By Christo Luüs
It is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so, that the most judicious operations of banking can increase the industry of the country. Adam Smith (1723-1790)
Capital is dead labour, which, vampire-like, lives only by sucking living labour, and lives the more, the more labour it sucks. Karl Marx (1818-1883)
Capital as such is not evil; it is its wrong use that is evil. Capital in some form or other will always be needed. Mahatma Gandhi (1869-1948)
Whatever one’s ideological view about how to best develop the resources of an economy for the benefit of its people, capital – however defined – is a necessary and often costly ingredient of the process.
In this paper, an attempt will be made to briefly explain how the effective and efficient allocation of capital resources can benefit growth and development.
Firstly the preconditions for higher and sustained levels of economic growth will be considered. Thereafter the role of savings and investment in a macro context and South Africa’s experience in this will be highlighted. Next, a short discussion will follow on some of the reasons for regulatory and market failures in ensuring sufficient availability of long-term finance for development. Thereafter some of the trends likely to constrain the future supply of long-term finance will be highlighted. The paper will conclude with some proposed international actions aimed at addressing the barriers to long-term financing.
Let us firstly look at what economic theory and experience across the globe have taught us about the most important factors which can be regarded as prerequisites to obtain high and sustainable rates of economic growth in an economy. This list should not be seen as exhaustive, while emphasis on various aspects can be expected to be different for different economies depending on their levels of development, location, resource endowment, etc.:
- Maintaining law and order, protecting private property rights, and eliminating corruption, which need to be the state’s top priorities
- Maintaining a stable macro-economic climate – especially low inflation – by sticking to sound fiscal and monetary policies
- Motivated and skilled people, which is mostly achieved by having a first-rate education system
- Embracing new technologies – something both the state and business must do
- A fair, efficient and non-penalising tax system
- Sufficient competition in all sectors of the economy, which the authorities need to ensure
- Maintaining international creditworthiness
- Allowing businesses to operate profitably and with the lowest possible regulatory burden
- Prioritising the expansion and maintenance of infrastructure
- Sufficient levels of saving and fixed capital formation.
The last two aspects are primarily concerned with the allocation of capital in the economy and the importance of savings to finance this capital.
Saving and investment in a macro context
This brings us to the way in which savings and capital formation interacts.
One basic but important identity describes the functioning of an economy:
Y = C + G + I + (X – Z)
Y = Gross domestic product
C = Private consumption expenditure
G = Government consumption expenditure
I = Gross fixed capital formation
X = Exports of goods and services
Z = Imports of goods and services
Taxes can now be added to the system, so we get:
(Y – T) = C + I + (G – T) + (X – Z)
(Y – T) is now disposable income while (G – T) is the budget deficit. And if we bring C to the left of the equation and shuffle the terms around, we get:
(Y – T – C) = I + (G – T) + (X – Z)
And one can immediately see that disposable income less consumption expenditure, is the saving in the economy:
S = I + (G – T) – (Z – X)
This equation simply states that domestic savings are used to finance domestic capital formation (I), the budget deficit, less the trade deficit. The trade deficit will normally be financed through offshore trade finance flows facilitated via the forex market. But if more I is required, a deficiency of S will need to be augmented by either the government running a smaller deficit or even a surplus, and / or by foreigners committing long-term capital to the economy.
Capital formation is seen as the spending on the various types of infrastructure that, all things being equal, can expand the productive capacity of an economy. This encompasses tangible assets (such as roads, bridges, ports, machinery, factories, commercial buildings, hospitals, and new housing units) and intangible assets (such as education, research and development) which increase future prospects for innovation and competitiveness.
Many of these investments are at least partially public goods that eventually generate greater returns for society as a whole by expanding vital services, increasing citizen’s’ quality of life, or enabling the movement of people and goods. They enable companies and governments to produce more goods and services with fewer resources, raising productivity growth.
Using this definition of long-term investment, it is perhaps useful to look at the level and composition of capital formation in South Africa, compared with some major emerging market and developed economies. The economies shown here together represent more than 60 percent of world gross domestic product (GDP).
From the graph it is clear that investment levels are typically between 25 percent and 30 percent of GDP, though they can be much higher in countries undergoing rapid industrialisation and urbanisation. India and China, for example, had capital formation levels equivalent to respectively 35 percent and 51 percent of GDP in 2011. Underscoring the pivotal role of the private sector, we find that equipment and software is the largest category of long-term investment, averaging 8.8 percent of GDP across this sample of economies. This is two to three times greater than infrastructure, and even exceeds investment in residential properties.
