Christopher Kent: Non-mining business investment - where to from
here?
Address by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank of
Australia, to the Bloomberg Economic Summit, Sydney, 16 September 2014.
* * *
I thank Lara Bui, Natasha Cassidy, Bernadette Donovan, Stephen Elias, Craig Evans, Gianni La Cava, Kevin
Lane and Tom Rosewall for help in preparing these remarks.
Accompanying graphs can be found at the end of the speech.
Introduction
I'd like to thank Bloomberg for the opportunity to talk to you today. I discussed this topic at
this same venue 18 months ago. The outlook for non-mining business investment is an
important element of our forecasts. It depends on a range of forces acting on the economy,
including the stimulus currently being provided by the very low level of interest rates. But,
forecasting economic activity is hard. Understanding and forecasting business investment is
arguably harder still.
When I was here in April of last year, I'd suggested that:
• mining investment would be likely to peak in 2013;
• non-mining investment would be likely to pick up, but only gradually; and
• growth for the economy as a whole would be a little below trend in 2013 and then
pick up gradually through 2014.
It now looks like mining investment peaked in late 2012 (Graph 1). Despite a substantial
decline in mining investment since then, growth of the economy overall picked up to a pace
that was around trend over the course of the past year. Much of that improvement has owed
to a sharp rise in resource exports.
At the same time, there has also been an improvement in the growth rate of economic
activity in the non-mining sectors, even though non-mining business investment has
remained subdued. This better growth of non-mining activity often gets missed given all the
focus on the resources boom. While this improvement is welcome, a key question is how
durable the improvement will be? It might even gather a bit more steam, thereby helping to
drive overall growth to an above-trend pace at some point. Such developments are possible
but by no means certain. They depend in part on non-mining business investment, which is
the motivation for my talk today.
Recent past
Over recent years, non-mining business investment has been subdued. After recovering from
the decline that followed the global financial crisis, non-mining business investment in real
terms has been little changed over the past three years or so (Graph 2). In nominal terms,
non-mining business investment is at a very low level as a share of GDP relative to its
history.1
Non-mining business investment should depend, in large part, on the strength of expected
demand in the non-mining sectors of the economy (over the life of that investment). Current
demand conditions, however, may have a strong influence on investment for two reasons.
First, firms tend to draw on recent experience when assessing prospects for future demand.
Second, stronger sales today will boost current cash flows, which will assist firms facing
financial constraints.
Hence, the gradual pick-up in the growth of non-mining economic activity over the past year
augurs well for investment. Low interest rates and robust population growth are underpinning
strong demand in the housing market, with house prices rising rapidly and dwelling
investment picking up strongly. Low interest rates are also supporting growth of consumption
at a time when subdued conditions in the labour market are weighing on the growth of
incomes. These developments, as well as growth in export industries such as tourism and
education, are consistent with a pick-up in business conditions across a range of industries.
Despite these gains, survey measures of non-mining capacity utilisation have not improved
much over the past year. A measure derived from the NAB survey (based on weighting
industries according to their contribution to investment) implies that capacity utilisation
remains a bit below average (Graph 3). By itself, this suggests that demand in the
nonmining sector will need to rise a little further before businesses feel the need to undertake
substantial investment in new capacity. Our forecasts for the economy suggest that this will
occur in time, but the extent and timing of new investment remains uncertain.
It's not just output/demand that matters
In addition to the strength of demand, a range of other factors also influence investment
decisions. In particular, investment depends on whether the expected return to new capital
outweighs the cost of installing it. In other words, a firm should invest whenever the market
value of its existing capital is greater than its book value. This is known, in academic circles,
as Tobin's Q theory of investment, where Q is the ratio of the market value to the book value
of capital.
It turns out that empirical support for the relationship between investment and the Q-ratio is
weak for the economy as a whole.2 However, it is possible to show that such a relationship
exists at the level of individual firms (Graph 4). Estimates from Tobin's Q type models based
on Australian firm-level data indicate that non-mining investment has been unusually weak
by historical standards in recent years. This is true after controlling for many other factors
typically included in such models, such as sales growth and cash flows. For firms in the
Bank's liaison program, it also appears that investment has been weaker than the recent
growth in sales would suggest.
With that in mind, let's consider some possible explanations for the weakness in non-mining
business investment, and what that might imply for the outlook.
The cost of borrowing remains too high and external finance is difficult to access?
My discussion so far has ignored the fact that firms face financing constraints of varying
degrees and certain types of finance are more costly to obtain than others. In particular, the
cost of external equity finance is typically greater than the cost of external debt which, in turn,
is greater than the cost of internal funding.
Financial constraints certainly became more pervasive for many firms as the global financial
crisis unfolded. However, those constraints have eased over time. More recently, external
financing has become widely available at very favourable cost. Primarily, this reflects the
stance of monetary policy (both in Australia and abroad), which is delivering historically low
levels of interest rates, ample liquidity and has helped to push up equity prices.
