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Non-mining Business Investment – Where to from here?

By Bangko Sentral ng PilipinasSep 16, 2014 10:39AM ET
 

Christopher Kent*
Assistant Governor (Economic)
Address to the Bloomberg Economic Summit
Sydney - 16 September 2014

Introduction

I'd like to thank Bloomberg for the opportunity to talk to you today. I discussed this topic at this same venue 18 months ago. The outlook for non-mining business investment is an important element of our forecasts. It depends on a range of forces acting on the economy, including the stimulus currently being provided by the very low level of interest rates. But, forecasting economic activity is hard. Understanding and forecasting business investment is arguably harder still.

When I was here in April of last year, I'd suggested that:

  • mining investment would be likely to peak in 2013;

  • non-mining investment would be likely to pick up, but only gradually; and

  • growth for the economy as a whole would be a little below trend in 2013 and then pick up gradually through 2014.

It now looks like mining investment peaked in late 2012 (Graph 1). Despite a substantial decline in mining investment since then, growth of the economy overall picked up to a pace that was around trend over the course of the past year. Much of that improvement has owed to a sharp rise in resource exports.

At the same time, there has also been an improvement in the growth rate of economic activity in the non-mining sectors, even though non-mining business investment has remained subdued. This better growth of non-mining activity often gets missed given all the focus on the resources boom. While this improvement is welcome, a key question is how durable the improvement will be? It might even gather a bit more steam, thereby helping to drive overall growth to an above-trend pace at some point. Such developments are possible but by no means certain. They depend in part on non-mining business investment, which is the motivation for my talk today.

Graph 1: Mining and Non-mining Activity

Recent Past

Over recent years, non-mining business investment has been subdued. After recovering from the decline that followed the global financial crisis, non-mining business investment in real terms has been little changed over the past three years or so (Graph 2). In nominal terms, non-mining business investment is at a very low level as a share of GDP relative to its history.[1]

Graph 2: Private Non-mining Business Investment

Non-mining business investment should depend, in large part, on the strength of expected demand in the non-mining sectors of the economy (over the life of that investment). Current demand conditions, however, may have a strong influence on investment for two reasons. First, firms tend to draw on recent experience when assessing prospects for future demand. Second, stronger sales today will boost current cash flows, which will assist firms facing financial constraints.

Hence, the gradual pick-up in the growth of non-mining economic activity over the past year augurs well for investment. Low interest rates and robust population growth are underpinning strong demand in the housing market, with house prices rising rapidly and dwelling investment picking up strongly. Low interest rates are also supporting growth of consumption at a time when subdued conditions in the labour market are weighing on the growth of incomes. These developments, as well as growth in export industries such as tourism and education, are consistent with a pick-up in business conditions across a range of industries.

Despite these gains, survey measures of non-mining capacity utilisation have not improved much over the past year. A measure derived from the NAB survey (based on weighting industries according to their contribution to investment) implies that capacity utilisation remains a bit below average (Graph 3). By itself, this suggests that demand in the non-mining sector will need to rise a little further before businesses feel the need to undertake substantial investment in new capacity. Our forecasts for the economy suggest that this will occur in time, but the extent and timing of new investment remains uncertain.

Graph 3: Capacity Utilisation

It's Not Just Output/Demand that Matters

In addition to the strength of demand, a range of other factors also influence investment decisions. In particular, investment depends on whether the expected return to new capital outweighs the cost of installing it. In other words, a firm should invest whenever the market value of its existing capital is greater than its book value. This is known, in academic circles, as Tobin's Q theory of investment, where Q is the ratio of the market value to the book value of capital.

It turns out that empirical support for the relationship between investment and the Q-ratio is weak for the economy as a whole.[2] However, it is possible to show that such a relationship exists at the level of individual firms (Graph 4). Estimates from Tobin's Q type models based on Australian firm-level data indicate that non-mining investment has been unusually weak by historical standards in recent years. This is true after controlling for many other factors typically included in such models, such as sales growth and cash flows. For firms in the Bank's liaison program, it also appears that investment has been weaker than the recent growth in sales would suggest.

Graph 4: Non-mining Q Ratio and Investment

With that in mind, let's consider some possible explanations for the weakness in non-mining business investment, and what that might imply for the outlook.

The cost of borrowing remains too high and external finance is difficult to access?

My discussion so far has ignored the fact that firms face financing constraints of varying degrees and certain types of finance are more costly to obtain than others. In particular, the cost of external equity finance is typically greater than the cost of external debt which, in turn, is greater than the cost of internal funding.

Financial constraints certainly became more pervasive for many firms as the global financial crisis unfolded. However, those constraints have eased over time. More recently, external financing has become widely available at very favourable cost. Primarily, this reflects the stance of monetary policy (both in Australia and abroad), which is delivering historically low levels of interest rates, ample liquidity and has helped to push up equity prices.
Indeed, a common refrain of firms in the course of our business liaison has been that neither the cost nor the availability of external finance have been factors limiting investment of late. Moreover, (non-financial) corporate balance sheet data indicate that many Australian companies currently hold relatively high levels of cash, suggesting that they have access to resources to finance investment when the time comes.

The exchange rate is too high?

The exchange rate has declined somewhat relative to its peak in the first half of 2013. But it remains high, especially given the sizeable decline in commodity prices this year. The implications of this vary across traded and non-traded sectors.

A further decline in the exchange rate would provide additional support to demand for domestic firms producing tradable goods and services. At the same time, however, the high exchange rate also means that imported capital goods are currently relatively cheap.

Hence, the still-high level of the exchange rate may be a net positive factor for the investment plans of some firms in non-tradable industries. For firms in tradable industries, on the other hand, the low cost of imported capital is offset by the effect of the high exchange rate on the demand for the goods and services they produce.

In short, the high exchange rate might be playing a part in restraining investment in some sectors of the economy, but it's unlikely to be the full story.

Animal spirits are too weak?

What is often referred to as ‘animal spirits’ consists of three key elements.[3] First, there is uncertainty, which describes the range of possible outcomes, let's say for demand, but other things like costs matter too. Second, there is the expected or most likely outcome. Together, these describe the distribution of possible outcomes. But firms' willingness to invest also depends on the third element, which is their appetite for risk. I'll consider each of these elements in turn.

The outlook is too uncertain?

On the surface, uncertainty seems like an appealing explanation for subdued investment. However, we should remember that firms always have to make investment decisions in an environment of uncertainty, not just about the prospects for the macroeconomy but also for their industry. Rather, the question we need to ask is whether uncertainty in recent years has been elevated?

There are a number of ways that we might try to measure the extent of uncertainty. One measure is the volatility of firms' share prices (Graph 5).[4] Another is the dispersion of analysts' forecasts of firms' earnings (per share). A third can be constructed by looking at the proportion of news stories that mention uncertainty.[5] These measures all increased at the time of the global financial crisis. All of the measures have since declined to be around the levels seen prior to the financial crisis, when non-mining business investment had been growing strongly.[6]

Graph 5: Uncertainty Indicators

Expectations regarding demand are too weak?

Even if uncertainty about the range of possible demand outcomes is not too different from the past, the most likely outcome – the mean of the distribution – might still be too weak to lead to significant new investment projects.

Business surveys ask firms what they expect conditions will be like in the near future; the results are described as ‘business confidence’. The long-running NAB survey suggests that business confidence was in decline and below its long-run average up to the middle of last year (Graph 6). Since then, it has picked up noticeably. This improvement was shortly followed by a broad-based pick-up in the survey's measure of actual business conditions (that is, trading conditions, profits and employment). According to the NAB survey, and a number of other business surveys, business confidence and conditions are now above average.

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