Economics: Investment vital to sustain revival
Sunday 01 May 1994
The amount companies invest in capital equipment helps determine how rapidly the economy can grow before its gears begin to grind. A lack of investment leaves industry with too little capacity to meet rising demand from consumers at home and abroad. If industry falls behind, exports stall, imports surge and inflation accelerates as frustrated consumers bid up prices. When this happens, the brakes have to be slammed on and the recovery brought to a halt.
The Trade and Industry Select Committee highlighted the threat of under-investment in a report on the competitiveness of British manufacturing last week. But it is important to remember that investment is vital throughout the economy; computerisation means that the amount spent per worker on capital equipment is as high in banking as metal-bashing.
As in most industrial countries, manufacturing in Britain has declined in importance relative to service industries. Manufacturing output grew quickly relative to other countries in the 1980s, but by early this year output was barely 2 per cent higher than in 1973.
Factory output has risen steadily since the recession bottomed out in the spring of 1992, but the select committee warned that under-investment could push manufacturing into a decline, as the quality of its technology and products fell behind those of overseas competitors. This is an alarming prospect. As manufacturing still provides 60 per cent of British exports, it would make the economy vulnerable to balance-of-payments crises at ever more anaemic rates of growth.
Tuesday's quarterly industrial trends survey from the Confederation of British Industry did not show any signs of an imminent surge in capital spending to rectify the problem. Only 30 per cent of manufacturers said they intended to increase investment in the coming year, while 26 per cent expected to cut it back.
More than half the manufacturers questioned said they were deterred from investing by uncertainty about demand. Slightly fewer said they were discouraged by inadequate rates of return, which is a jargonistic way of saying that the potential projects were not expected to produce enough revenue to offset their expense and risk.
But the select committee argued that many manufacturers are too short-termist. They look for unrealistically high rates of return that enable investment spending to be recouped unnecessarily quickly. Potentially profitable projects are being missed and opportunities to improve the quality of products and production processes squandered because manufacturers are not prepared to wait more than a couple of years for a project to make money.
A survey by the Cranfield School of Management of investment projects undertaken last year found that the rate of return demanded of strategic investment projects (such as introducing a significant change in technology) averaged 16 to 20 per cent. This was well above the cost of borrowing the money to fund the investment, even with a premium to cover the risk of it failing.
The Bank of England argues that companies have not yet adjusted the rates of return they demand from capital investment to the new era of low inflation and interest rates. Investment is paid for upfront, but the resulting flow of revenue is spread over a number of years in which inflation can erode its value. So managers should be prepared to accept lower rates of return when inflation is expected to stay subdued.
The relatively high inflation and interest rates of the 1970s and 1980s justified required rates of return of 20 per cent or so, according to M & G, the fund management group. But if companies expect the Government to keep to its 1-4 per cent inflation target, then rates of return a little over 10 per cent would be more appropriate.
Manufacturers and the banks who lend to them may indeed have been slow to adjust the rates of return they look for to this sort of level. But this probably has less to do with inertia or ignorance than an entirely reasonable suspicion that the Bank and the Treasury will botch things up and allow inflation to take off again.
The authorities will only be able to remove this barrier to investment by convincing managers that they can maintain a stable economic environment of low inflation and reasonable growth. The example of the German Bundesbank shows that this is not achieved overnight by pious promises - or even the publication of the minutes of policy-making meetings - but by getting the right results year after year.
However, there are more direct ways in which the Government could help. One reason managers only invest when rates of return are high is the demand of institutional shareholders for high and unvarying dividend payments, which have left British companies paying a higher share of profits to shareholders than their German and Japanese counterparts. High dividends reduce the funds available for investment and discourage projects that threaten dividend payments in the short term.
The select committee sensibly proposed tax changes to encourage retention and reinvestment of profits, perhaps by promoting the payment of dividends in the form of extra shares. The committee also suggested controls on hostile takeovers to reduce the pressure on companies to boost their share price, but this would also remove a useful discipline on under-performing managements.
It is hardly surprising that the select committee should be voicing its concern about investment after three years in which it has fallen by more than 20 per cent. But the pessimism of the CBI survey notwithstanding, there are good reasons to expect that another sharp rise is about to occur.
Companies have plenty of funds with which to invest, and utilisation of existing capacity now exceeds its long-term trend. Growing sales revenues, lower taxes and smaller interest payments have all helped the corporate sector reverse the enormous deficit it ran in 1989 and 1990 after companies over-invested in the boom. Profits are growing rapidly, with plenty being retained despite the high dividend payments.
Given this scenario, it would not be surprising to see investment rise by 5 per cent this year and more still in 1995. But does this not mean that the select committee is being unecessarily alarmist? Two points are important to remember. First, that investment always rises more quickly than consumption once a recovery is under way, increasing its share of national spending. It is still the case that we invest too little and consume too much at any given stage of the economic cycle. Second, the type and quality of investment is just as important as its quantity.
Kevin Gardiner, economist at Morgan Stanley, argues that the cyclical upturn in investment will deepen the industrial base rather than widen it. Successful industries - such as pharmaceuticals, food processing and aerospace - will reinforce their position, but the product range offered by UK plc is unlikely to widen very much. So if consumers are still forced to buy imports, the balance-of-payments constraint will remain tight.
One response to this problem would be for the Government to pick a sector it thought had potential and invest in it itself. The Clinton administration took this route on Thursday, granting up to dollars 700m ( pounds 490m) for the development and manufacture of flat- screen technology such as that used in laptop computers. The plan is to create an industry virtually from scratch - the US has only 3 per cent of the market.
But the omens are not good. Western governments have been notoriously inefficient in 'picking winners', be they companies or industries. The British government would be ill-advised to follow suit. Far better to address the general barriers to investment identified by the select committee and to provide funding to individuals to buy themselves flexible technical education and training. The benefits will be slow coming, but more durable once they appear.
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