Thursday, June 29, 2017 06.58AM / By, Mark Carney, Governor of The Bank Of England at the 2017 ECB Forum On Central Banking, Sintra, 28 June 2017
The experience of business investment in the UK since the onset of the financial crisis broadly matches that elsewhere in the advanced world – a sharp fall followed by a feeble recovery (Chart 1). Peak to trough, the level of UK business investment fell by 20%, and it was six years before it surpassed its pre-crisis level, putting the recent experience at the bottom of the swathe of past UK cycles.
In my brief remarks today, I will offer some possible explanations for this performance before concluding with comments on the outlooks for UK investment and monetary policy.
I. Investment since the crisis
In part, weak investment reflects a weak economy, with the recovery following the crash being the slowest since the Great Depression.
Weakness in demand is not, however, the whole explanation. Business investment has underperformed relative to output since the crisis, with the ratio of the two falling in the UK by around 2 percentage points in the immediate aftermath (Chart 3), similar to the experience in other advanced economies.
Falls in investment tend to be more persistent for recessions associated with financial crises (Chart 4).1 This partly reflects restrictions in credit supply constraining investment, as well as productivity, wages and economic performance more generally.2 But weak UK investment also reflected a necessary adjustment in the capital stock. That overhang – which peaked at close to 10% in the UK – is being gradually worked off through a combination of a recovery in output and a prolonged period of subdued net investment (Chart 5).
And in part weak investment could reflect a misallocation of capital in the run-up to the crisis. In this regard, the situation in the UK was a bit different to that in countries such as Spain and the US where significant residential and commercial property construction booms subsequently turned to busts. Without a housing glut to work off, the weakness of UK investment is all the more striking.
Another form of misallocation could be the ability of so-called zombie firms to live on in the very low interest rate environment. The BIS’s proxy for this has seen the share of the “living dead” more than double since the crisis.3 In contrast, the Bank of England estimates that the proportion of zombie firms in the UK has fallen by a quarter since 2008 (Chart 6).
Increased uncertainty has undoubtedly contributed to weak investment.4 Confirming the adage that bad things come in threes, companies have faced uncertainty about the economy, geopolitics, and economic policy, all of which are likely to have clouded the outlook for how investments will perform (Chart 7).5 Greater uncertainty about returns means that fewer investment projects will be seen as worthwhile. This could help explain the “puzzle” of why hurdle rates in business investment have remained stubbornly high despite the weaker secular outlook for growth implied, for example, by long-term bond yields. The answer may be that the expected volatility of earnings growth has increased.
As an illustration, a simple Black – Scholes model suggests that the hurdle rate for expected returns is high – in the region of 10 percentage points (Chart 8)6 –consistent with survey evidence for the UK (Chart 9). A 10-percentage point pick up in the volatility of expected earnings could almost double that rate, swamping the impact of lower risk-free returns.
All of these explanations concern the legacy effects of the crisis, but secular forces may also be at work. For example, over the past thirty years investment has shifted from fixed assets towards intangibles – such as computer software, intellectual property, and research and development.7 This may have dampened the traditional investment accelerator. Increases in demand are usually accelerated by increases in investment – higher demand boosts companies’ profits, increasing their net worth and so allowing them to undertake further investment, as well as stimulating incomes and spending further.
A wide range of analysis suggests that the shift towards intangibles has, however, dampened this effect, perhaps because intangible assets are less suitable for use as collateral than physical assets, such as property.8 The weakness in investment is of course linked to weak productivity. In the UK, while the most productive companies have continued to innovate, others have become slower at adopting those innovations. That has stalled diffusion of productivity gains through the economy (Chart 10).
This shortfall in investment could reflect deeper causes such as inadequate competition, barriers to investment in knowledge-based capital and sub-optimal managerial practices.9 Although these secular forces may likely persist, many of the conditions for a revival in business investment are now in place.
II. The Contribution of Central Banks to Investment
Recognising that the most important contributions will be from structural policies, how can central banks support that belated investment recovery?
First, we must acknowledge that, while the cost and availability of finance matters; internal cash flows, the profit outlook and uncertainty are far more important determinants of investment. Monetary policy affects companies’ profits and cash flows through its effects on domestic demand and, via the exchange rate, external demand. Given the importance of internal finance for investment, and the high hurdle rates investment projects must clear, such indirect effects are more important for investment than the direct effects on the cost of capital. The biggest contributions of central banks are therefore improving the demand and profit outlooks and reducing uncertainty.
Allow me to use the current situation in the UK to illustrate these points.
UK output is now in sight of potential, and the capital overhang looks set to be eliminated over the next few years. In order to expand, companies will increasingly need to invest.
A strengthening global economy should tempt UK companies to do so, particularly since UK companies are generally competitive given the recent fall in sterling. Indeed, the broad-based global recovery is creating the possibility of a self-reinforcing revival in investment. The Bank of England estimates that more than 80% of the world economy is now growing above potential. Global measures of industrial production and capital goods orders, as well as world trade, have strengthened markedly over the past year, suggesting some rotation in the composition of global demand towards investment. With that more favourable outlook, investment intentions are now rising around the world (Chart 11).
