It’s a cliché that history repeats. Clichés usually become clichés precisely because there’s an observable pattern through time.
This article was published in the NZIF Newsletter 2007/35, 7 September 2007. At the time the US Fanny May and Freddie Mac property mortgage companies were wobbling. And our own New Zealand finance companies were like stars imploding in the night sky ….. and a year later …. The GFC.
Is the pattern repeating again? The Chinese property market is wobbling, principally through the dubious financial position of Evergrande, the Chinese property development mega-beast. But, as the Wall Street Journal recently pointed out, the Chinese property market issues go beyond Evergrande. The whole Chinese property market “faces a $US five trillion reckoning.”
I’m not republishing this simply because of potential historic parallels. There’s also the increasing fragility of the New Zealand forestry sector (the opposite of Resilience), with an export trade mix that has generally shifted down the grades from construction and some (dubious) finishing markets, to form work to keep in the concrete. The high quality Japanese trade through to the 1990s dropped in grade to the Korean trade, which then dropped again to the Chinese trade. So what’s next? Firewood to India?
Holding price through market position is far more important than financial ‘efficiency’ gains. Without the former, the strong commodity buyer always takes the latter. And so often, ‘efficiency’ equates with quality reduction. And so you chase the crap markets down the rabbit holes of your own mind.
And the forestry “agronomy/finance” sector – with notable exceptions from those fleet footed companies who can think beyond radiata pine and the spreadsheet oracle (those generally privately owned, rather than owned by some investment fund or mega-corporate) – kept on doing what it always does, like dedicated followers of fashion. Perhaps they’ll meet the hookah-smoking caterpillar, and all will be well.
Some of the complacency is due to the relative metaphorical biblical feast forestry has enjoyed over the last 30 years: cheap privatisations, the log price spike, Korean trading rising like a miracle as Japan fell, then China as Korea fell, then the ETS, and strong Chinese property development post the GFC in 2008. Happy days. Let’s not think of tomorrow. Never mind the biblical cycles. Famine, what famine?
Many foresters were trying to question the questionable industrial approaches and the emphasis on financially-driven tactics over wider strategy from more than 20 years ago.
And sadly nothing much has changed. In fact, the trends to head down a financial, tactical, narrow-and-now rabbit hole is arguably more apparent now than it was in 2007 when this was published.
These are the finance companies. They offer what many consider the excellent return of 9.25% p.a., and they fail; nine in the last 18 months. But how good is this return? It is annually eroded by tax, that amount not being able to compound for you into the future. Inflation erodes it. If you take such a return and convert it to a real, post tax return (assuming 39% tax and 3% inflation) you get the annual return of 2.57 percent[1].
Although the nominal, pre-tax return appears reasonable, it’s associated real, post-tax return appears pathetic. If, however, you ask an actuary what sort of average return you get on investments real, post-tax, they will tell you that for the whole basket of investment types, it is close to this 2.6 percent mark.
All of which begs a question; why in hell do we use the seven to nine percent real post-tax discount rates? This is a figure that – theoretically – is supposed to reflect the real cost of capital, with an added risk loading. The real, risk free cost of capital is usually stated as being between 2% and 4%, though even there, investment in solid things, rather than paper money, is not so subject to the vagaries of tax rate and interest rate changes as are interest deposits. If you doubt that, try doing the calculations on marginal tax rates of 66%, inflation at 12% and nominal interest rates at 15% – more than a negative 7% return. Tangible things like land, sheep, trees, & buildings (as compared to yachts, rugby league teams, and flash new cars), do tend to provide some element of reality to any investment. But we live in the age of the get rich quick, flash Harry. Few are happy with the get rich slowly approach.
I know one thing for certain; there remains considerable confusion between nominal and real interest rates. People perceive a 7% or 9% return as “OK”. In the next breath, they presume that the nominal one is directly comparable to the real other. So interest rates are around 7 to 9 %, and forestry discount rates take their lead from that. I’ve seen that implicit misunderstanding with university management professors, with accountants, with ministers of forestry, with Joe Average in the streets. And even though we as forestry professionals – who will be forever damned for the fact that one of our own (Martin Faustmann) invented the damned things – are expected to know the difference, the choice of real forestry discount rates bears too much a similarity to those nominal interest rates for it to be just coincidence, afterwards rationalised by ‘risk’. The financiers demand these types of rates (like those in Treasury), and the humble foresters follow, then we survey discount rates because they are of course a manifestation of the rational Lord Market, which provides an ‘objective’ basis for the perpetual motion machine. Such delusions are not uncommon. Values and core beliefs underpin the most ‘objective’ of research. Think tulips, South Seas stock, George Bush’s foreign policy, Newton’s alchemy, Ptolemaic astronomy, Aristotelian physics. It’s the power of ideas that dominate over our attempts at reason. And once settled in our ways, we all would rather the heretic be burned.
There were some commentators saying that these finance company nominal deposit rates were typically four percent higher in place like the United States. Given the return of the financial chickens in our own markets – and in the US housing markets – perhaps they have a better handle on their risk profiles. But even if given that 4% increase, to 13.25%, the real, post-tax returns would be 4.93% using the assumptions above. And that is for an acknowledged high risk profile. Now here’s the real test: in order to get a real, post tax rate of 8% – the one expected of forest growers – you would need a post-tax rate of 11.24%, and a nominal pre-tax deposit rate of ……. 18.26 %. This is, some argue, where forestry risk sits relative to deposit rates. Is it?