Fixed capital formation (which excludes R&D and education spend) in South Africa fell from an average of almost 30 percent of GDP in the early 1980s to about 16 percent of GDP by the early 2000s. Public infrastructure spending is also at low levels by historical standards. In effect, South Africa has missed a generation of capital investment in roads, rail, ports, electricity, water, sanitation, public transport and housing. To grow faster and in a more inclusive manner, the country needs a higher level of capital spending. Gross fixed capital formation needs to reach about 30 percent of GDP by 2030, with public sector investment reaching 10 percent of GDP, to realise a sustained impact on growth and household services.
In the National Development Plan, which has been adopted as the blueprint for South Africa’s economic policy conduct leading up to 2030, the National Planning Commission expresses the view that in the long term, users must pay the bulk of the costs for economic infrastructure, with due protection for poor households. The role of government and the fiscus should be to provide the requisite guarantees so that the costs can be amortised over time, thereby smoothing the price path. The state must also put in place appropriate regulatory and governance frameworks so that infrastructure is operated efficiently and tariffs can be set at appropriate levels. For infrastructure that generates financial returns, debt raised to build facilities should be on the balance sheets of state-owned enterprises or private companies that do the work. Guarantees should be used selectively to lower the cost of capital and to secure long-term finance. Subsidies to poor households should be as direct and as transparent as possible. Social infrastructure that does not generate financial returns – such as schools or hospitals – should be financed from the budget.
Financing long-term investment requires long-maturity instruments and investors with long time horizons
Diagram 1 illustrates the flow of long-term finance from providers through the intermediation process to the end users. Long-term finance is the provision of long-dated funds to pay for capital-intensive undertakings that have multiyear payback periods.
Various sources act as providers of long-term finance including domestic and foreign households, corporations, and governments. Funds may also come from corporate earnings, government revenues, or household income and wealth, and a proportion of the financing may go directly to the end users. However, due to mismatches in risk aversion, time horizons or simply the availability of funding, intermediate systems may be required to match the sources with the users of funds.
Long-term finance may then flow through various intermediaries (such as banks, insurers, pension funds, etc.), or alternatively the intermediation may be undertaken by the capital markets. The precise balance within this intermediation process between financial institutions and capital markets varies across the globe.
The users of long-term finance apply them to different investments including infrastructure, commercial and residential properties, plant and equipment, equipment and software, and so forth.
The academic research on the connection between finance and growth is well established. However, the literature has often not distinguished between long-term and short-term finance. Nevertheless, it is regarded as important to focus on long-term finance since it is less procyclical than short-term finance and perhaps more supportive of long-term economic growth. Moreover, a prevalence of long-term finance may promote a more stable financial system. Because many long-term investments require an extended gestation period to account for complex development or construction, investors must be prepared to accept a long time horizon for debt repayment or return on equity. They must also be prepared for the likelihood of major downside risk along the way. This is a crucial consideration in designing the appropriate financing mechanisms, because relying on short-term finance for long-term projects likely adds an additional layer of instability.
Reasons for regulatory and market failures in ensuring sufficient availability of long-term finance for development
As was alluded to, one of the goals of the financial system is to efficiently and seamlessly match savings with long-term investment opportunities. In reality, however, long-term financing is often executed with terms and vehicles that are not appropriately tailored to the needs of the borrower or the investor—and in some instances, these frictions can substantially increase risk. There is a need to increase the level of savings available, and to more effectively match savings to long-term investment opportunities.
Long-term finance may be constrained or fall short of the objectives to satisfy the demand for economic development. The following points must be seen as generic and the conditions described may not always apply to the South African situation.
Firstly, potential long-term investors should not be constrained in their ability to provide financing. Pension funds, sovereign wealth funds, insurance companies and other investment operations are ideal candidates to provide long-term financing for projects. But barriers such as incentives and restrictions on portfolio allocations may make this difficult to achieve. Pension funds in many developed economies face shortfalls that have intensified short-term performance pressures, while they also face risk-mitigation rules that favour low-risk fixed-income securities.
For example, allocations to equities in both defined-contribution and defined benefit funds has dropped by 22 percent in the United Kingdom, 17 percent in the Netherlands, and 9 percent in Switzerland since 2001. Meanwhile, pension funds in most emerging markets are relatively small, contributing to the lack of long-term financing supply.
Sovereign wealth funds represent another set of potential long-term investors, but some are mandated to focus on fiscal stabilisation and thus hold large shares of cash or low-risk government debt. In major Asian economies alone, between US$3 and US$4 trillion of central bank reserves could be invested through diversified sovereign wealth funds.
