A company borrows money to finance expansion using the land it owns as collateral. Land prices then collapse, leaving the company with insufficient collateral to underpin the debt. The lender, usually a bank, calls in part of the debt which affects the company’s expansion plan and ultimately harms economic growth.
This typical vicious cycle was illustrated while researchers from The Hong Kong University of Science and Technology investigated links between investment and collateral.
Using data from Japan’s bursting bubble economy in the 1990s, they found that for every 10 percent drop in collateral value, the investment rate of an average company is reduced by 0.6 percentage points.
|Dr Gan: Corporate governance warnings
Principal Investigator Dr Jie Gan said: “Theoretically, the relationship between investment and collateral has always been suspected but no-one so far has used data from the real world and checked whether or not it is true, or the magnitude of the effect.”
The lack of research is because of difficulties in testing the theory; the biggest challenge is that when firms make investment, they need to buy machinery and build plants which expands their collateral. Even if a positive association between investment and collateral is observed, it is difficult to establish cause and effect, she said.
Other difficulties have been encountered, for example, in the US where plant and machinery is sometimes used as collateral. As there is no active secondary market for the hardware, the collateral value is not readily observable.
For the research, Dr Gan studied about 800 companies in Japan and focused on the “bubble” years between 1990 and 1993 when the price of land, traditionally used as collateral, dropped by almost 50 percent. “It was a huge shock and exogenous; beyond the control of companies,” said Dr Gan.
“At the peak before the bubble burst, the total market value of land in Japan was four times the total market value of land in the US, even though the US is 25 times larger,” she added.
“We found that companies were hurt proportionally to the land they held before the shock, so debt capacities were also reduced by about 50 percent.”
She added: “Academically I’ve been solving a big puzzle as to whether the relationship between investment and collateral really exists, how important it is and the magnitude. In fact, we showed that in Japan the collateral-investment problem had a huge impact on the economy with a 3 percent drop in the rate of investment.”
The impact of collateral can occur in economies that both boom and bust, she said. The main problem in booming economies is that assets are overvalued, which leads companies to invest more than is safe for them. “Companies often try to convince outsiders that they have better investment opportunities than they actually have,” she added.
Among lessons from the research, said Dr Gan, are corporate governance warnings for companies that know their assets are overvalued, the dangers of run-away real estate prices, and a fundamental question for banks on why they demand collateral.
Dr Jie Gan : firstname.lastname@example.org