Returning to Investment

GENEVA – 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.

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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 four-fifths 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-and-distribute” 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 developing-economy companies pursuing the same corporate-governance strategies as firms in developed countries. Judging by non-financial firms’ balance sheets, investment-to-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 portfolio-investment options in liberalized 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, financialization continues to disrupt macroeconomic stability worldwide. For example, developed economies’ quantitative easing programs have contributed to excess liquidity – and thus to the recent corporate-debt explosion in emerging economies. Across a sample of these economies, non-financial 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-fueled 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, telecommunications, 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 financialized corporate strategies. This will require changes in corporate governance generally, and in non-financial 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.

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As for the macroeconomic environment, governments can improve conditions through public investment, particularly 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.