Insurance firms, like pension funds, have long-dated liabilities, but over the last decade, many have reduced their allocation to equities in many countries. This is a particularly striking trend in Europe, driven by management-led, risk-reduction strategies over the last ten years and, more recently, by anticipation of Solvency II regulations. Policy makers need to address regulatory and other barriers that currently constrain and limit the ability of these key long-term investors to provide the finance economies will need in the future.
Although South Africa’s Regulation 28 now prescribes maxima for various types of investment that may be made by a retirement fund, the same reduction in allocations to equities as had occurred in some developed markets, did not happen locally. In fact, official pension funds increased their exposures to shares from only 12 percent in 1993 to 54 percent in 2013, while private pension funds’ exposure to shares increased from 39 percent to 57 percent over the past twenty years. Long term insurers maintained their equity exposures to around 50%. Fixed property holdings decreased amongst all three major investor groups shown here, while insurers’ and official pension funds’ relative holdings of bonds also decreased.
Secondly, long-term financing in many countries might rest on a narrow range of instruments. Policy-makers intent on unlocking new sources of long-term finance should foster the growth of new markets and instruments that can help fill the gap between the current sources and projected future demand for long-term investment. While US bond, equity, and securitisation markets are mature and liquid, this is not the case in much of the world. Banks are and will remain for the medium term the dominant source of external financing for most countries outside the United States. Commercial bank loan maturities average only 2.8 years in emerging economies and 4.2 years in developed economies—far shorter than bond maturities. There is large scope to increase the size of corporate bond markets in Europe and several other advanced economies, and in emerging economies over the medium to long term as a complement to the continuing important role that banks must play.
Bank lending will remain an important source of financing in Europe. However, with the right standards and regulations in place, more small business loans could be packaged into securities and sold to investors, enabling banks to extend more credit. Emerging economies account for a rising share of the world’s wealth, but their corporate bond, securitisation, and even equity markets remain largely underdeveloped. Bank lending provides the majority of financing in most of these economies, with banks accounting for 75 percent of financing in China.
Prudent growth of new bond, securitisation, and equity markets in emerging economies, adequately overseen and supervised, must be part of the solution to the long-term finance problem.
Thirdly, cross-border capital flows have often been driven by short-term, volatile lending. Globally, cross border capital flows increased from US$4.9 trillion in 2000 to US$11.7 trillion in 2007. Nearly 60 percent of this growth was driven by cross-border lending, but most of this was short-term in nature. Since then, cross-border capital flows have fallen precipitously, and they now remain nearly 60 percent below their pre-crisis peak. Approximately half of this drop was driven by a contraction in cross-border bank lending, primarily within Europe.
It is clear that enabling more stable flows of long-term capital (such as foreign direct investment) to countries with large investment needs will need to become a priority. Some countries, like China, may have sufficient domestic savings to fund their growth. But many rapidly industrialising and urbanising emerging markets will need foreign investors to help fund capital-intensive investments.
Trends likely to constrain the future supply of long-term finance
By 2020, annual long-term investment in ten of the major developed and emerging economies shown in graph 1, is projected to increase by roughly US$7 trillion above current levels. But a few major trends on the horizon are likely to constrain the future supply of long-term finance. In the absence of adequate responses to these trends, prospects for achieving the levels of annual long-term investment assumed in most investment demand projections will be greatly reduced. Under these circumstances, long-term economic growth and future job creation may well be jeopardised.
Bank deleveraging and new regulation. In the aftermath of the financial crisis, banks have been rationalising their business models by tightening underwriting standards or forgoing certain types of lending altogether. The banking industry is also adjusting to market demands for more and higher quality capital, and to new regulatory regimes and higher capital and liquidity requirements. Basel III, in particular, raises the cost of issuing long-term corporate and project finance loans above the cost of issuing mortgages and short-term loans. This is not to argue for a reversal of the new capital regime, but perhaps to call for the emergence of new sustainable sources of finance beyond bank lending.
Fiscal consolidation. Mature economies are struggling to manage a heavy and/or growing burden of public debt. Fiscal consolidation over the medium term is likely to become a reality in many countries – a trend that could particularly constrain government capital formation in infrastructure and education. In future, the private sector will need to be mobilised to fill the gap and ideological opposition against such developments will need to be overcome rather urgently.
Ageing populations. Ageing is one of the most powerful demographic trends worldwide, including in Australia, Canada, China, Europe, Japan, the Republic of Korea, and the United States. Older investors are already shifting their portfolios toward lower-risk assets such as deposits and fixed income. Equity is a crucial source of long-term finance for corporations, but the cost may increase significantly in the face of declining demand.
