demand means that supply still vastly outweighs sales. At 9.8 months' worth of sales, the stock is at a 26-year high. The official overhang of existing homes (which excludes those repossessed) is not much lower. The excess of supply over demand means that the fall in house prices is accelerating. According to the S&P/Case-Shiller index, house prices are 13% off their peak. They fell at an annual rate of 25% in the three months to January.

The drop in house prices so far has left some 9m people, or 10% of all those with mortgages, owing more than their houses are worth. Among all mortgage borrowers, 6% are behind on their payments; among subprime borrowers, 17% are in arrears. Lenders are already foreclosing on more than 1m homes. The pessimists expect these figures to climb much higher, adding to supply and further depressing prices.  


In the short term that is likely. But there are some signs of hope. Demand seems to have stabilised: since November total home sales have been running at an annualised rate of 5m or so (see chart 1). Lower prices have made houses a bit more affordable. And government action may help to ease the drought of mortgage finance stemming from the collapse of the subprime market and the contraction of the market for large (“jumbo”) mortgages, and to limit foreclosures. 

At the height of the housing boom in 2006, non-traditional loans, such as subprime and jumbo mortgages, backed nearly 40% of home sales. Some $750 billion of financing disappeared as they shrank. Fannie Mae and Freddie Mac, America's government-backed mortgage behemoths, will fill part of that hole. The Bush administration recently announced changes to these institutions' capital rules, to let them buy up to an extra $200 billion of mortgages. Political momentum is also building to prevent a surge of foreclosures. For now Congress is debating some modest tax incentives. But a more ambitious idea is gaining support: to allow the Federal Housing Administration to refinance troubled mortgages at a discount. 

Hit from all sides

Despite these hopeful signs, house prices will continue to fall until the excess inventory is worked off. Even the cheeriest analysts expect that average house prices will continue to fall this year. Worse, house-price deflation is only the first element of a quadruple whammy that is thumping American consumers. The other three elements are tougher credit conditions; a deteriorating labour market (with unemployment on the way up and wages slowing); and high commodity prices pushing up the cost of fuel and food.

Weekly private-sector wages rose by 3.6% in the year to March, the slowest pace since mid-2003. Headline consumer-price inflation is likely to have topped 4% in the same period, so for many real pay is falling. Economists at Goldman Sachs reckon that consumers' real discretionary cashflow—their income plus any new credit minus debt service and spending on essentials—has been shrinking since late last year.

Faced with all this, no wonder Americans are glum. The forward-looking bit of the Conference Board's measure of consumer confidence is at depths not seen since the recession of 1973. Indicators of financial stress outside housing, such as delinquencies on car loans and credit cards, are rising. And consumer spending, after years of resilience, has finally cracked. Not all economists share the IMF's view that spending is actually falling, but none doubts that it is at best barely growing. Because it makes up 70% of total demand, its feebleness does much to explain why the economy has tipped into recession. 

On all four counts—house prices, credit, the labour market, and fuel and food prices—the consumer's position is likely to worsen in coming months. Granted, the imminent fiscal stimulus should help. Between early May and mid-July $117 billion will be paid out in tax rebates. The average American household with two children will get a cheque from Uncle Sam for up to $1,800 and will spend at least some of it.

Unfortunately, most of the forces dragging down consumer spending are likely to persist long after the cheques have been banked. Even with stronger exports, growth is likely to be too sluggish to raise incomes by a lot or offer much support to employment. Looser monetary policy will cushion but not avert financial deleveraging. Lending standards are usually tight for years after credit busts, not months. And by most estimates less than half the likely losses in America's financial sector have been written down. Meanwhile, lower house prices will reduce both homeowners' wealth and their potential collateral.  


Even when house prices eventually stop falling, they will not suddenly soar. After years of tapping rising housing wealth to finance their consumption, Americans will need to build wealth the old fashioned way, by saving more. At 0.3%, the household saving rate is above its all-time nadir, but not by a lot (see chart 2). 

