Clos­ing the in­vest­ment gap

Financial Mirror (Cyprus) - - FRONT PAGE -

The weak­ness of pri­vate in­vest­ment in the United States and other ad­vanced economies is a wor­ri­some – and per­plex­ing – fea­ture of the re­cov­ery from the 2008 global fi­nan­cial cri­sis. In­deed, ac­cord­ing to the In­ter­na­tional Mon­e­tary Fund, through 2014, pri­vate in­vest­ment de­clined by an av­er­age of 25% com­pared to pre-cri­sis trends.

The short­fall in in­vest­ment has been deep and broad­based, af­fect­ing not only res­i­den­tial in­vest­ment but also in­vest­ment in equip­ment and struc­tures. Busi­ness in­vest­ment re­mains sig­nif­i­cantly below pre-2008 ex­pec­ta­tions, and has been hit hard again in the US dur­ing the last year by the col­lapse of en­ergy-sec­tor in­vest­ment in re­sponse to the steep drop in oil prices.

In­ter­est­ingly, the in­vest­ment short­fall in the US co­in­cides with a strong re­bound in re­turns to cap­i­tal. By one mea­sure, re­turns to pri­vate cap­i­tal are now at a higher point than any time in re­cent decades. But ex­ten­sive em­pir­i­cal re­search con­firms that at the macro level, busi­ness in­vest­ment de­pends pri­mar­ily on ex­pected fu­ture de­mand and out­put growth, not on cur­rent re­turns or re­tained earn­ings. Ac­cord­ing to the IMF, this “ac­cel­er­a­tor” the­ory of in­vest­ment ex­plains most of the weak­ness of busi­ness in­vest­ment in the de­vel­oped economies since the 2008 cri­sis.

In ac­cor­dance with this ex­pla­na­tion, in­vest­ment growth in the US has been in line with its usual his­tor­i­cal re­la­tion­ship with out­put growth. In short, pri­vate in­vest­ment growth has been weak pri­mar­ily be­cause the pace of re­cov­ery has been ane­mic. Busi­nesses have marked down their pre­cri­sis in­vest­ment plans to re­flect a post-cri­sis “new nor­mal” of slower and more un­cer­tain growth in de­mand for their out­put.

Un­der con­di­tions of weak ag­gre­gate de­mand, stronger pub­lic in­vest­ment en­cour­ages more pri­vate busi­ness in­vest­ment. But pub­lic in­vest­ment, too, has fallen below pre­cri­sis ex­pec­ta­tions, ag­gra­vat­ing rather than ame­lio­rat­ing the slump in pri­vate in­vest­ment.

The ac­cel­er­a­tor ex­pla­na­tion of the short­fall in busi­ness in­vest­ment in the US is con­sis­tent with ev­i­dence that, where pro­jected de­mand growth has been rel­a­tively strong – for ex­am­ple, in ca­ble, telecom­mu­ni­ca­tions, dig­i­tal plat­forms, so­cial net­work­ing, and, un­til re­cently, en­ergy – in­vest­ment growth has also been rel­a­tively strong. In­deed, tele­com and ca­ble com­pa­nies ac­counted for the largest share of busi­ness cap­i­tal ex­pen­di­tures dur­ing the last three years, with en­ergy pro­duc­tion and min­ing se­cond on the list.

Dif­fer­ences in in­no­va­tion op­por­tu­ni­ties across in­dus­tries are also con­sis­tent with the chang­ing com­po­si­tion of busi­ness in­vest­ment. Dur­ing the 2009-2015 pe­riod, while busi­ness in­vest­ment in equip­ment slowed in the US, it ac­cel­er­ated in in­tel­lec­tual prop­erty prod­ucts, in­clud­ing re­search and de­vel­op­ment, soft­ware, and so-called artis­tic orig­i­nals (the out­put of artists, stu­dios, and pub­lish­ers).

R&D in­vest­ment usu­ally ex­pands faster than GDP dur­ing cycli­cal ex­pan­sions, and the cur­rent pe­riod is in line with his­tor­i­cal trends. In­deed, as a share of the econ­omy, R&D in­vest­ment is now at its high­est level on record, which bodes well for fu­ture pro­duc­tiv­ity growth.

