Should investment be left to the investors?

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Last autumn the Chancellor launched a rather vague-sounding Treasury review of the 'impact of tax and other government policies on savings and the flow of funds through the economy'. At the time this provoked no more than a brief flurry of interest and little more was heard through the winter. The silence was broken by a speech last week to the Confederation of British Industry by Stephen Dorrell, Financial Secretary to the Treasury.

Mr Dorrell is the minister in charge of the review and he used his speech to set out a proposed agenda for the issues the review needs to address. The agenda now being drawn up is topped by official unease at how the UK capital markets are working.

The view that our financial markets do not serve our industrial base particularly well can be traced back to the 1930s, if not beyond. Blaming the financiers nevertheless seems to be a growing theme of the 1990s. The clearing banks, for example, attracted considerable criticism through the recession and are now subject to a Treasury review all of their own.

Mr Dorrell now seems to be looking at equity investors as well. In particular, he is worried that institutional shareholders may place too much emphasis on dividend yield.

Recent years have been marked by concern at the share of corporate earnings going to finance dividend payouts rather than being retained to finance investment. So Whitehall has probably been far from pleased to note dividend increases well ahead of inflation in this spring's reporting season, despite a level of dividend cover that has barely started to recover from the recession.

The worry is that companies are paying out cash in the form of dividends that might have been profitably invested in new plant and equipment, improving competitiveness and creating jobs - creating the capacity, in other words, to meet the recovery in consumer demand without it all leaking away into higher imports.

The institutions' response to accusations that the company sector is being forced into over-distribution is straightforward enough - companies with a good case for fresh investment seldom find it difficult to raise funds in the market.

Last year, for example, despite having to help fund a record public sector borrowing requirement in the gilts market, institutional investors funded a record level of rights issues in the equity market, helping to bring about the biggest ever financial restructuring of the UK corporate sector. Thus, despite Mr Dorrell's doubts, the capital markets seem to be working well. If it works, don't fix it.

Moreover, scaling back dividends and allowing the cash simply to roll up inside companies may fail to get it where it is really needed to fund the best new investment projects.

One of the traditional risks for investors in companies with lots of cash in the balance sheet is that they embark on some vaguely madcap diversification scheme. Fund managers, with their ability to look across the whole span of the market, may be in a stronger position to form the best view of where investment returns are most promising in the economy.

Perhaps not surprisingly, the Treasury seems unconvinced by this argument. The process of companies paying out high dividends to investors, only to ask the same investors for cash to fund capital spending programmes, could, Mr Dorrell notes, lead to unnecessary and expensive churning of capital.

In addition, the Treasury needs to be convinced that institutional investors are as good at getting capital to where it is needed in the ecomony as they claim.

Since institutional shareholders play such a crucial role in our capital markets, the Treasury feels it important to ask how well they function in identifying good investment opportunities and avoiding bad ones.

To echo Tony Benn's memorable phrase, Mr Dorrell seems to be suggesting that investment may be far too important to be left to the investors, an important shift from the Thatcherite policy of letting the market decide.

Little wonder, therefore, that in its response to last week's speech the CBI concluded that the Treasury review of savings and taxation 'is potentially of greater significance for business than we originally thought'. The investment community might well draw the same conclusion after the next Budget.

The author is UK strategist at S G Warburg Securities.