Robert Solow’s (Nobel Prize winner in Economics) note on the subject, “How to save American Finance from itself”, which came out on 8th April, has a few important implications for some of the industry sectors where investments have been intense and it is time the last dollars invested are measured against the marginal efficiency it brings in to the overall industry. Solow has rightly pointed out that the last financial investments (marginal financial investment) in over-heated sectors are more likely to draw in resources at a higher rate while doing precious little to the incremental gain in value (marginal value) that one would normally expect.

Although he has raised a broader question on the economy that for it to grow efficiently we must have financialization to not absorb resources at the cost of the normal jobs it is suppose to do, which is “to allocate dispersed capital to dispersed productive uses, to provide liquidity, to do maturity and risk transformation, and to produce market evaluations of uncertain prospects,” it is time that in some of the Industry clusters like Base Metals, we make a closer inspection of this phenomenon in the context of whether the incremental investments have created incremental value.

The Aluminum industry for example drew in investments in excess of $150 Billion in the last two decades and moved from 14 Million tons of primary output to currently more than 40 Million tons and if the downstream is also included the total investments would top $180 Billion. This massive injection of debt and equity into this sector had other risk mitigation efforts working in tandem as the financial sector grappled with the issue of business cycles working against the financial cycles for almost two decades. The majority of these risk mitigation products provided by the commodity trading markets allowed hedges against losses as the prices moved from one extreme to the other, but as Rajan has pointed out in his seminal paper in 2005, the financial products could not stymie the effects of volatility.

As investments were drawn into this sector, the country economics (presence of factors like availability of Bauxite ore and coal or other economic advantages) weighed against the economics that Vision of a country provided, which is China, which alone added 18 Million tons of capacity in this period defying all odds. While the industry balance sheet in China can absorb any amount of losses, the rest of world has limits.

The Middle East, where large deposits of natural gas posed as a stranded energy which could be transformed into Aluminum, gave a new industry frontier to that region and attracted further investments, while the hugely uncompetitive Smelters in Europe that were starved of the electricity contracts (without subsidy) were at the crossroads of viability; some experiments in the Nordic region were the only ones having signs of vitality left. But Aluminum industry has one pitfall that few realize is that in most small towns of Europe, the Smelter is the only last bastion of hope for the town and becomes almost impossible to be closed down given the disproportionate social cost that ensues.

The crisis struck in 2008-09 and the prices crashed to a level that was far below the median cost of the industry and since have recovered only partially while no large capacity had been taken out as the financial products provided fillip to almost 5 Million ton of capacity not to be closed as Aluminum could be stocked in warehouses in Rotterdam and Baltimore ; the return on capital invested for the $180 Billion at the current prices is negative, while the investments on the anvil are in the order of another $10 Billion in the immediate future. Solow’s point on this last $10 Billion is very apt as there is a limit that trading could do in supporting prices, while the fundamentals of consumption and supply has seen a gradual shift towards recycling where much of the old scrap has started to come to the market.

The last dollars weigh heavily in terms of drawing resources to a sector which has not seen balancing happen for a protracted period of time, when more than the consumption drivers and cost curves, financial intermediaries including the banks have taken the onus of price recovery through interventions of all kinds. This is what Solow draws attention to and one should be wary of the consequences.

Procyon Mukherjee

11th April 2013

The Marginal Efficiency Question With The Last Dollars Invested: Impact Of Financialization
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