No one knows by how much, or for how long, America's economy will be weighed down. The IMF's gloom is based in part on its reading of history. An analysis by the fund of post-war housing busts in rich countries, written in 2003, suggests that crashes typically last about four years and are often accompanied by banking crises. Economies end up 8% smaller, on average, than they would have been had they carried on growing at pre-crunch rates. Perhaps this time will be different, and the hangover will soon be gone. But given the scale of America's housing binge and of the financial crisis the bust has spawned, that seems unlikely.


REIT option for Malay reserve land in ECER

by Sharon Tan

KUALA TERENGGANU: The development council for the East Coast Economic Region (ECER) is mulling the setting up of a real-estate investment trust (REIT) for Malay reserve land in the development corridor.

Under the proposed REIT, all the Malay reserve land would be parked under an umbrella fund with the land leased out and the owners receiving dividends, or equity, or both.

The chief executive officer of the newly launched ECER development council (ECERDC), Datuk Jebasingam Issace John, said there was a mix of land types in the region.

“But for the Malay reserve land, we are looking at the setting up of a real-estate trust. The mechanisms and details are being worked out now. The state will be involved in it,” he told The Edge Financial Daily in an exclusive interview.

The REIT option is being considered to realise value for the Malay reserve land, the bulk of which is unutilised at present.

A total of RM112 billion has been targeted as total investments in the ECER by 2020. John said an initial investment of RM18 billion was expected to flow into the region by 2010.

Apart from domestic investors, he said the ECERDC hopes to draw investments from the Middle East, Japan, China and Taiwan. For now, there are local commitments in the plastics and kenaf industries.

It is learnt that some Australian parties have expressed interest in fisheries while several European firms are keen on the tourism industry. Announcements on some of these ventures are expected by year-end.

The ECERDC, formed to take charge of the development of the ECER, can now begin its marketing and promotion work although the Ministry of International Trade and Industry and the Malaysian Industrial Development Authority have been marketing the region since its launch last year.

The setting up of the council was announced by Prime Minister Datuk Seri Abdullah Ahmad Badawi last Saturday.

Abdullah, who is also the chairman of the council, also announced location-based incentive packages for investors, the first of their kind in the country.

Investors in sectors such as tourism, petrochemical, manufacturing and agriculture can enjoy up to 10 years of income tax exemption from the first year of profit, or investment tax allowance amounting to 100% of capital expenditure for five years.

“We should be able to draw investors not only through incentives but incentives supported by infrastructure,” said John.

He said focus would be given to industrial parks such as the Gebeng Industrial Complex in Pahang which comes with port facilities, Teluk Kalong Heavy Industry Park in Kemaman, which is linked to Kemaman Port, and the petrochemical complex in Kerteh, which includes the Kerteh Plastics Park.

“Infrastructure work at the Kerteh plastics park is almost completed and there are already three investors in place with RM50 million investments,” said John.

“The other three parks are already ongoing. We only need to strengthen the infrastructure and do marketing and promotion to bring the investors here. With the incentive package that we have now, we should be able to draw the investors,” said John, adding that halal parks would be developed in Gambang, Pahang and Pasir Mas, Kelantan.

ECER would also be well linked to the Kuantan-Kuala Terengganu Highway currently under construction.

John also said a feasibility study was being undertaken for the extension of the highway to Kota Bahru. He hoped to see work on this stretch take off under the 9th Malaysia Plan period, or the 10th Plan. Also, the connection between Ipoh and Kuala Berang was expcted to be ready next year.

To expedite work, the ECERDC would appoint an Implementation Coordination Committee (ICC) in each state to fast-track approvals and implementation.

John said the ECER’s agropolitan projects are targeted at the 30,000 hardcore-poor households in the region.

“The target is to eliminate hardcore poverty by 2010. The agropolitan projects are integrated rural development projects. They would have as their main crops rubber and oil palm.”

John said the farmer’s dependents would not be left out. “We want to create other agro-based job opportunities such as poultry farming and cocoa cultivation,” he said, adding that although it was a tall order to provide jobs for the family members, it had to be done.