Rising compliance and regulatory costs. Although fund management is a growth industry internationally, in South Africa an onerous regulatory burden is contributing significantly to rising costs and squeezed margins. Fund managers’ costs have become harder to control with increased regulation, compliance and reporting – requiring more systems, software and staff. Fund management fees are also under scrutiny as the National Treasury looks to broaden the savings base, improve preservation and reduce the costs of saving. However, a point often missed is that the asset management fee is only part of the overall cost of saving.
International actions to address the barriers to long-term financing
To stimulate public debate, the G30 Working Group on Long-term Finance has set out five core objectives and fifteen proposals that, if acted upon, would support the growing need for long-term finance and address regulatory changes, market developments, issues of international coordination, and the creation of new institutions. These core objectives can be summarised as follows:
Ensure investors are better able to take a long-term horizon in their investment decisions. Action by national and international regulatory bodies will be essential in achieving this objective. National regulators and international bodies such as the International Monetary Fund, the World Bank, the Organisation for Economic Co-operation and Development, and the Financial Stability Board, therefore need to propose new best-practice guidelines to promote long-term horizons in the governance and portfolio management of public pension funds and sovereign wealth funds.
National policy makers should consider steps to differentiate between short-term and long-term debt (whether public or private), and should consider weighing the pros and cons of phasing out the preferential treatment of sovereign debt in insurance and bank regulation over an extended time horizon. The Financial Stability Board, in coordination with relevant standard-setting bodies, should review the regulatory and accounting treatments of assets held with long-term horizons to avoid excess focus on short-term market volatility.
Create new intermediaries and instruments geared toward the provision of long-term finance. The creation of new instruments should be supported to enable the public sector to leverage private sector capital for long-term financing, including greater use of public/private partnerships and the creation of new dedicated long-term financing institutions. Creating and fostering new savings pools that can act as sources of long-term finance in the future, will also be necessary. Long-term pension and insurance-based savings can be encouraged by setting up compulsory auto-enrolled savings programs. Governments may also consider redirecting a portion of structural surpluses in national savings to diversified sovereign wealth funds with a long-term investment mandate.
Develop debt and equity capital markets in order to promote a broad spectrum of financing instruments. Policy makers seeking to achieve this objective ought to balance systemic and supervisory oversight with the need to grow markets that support new instruments and channels for flows of long-term investments from providers to end users. The implementation of the Financial Stability Board’s regulatory reforms is designed to transform shadow banking into resilient market-based finance. Policy makers are urged to take the necessary steps to develop corporate bond markets that support the efficient and sound securitisation of long-term debt. Developing the infrastructure for capital markets in emerging economies to lengthen financing horizons and diversify sources of funding will also be important. If policy makers are to develop and support markets they should also aim to eliminate regulatory biases and perverse incentives. In particular, they should consider removing the bias against equity in countries where it is present.
Ensure that cross-border flows support the efficient global allocation of capital to long-term investment. It is clear that open markets help support sustainable economic growth, and cross-border capital flows assist in the efficient allocation of capital to that end. But it should be recognised that volatile short-term capital flows can create financial instability. Policy makers must support the international diversification of investment portfolios in both developed and emerging markets. Policy makers should also gradually move toward liberalisation of capital accounts in emerging markets while maintaining financial stability, using macro prudential policy tools.
Strengthen systemic analysis when setting future regulatory policy. Policy makers must consider the systemic impact of ongoing and future regulatory changes on long-term investment. Failing to do so could result in today’s modest unintended consequences becoming tomorrow’s much larger real economic problems. Ensuring a supply of long-term finance adequate for the needs of the global economy as it emerges post-crisis will be a huge task. Above all, addressing the need for adequate long-term finance requires a sense of urgency. The solutions are not simple: they are complex, multifaceted, and multidimensional. But strengthening the provision of financing for long-term investment will be critical to the building of a solid foundation for economic growth and job creation in the years to come.
Sources and references
Long-term Finance and Economic Growth; Group of Thirty; Washington DC; 2013
Long-Term Investment Financing for Growth and Development: Umbrella Paper; Prepared by World Bank staff based on input from the staffs of the Organisation for Economic Cooperation and Development, International Monetary Fund, UNCTAD, UN-DESA, World Bank Group, and the Financial Stability Board; Moscow; February 2013
National Development Plan – 2030; National Planning Commission
The rise of capital markets in emerging and frontier economies; Association of Chartered Certified Accountants; March 2012