Re­turn­ing to in­vest­ment

Financial Mirror (Cyprus) - - FRONT PAGE -

At the G20 sum­mit last month in Hangzhou, China, world lead­ers out­lined an am­bi­tious plan for a “new era of global growth.” But they left out a key in­gre­di­ent: fix­ing the in­vest­ment cli­mate.

Con­ven­tional wis­dom holds that, through ef­fi­cient fi­nan­cial mar­kets, house­hold sav­ings will flow to com­pa­nies that can best put the money to pro­duc­tive use. But in many de­vel­op­ing coun­tries, eas­ier ac­cess to fi­nance – ow­ing to un­re­stricted cross-bor­der cap­i­tal flows and fi­nan­cial-mar­ket dereg­u­la­tion – still has not led to more fi­nanc­ing for long-term in­vest­ments, par­tic­u­larly in man­u­fac­tur­ing.

In­vest­ment de­ci­sions de­pend on a va­ri­ety of com­plex fac­tors and con­tin­gen­cies, and a mix of pub­lic and pri­vate fi­nance is cru­cial for bring­ing new projects to fruition. In East Asia, which has ex­pe­ri­enced rapid growth and de­vel­op­ment in re­cent years, pol­i­cy­mak­ers have not only al­lowed, but en­cour­aged, higher cor­po­rate prof­its, so long as they are chan­neled into pro­duc­tive in­vest­ments. As a re­sult, as much as four­fifths of large East Asian com­pa­nies’ in­vest­ment spend­ing is funded from re­tained earn­ings, while pub­licly owned fi­nan­cial in­sti­tu­tions have helped main­tain the pace of in­vest­ment-led growth. An im­bal­ance be­tween prof­its and in­vest­ment is a ma­jor rea­son for to­day’s tepid growth in de­vel­oped and de­vel­op­ing coun­tries alike; un­less it is ad­dressed, the re­sult could be a wider cri­sis of le­git­i­macy for cor­po­rate gov­er­nance and eco­nomic man­age­ment.

In de­vel­oped economies, cor­po­rate prof­itabil­ity has been steadily ris­ing, partly ow­ing to “share­holder-pri­macy” strate­gies that fo­cus on short-term de­ci­sion-mak­ing, cost-cut­ting mea­sures, and other forms of fi­nan­cial engi­neer­ing en­cour­aged by in­sti­tu­tional in­vestors. To vary­ing de­grees, con­ven­tional “re­tain-and-in­vest” strate­gies are be­ing re­placed by “down­size-and­dis­tribute” strate­gies, whereby prof­its are spent on in­creased div­i­dends, stock buy­backs, and merg­ers and ac­qui­si­tions.

In de­vel­op­ing economies, global fi­nan­cial flows have most vis­i­bly contributed to macroe­co­nomic shocks that fuel eco­nomic un­cer­tainty, which short­ens cor­po­ra­tions’ in­vest­ment-plan­ning hori­zon. More re­cently, one can also see de­vel­opinge­con­omy com­pa­nies pur­su­ing the same cor­po­rate-gov­er­nance strate­gies as firms in de­vel­oped coun­tries. Judg­ing by non­fi­nan­cial firms’ bal­ance sheets, in­vest­mentto-profit ra­tios de­creased from 1995 to 2014, with es­pe­cially steep de­clines in Brazil, Malaysia, South Korea, and Turkey.

Large pub­lic cor­po­ra­tions are less com­mon in most de­vel­op­ing economies than they are in de­vel­oped economies; but for those firms that do reg­u­larly dis­trib­ute div­i­dends in de­vel­op­ing economies, pay­outs to share­hold­ers have been in­creas­ing, even when prof­itabil­ity has re­mained roughly the same. Such firms are also ac­cu­mu­lat­ing fi­nan­cial as­sets – some­times faster than they are ac­cu­mu­lat­ing cor­po­rate debt – which sug­gests that they lack prof­itable long-term in­vest­ment op­por­tu­ni­ties and port­fo­lioin­vest­ment op­tions in lib­er­alised fi­nan­cial mar­kets. It would be pre­ma­ture to sug­gest that the re­la­tion­ship be­tween prof­its and in­vest­ments has bro­ken down in the de­vel­op­ing world. But, as cor­po­rate prof­itabil­ity has risen across the board, in­vest­ment trends ev­ery­where (with the ex­cep­tion of China and In­dia) have been weak, which was true even be­fore the 2008 global fi­nan­cial cri­sis.

Mean­while, fi­nan­cial­i­sa­tion con­tin­ues to dis­rupt macroe­co­nomic sta­bil­ity world­wide. De­vel­oped economies’ quan­ti­ta­tive eas­ing pro­grams have contributed to ex­cess liq­uid­ity – and thus to the re­cent cor­po­rat­edebt ex­plo­sion in emerg­ing economies. Across a sam­ple of these economies, non­fi­nan­cial cor­po­ra­tions’ dollar-de­nom­i­nated debt rose by 40%, on av­er­age, from 2010 to 2014; from 2007 to 2015, their debt-ser­vice ra­tios also soared by 40%. These num­bers sug­gest a sys­temic bank­ing cri­sis in the mak­ing. More­over, debt-fu­elled in­vest­ment has been con­cen­trated in highly cycli­cal nat­u­ral-re­sources-based sec­tors that do not con­trib­ute to in­clu­sive and sus­tain­able growth. In fact, just seven sec­tors – oil and gas, elec­tric­ity, con­struc­tion, in­dus­trial com­modi­ties, real es­tate, tele­coms, and min­ing – ac­count for more than two-thirds of the to­tal in­crease in both debt and in­vest­ment. This sug­gests that easy ac­cess to cheap money and debt fi­nanc­ing have not fa­vored the high-tech sec­tors that con­trib­ute the most to pro­duc­tiv­ity growth. To re­verse these trends, we must first re­verse the trend in emerg­ing economies to­ward highly fi­nan­cialised cor­po­rate strate­gies. This will re­quire changes in cor­po­rate gov­er­nance gen­er­ally, and in non­fi­nan­cial cor­po­ra­tions’ in­cen­tive struc­tures, in­clud­ing pref­er­en­tial tax treat­ment for re­tained prof­its and eq­uity fi­nance, and spe­cial de­pre­ci­a­tion al­lowances for rein­vested prof­its.

Beyond cor­po­rate gov­er­nance, we must re­store bal­ance to the profit-in­vest­ment re­la­tion­ship through in­sti­tu­tional as well as pub­lic-pol­icy ini­tia­tives, and with proac­tive in­dus­trial poli­cies. This will re­quire re­form­ing and deep­en­ing the bank­ing sys­tem to en­sure enough lend­ing ca­pac­ity for long-term in­vest­ments, in­clud­ing for small- and medium-sized en­ter­prises.

As for the macroe­co­nomic en­vi­ron­ment, gov­ern­ments can im­prove con­di­tions through pub­lic in­vest­ment in in­fra­struc­ture, which will aug­ment pro­duc­tiv­ity and add to pri­vate-sec­tor prof­itabil­ity. Lastly, the in­ter­na­tional com­mu­nity should vig­or­ously pur­sue ef­forts to po­lice tax avoid­ance and cap­i­tal flight, both of which erode states’ rev­enue base. Long-term in­vest­ment in pro­duc­tive as­sets is es­sen­tial to en­sur­ing the sus­tained growth that de­vel­op­ing economies need. But they won’t achieve it by main­tain­ing an en­vi­ron­ment that en­cour­ages short-term strate­gies.

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