Which then exposes another note of poor logic from those that argue we need these high risk loading on our discount rates. The same country – the US – that recognises finance company risks by loading 4% over and above our finance company deposit rates, also has forestry discount rates that are in real terms between 4% and 6% – i.e. considerably lower than our own. So they recognise risk in finance companies which we apparently don’t, and don’t recognise risks in forest growing that we apparently do. So who is right? Given the crisis in finance, the evidence points to them, rather than us. And it is also reflected in the facts that the US-based TIMOs are coming in buying our forestland, for what they may well consider a bargain.
In Europe, the rates are even lower at 2% to 4% real, sometimes zero where forests are treated as different accounting entities – as going concerns with long-sunk costs. This remains an excellent option, especially for existing native forests, but seems to be lost on most of us foresters always looking from a Greenfield investment perspective, viewing forests as capital entities alone – as we were often taught. Are they?
But are we that much more risky as a forest grower than those in Europe and the US? Yes, we have a geographical disadvantage – emphasised more by focusing on anything low value relative to bulk or weight – but a highly favourable growing advantage, with essentially excellent social, environmental, and physical infrastructure. Do we rate up there with the finance companies offering 18 percent or more? Because that is what our commonly discount rates are implying.
But let’s not be too hasty. Ironically, perhaps we are more risky. I say “ironically”, because it is the high discount rates we encourage that create high risk enterprises. Take a case example: if you are required to have a non-negative net present value at a ten percent discount rate (an example of idiotic Treasury’s usual SNAFU applied to NZ Forest Service new land plantings – and why didn’t someone in NZFS point out to those autistic Treasury geniuses the consequences??!!), then you look for the thing that can theoretically achieve it. Radiata pine can. So can short rotation eucalypt (14% IRR on some prospectuses). Douglas fir – or anything with a rotation length much over 45 years – cannot. Discount a million dollars for 60 years at 10% and you get $3,280 – which means you can effectively – and of course ‘rationally’ – bankrupt your grandchildren by loading the million dollar cost on to them. Do a discounted cashflow on the effects of radical climate change 200 years into the future using these real discount rates Treasury seems to prefer, and don’t give it a second thought; it’s not a problem. A billion dollar cost then comes out as $5.27 now. Cheap! Why should we care, it’s only money after all. A bit different perhaps if you happen to be there at the time.
But back to risk, and discount rates driving us to a more risky commercial environment. At the moment, at a period of a high dollar and high freight costs, Ernslaw One can’t get enough Douglas fir, and their mill has hired 30 more staff. Of course, Ernslaw One, the Queenstown Lakes DC, and Blakely Pacific are all irrational for planting Douglas fir, and their negative valuations illustrate this profoundly, and beyond any ‘rational’, or even reasonable doubt. Unless you happen to have a bit of Douglas fir coming on to the market at the moment.
But we should count ourselves lucky. It could have been worse. If Treasury in their eternal HUD spreadsheet wisdom had demanded use of a 14% discount rate, we may have planted short term eucalypt pulp everywhere. We can see that as immediately a nonsense, and perhaps even Treasury would have enough wit to realise it as well, but we don’t associate any nonsense with wall to wall radiata pine. If they’d had a more sophisticated view of either the multifunctional nature of forests (which are more – I know I will be vilified by all the financiers for saying this – than just a manifestation of capital) or the complexities of real versus nominal finance, they may have helped set up a decision making culture in New Zealand forestry that was less narrow and doctrinaire, more inclusive, contextual, and thinking.
And that is, I think, the nub of all the questions that are raised above. Our use of discount rates is nothing to do with some rationally derived assessment criteria taking into account the complexities of the issue – it is fashion; it is convention; it is follow-the-leader-let’s-not-step-out-of line conformity. It is what Pierre Bourdieu calls habitus, the institutional values, beliefs, and patterns of behaviour that are unthinkingly applied, like some Taliban in prayer while stoning an infidel. We advocate acts and are influenced by ‘ways of seeing’ that are so often accorded some façade of rationality to give them respectability. It is Field Marshall Haig decision making, all the numbers correctly counted, all the formula correctly applied, all the ducks in their right position in the row, all the butts covered by our reference back to the appropriate techniques as illustrated by the Horse Guards Manual of Manoeuvre (1879), or the equivalent current day quantitative decision support system.
I’ve never held with financial analysis alone setting strategy. That will always involve investing in the fashionable wringer washing machines while the opportunities in the future are ignored. But let’s assume that finance is sufficient for the moment. Try a thought experiment. Assume that land rather than financial capital is limiting, which means that Discounted Cash Flow rather than Internal Rate of Return is the appropriate approach. Then assume a 4% real post-tax discount is loaded with any amount of risk. Then see what species and regimes we’d plant. So much hinges on these financial assumptions we think so ‘objective’.
Chris Perley
Thoughtscapes
[1] Calculated by 1. removing annual tax (9.25 – (0.39x 9.25) = 5.6425), then 2. by correcting for inflation using r =(1+ i/1+ p) – 1 where r = real rate, i = nominal rate, p = inflation expressed as proportion ((1.05625/1.03)-1).
Chris Perley grew up in landscapes. His playgrounds were hills, streams, fields and woods. He studied forest ecology because of the experience he had sitting within a complex forest. You can see, hear, feel, smell and even taste a forest. But those feelings were not taught in his science education. Something was missing. A rainbow was being unwoven. Quanta was all.
The quiet dissatisfaction grew while working to integrate the woodlands into what were essentially colonial factory landscapes, and later in policy and research. The marginalising of our potential, and our connection to place, was all too evident. He has called for a ‘Reimagining’ ever since. From a machine able to be reduced to disconnected bits, to a complex system that is inherently indivisible.
His subsequent work was on the philosophy – old and new – required to reimagine our landscapes, to see and be something different as members of place and community.
Chris has worked as an editor, a writer, and is an affiliated researcher for Otago University’s Centre for Sustainability.
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