As the ac­cel­er­a­tor the­ory of in­vest­ment would pre­dict, much R&D in­vest­ment is oc­cur­ring in tech­nol­ogy-in­ten­sive sec­tors where cur­rent and fu­ture ex­pected de­mand has been strong. There is also ev­i­dence that the dis­tri­bu­tion of re­turns to cap­i­tal is be­com­ing in­creas­ingly skewed to­ward th­ese sec­tors. Ac­cord­ing to a re­cent McKin­sey Global In­sti­tute re­port, the most digi­tised sec­tors – ranked by 18 met­rics on dig­i­tal as­sets, dig­i­tal us­age, and dig­i­tal work­force – en­joy sig­nif­i­cantly higher profit mar­gins than tra­di­tional sec­tors.

In a re­cent let­ter to the chief ex­ec­u­tives

av­er­ages. The macro ev­i­dence in­di­cates that the pri­mary cause of dis­ap­point­ing busi­ness in­vest­ment in the US and other de­vel­oped coun­tries in the years fol­low­ing the global fi­nan­cial cri­sis has been ane­mic de­mand, not a lack of in­vestable funds re­sult­ing from ex­ces­sive dis­tri­bu­tions to share­hold­ers. Over the longer term, how­ever, the up­ward trend in div­i­dends and share buy­backs as a per­cent­age of cor­po­rate in­vestable funds is a symp­tom of mount­ing share­holder pres­sure on cor­po­ra­tions to fo­cus on short-term re­turns at the ex­pense of long-term in­vest­ments.

In a re­cent McKin­sey sur­vey of 1,000 top ex­ec­u­tives and cor­po­rate di­rec­tors, 63% re­ported that share­holder pres­sure to re­alise short­term re­turns has in­creased over the last sev­eral years. In­deed, some 79% re­ported pres­sure to demon­strate strong fi­nan­cial re­turns in two years or less.

Share­holder pres­sure tends to be greater in older firms, and in the US over the last few decades, the pro­por­tion of older firms has been grow­ing as the startup rate for new busi­nesses has fallen. In ad­di­tion, as Fink and oth­ers have warned, com­pen­sa­tion prac­tices that link top ex­ec­u­tives’ pay to mea­sures of short­term suc­cess like quar­terly earn­ings per share or an­nual equity per­for­mance also en­cour­age “short­ter­mism” in cor­po­rate in­vest­ment de­ci­sions.

A slid­ing cap­i­tal gains tax, with rates that de­cline as the hold­ing pe­riod for in­vest­ments in­creases, would re­duce in­cen­tives for short-ter­mism among in­vestors. Among oth­ers, Larry Fink, the Cen­ter for Amer­i­can Progress, and Hil­lary Clin­ton pro­pose this ap­proach. In his re­cent CEO let­ter, Fink also calls on com­pa­nies to is­sue an­nual “strate­gic frame­works” for long-term value cre­ation, sup­ported by quan­tifi­able fi­nan­cial met­rics and link­ing longterm ex­ec­u­tive com­pen­sa­tion to per­for­mance on them.

Th­ese frame­works, Fink notes, should cover en­vi­ron­men­tal, so­cial, and gov­er­nance (ESG) fac­tors that are core de­ter­mi­nants of long-term value. Com­pa­nies can use the new ev­i­dence-based stan­dards de­vel­oped by the Sus­tain­abil­ity Ac­count­ing Stan­dards Board to dis­close ma­te­rial in­for­ma­tion about their ESG per­for­mance to their in­vestors. Strate­gic frame­works, along with ESG dis­clo­sure, should en­cour­age both com­pa­nies and their share­hold­ers to fo­cus more on long-term value and less on short-term fi­nan­cial per­for­mance. But at the macro level, ex­pected growth in de­mand and as­so­ci­ated in­no­va­tion op­por­tu­ni­ties will re­main the pri­mary driv­ers of busi­ness in­vest­ment.

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