If these intentions are realised, the global equilibrium interest rate could rise somewhat, making a given policy setting more accommodative.
The extent to which it does will depend on other secular factors that have been holding it down, including demographics, debt overhangs and the capital intensity of production.10 In this generally constructive environment, the main issues facing UK companies are uncertainties – about how consumers will adjust to a period of weaker real income growth; about market access post-Brexit; about the potential risks in the transition to new arrangements with the EU and the rest of the world.11 In this context, the best contribution the Bank of England can make is maintaining financial and monetary stability by pursuing the right policies within consistent frameworks.
In recent years, the Bank has been determined to remove any lingering uncertainties that companies may have about access to finance in good times and bad. The Bank is building the resilience of the financial system through much higher capital levels, more prudent underwriting standards, rigorous stress testing and appropriate contingency planning. The core tier 1 capital ratios for major UK banks are now almost 14% (Chart 12). Yesterday, the FPC increased the countercyclical capital buffer rate to 0.5% from 0%, announced higher expectations of lenders’ underwriting standards for consumer credit, and recalibrated the leverage ratio. With detailed contingency planning for the financial stability impacts of Brexit, UK companies can be confident of continued access to finance in an uncertain world.
Reforms mean the UK financial system is working well. Net lending to private companies is been growing following six years of contraction. Corporate bond spreads are well below their long-run averages (Chart 13). And credit conditions among SMEs have been steadily improving.
If the opportunities present themselves, UK corporates could readily draw on this finance as their balance sheets are in good health following a decade of de-levering to ratios amongst the lowest in advanced economies.12 Turning now to monetary policy, the Bank operates within an established framework, anchored in the inflation target (Chart 14). The MPC set out in advance of the referendum how it would apply that framework, emphasising that the effects of the process of leaving the EU on inflation would depend on its impact on demand, supply and the exchange rate. The Committee has repeatedly stressed that, as a result, the implications for monetary policy would not be automatic.
The MPC has also clearly set out its reaction function consistent with its remit. Under the exceptional circumstances Brexit entails (with an inflation overshoot driven entirely by an exchange rate depreciation caused a large fundamental shock), the Committee is required by its remit to balance a period of above-target inflation with a period of weaker growth. As the primary objective of monetary policy remains inflation control, any overshoot of inflation above the target can only be temporary in nature and limited in scope. As such, the MPC has been clear that its tolerance for above-target inflation is limited.
Since the prospect of Brexit emerged, financial markets, notably sterling, have marked down the UK’s economic prospects. Monetary policy cannot prevent the weaker real income growth likely to accompany the transition to new trading arrangements with the EU. But it can influence how this hit to incomes is distributed between job losses and price rises. And it can support households and businesses as they adjust to such profound change.
As spare capacity erodes, the trade-off that the MPC must balance lessens, and, all else equal, its tolerance for above-target inflation falls (Chart 15). Different members of the MPC will understandably have different views about the outlook and therefore the potential timing of any Bank Rate increase. But all expect that any changes would be limited in scope and gradual in pace.
When the MPC last met earlier this month, my view was that given the mixed signals on consumer spending and business investment, it was too early to judge with confidence how large and persistent the slowdown in growth would prove. Moreover, with domestic inflationary pressures, particularly wages and unit labour costs, still subdued, it was appropriate to leave the policy stance unchanged at that time.
Some removal of monetary stimulus is likely to become necessary if the trade-off facing the MPC continues to lessen and the policy decision accordingly becomes more conventional. The extent to which the trade-off moves in that direction will depend on the extent to which weaker consumption growth is offset by other components of demand including business investment, whether wages and unit labour costs begin to firm, and more generally, how the economy reacts to both tighter financial conditions and the reality of Brexit negotiations. These are some of the issues that the MPC will debate in the coming months.
After an expansion that has relied overly on consumption, the rotation to other components of demand, particularly investment, will be important to sustain momentum. Stronger investment will support productivity growth, stronger wages and higher welfare for all.
It will also give monetary policy more traction. Globally, there are signs that such a rotation may be beginning. Although some UK–specific uncertainties might limit the UK’s participation in that pickup, the Bank of England will make its contribution by pursuing determined policies within well-established frameworks in order to maintain monetary and financial stability.
References – Full Speech & Slides
1. Building The Infrastructure To Realise FinTech's Promise - Speech by . Apr 2017
2. Speech Given By Mark Carney, Governor Of The Bank Of England, At .Jan 2017
3. Financial Policy Committee Statement From Bank Of England's ..Sept 2016
4. China’s Yuan Achieves Milestone, Becomes A Global Reserve Currency
5. West Africa RiskMap 2017; No Smooth Sailing in the “New Normal”
6. Bank Of England Statement On EBA Stress Test Publication
7. Globalisation is Dented but not Doomed
8. Opening Remarks by the Governor, Bank of England - Financial Stability Report
9. The UK's Future Economic Relationship With The EU