Indeed, a common refrain of firms in the course of our business liaison has been that neither
the cost nor the availability of external finance have been factors limiting investment of late.
Moreover, (non-financial) corporate balance sheet data indicate that many Australian
companies currently hold relatively high levels of cash, suggesting that they have access to
resources to finance investment when the time comes.
The exchange rate is too high?
The exchange rate has declined somewhat relative to its peak in the first half of 2013. But it
remains high, especially given the sizeable decline in commodity prices this year. The
implications of this vary across traded and non-traded sectors.
A further decline in the exchange rate would provide additional support to demand for
domestic firms producing tradable goods and services. At the same time, however, the high
exchange rate also means that imported capital goods are currently relatively cheap.
Hence, the still-high level of the exchange rate may be a net positive factor for the
investment plans of some firms in non-tradable industries. For firms in tradable industries, on
the other hand, the low cost of imported capital is offset by the effect of the high exchange
rate on the demand for the goods and services they produce.
In short, the high exchange rate might be playing a part in restraining investment in some
sectors of the economy, but it's unlikely to be the full story.
Animal spirits are too weak?
What is often referred to as "animal spirits" consists of three key elements.3 First, there is
uncertainty, which describes the range of possible outcomes, let's say for demand, but other
things like costs matter too. Second, there is the expected or most likely outcome. Together,
these describe the distribution of possible outcomes. But firms' willingness to invest also
depends on the third element, which is their appetite for risk. I'll consider each of these
elements in turn.
The outlook is too uncertain?
On the surface, uncertainty seems like an appealing explanation for subdued investment.
However, we should remember that firms always have to make investment decisions in an
environment of uncertainty, not just about the prospects for the macroeconomy but also for
their industry. Rather, the question we need to ask is whether uncertainty in recent years has
been elevated?
There are a number of ways that we might try to measure the extent of uncertainty. One
measure is the volatility of firms' share prices (Graph 5).4 Another is the dispersion of
analysts' forecasts of firms' earnings (per share). A third can be constructed by looking at the
proportion of news stories that mention uncertainty.5 These measures all increased at the
time of the global financial crisis. All of the measures have since declined to be around the
levels seen prior to the financial crisis, when non-mining business investment had been
growing strongly.6
Expectations regarding demand are too weak?
Even if uncertainty about the range of possible demand outcomes is not too different from
the past, the most likely outcome - the mean of the distribution - might still be too weak to
lead to significant new investment projects.
Business surveys ask firms what they expect conditions will be like in the near future; the
results are described as "business confidence". The long-running NAB survey suggests that
business confidence was in decline and below its long-run average up to the middle of last
year (Graph 6). Since then, it has picked up noticeably. This improvement was shortly
followed by a broad-based pick-up in the survey's measure of actual business conditions
(that is, trading conditions, profits and employment). According to the NAB survey, and a
number of other business surveys, business confidence and conditions are now above
average.
However, our liaison program suggests that businesses generally remain reluctant to take on
significant new investment projects until they can be confident of a more sustained
improvement in demand conditions. How long do conditions need to hold at above average
levels before the improvement is considered to be sustainable?
We don't know the answer to this. In part, this is because animal spirits are by no means
mechanistic or predictable. What matters for your investment plans is not just what you think
about the future, but what you think your competitors think about the future. In part, this is
because if your competitors are less than enthused about investing, the pressure for you to
invest to avoid being left behind is lessened, and vice versa.
Elevated risk aversion?
Even though measures of uncertainty appear to have declined, and firms' confidence about
future business conditions is above average, firms' investment plans may sit idle if they are
more risk averse than in the past. (By firms, I mean both managers and shareholders alike.)
It's clear that firms became more risk averse at the onset of the global financial crisis. It
seems that they remain affected by that experience. While the direct effects of the crisis on
the Australian economy were generally short-lived and relatively minor compared with the
experience of many economies, the events of that time led many Australian businesses and
households to re-evaluate their appetites for risk. The household sector increased its saving
rate noticeably at the time of the crisis and it remains around the more prudent levels that
had been the norm in earlier decades.7 Also, businesses deleveraged and have built up their
levels of cash holdings.
One measure of firms' appetite for risk is their "hurdle" rates of return. These serve as rules
of thumb for firms to evaluate whether or not to proceed with a particular project. The higher
the hurdle, the less likely any given project will be given the go ahead. There is no evidence
that hurdle rates of return have increased over recent years. But neither is there evidence
that they have declined even though the average cost of capital for firms has fallen.8 This
larger gap between the hurdle rates and the average cost of capital implies a reduction in
firms' appetite for risk. This result, which is consistent with information from our liaison
program, appears to be a global phenomenon.
Our liaison provides other evidence of a more cautious approach to investment over recent
years. In particular, many firms now require investment projects to satisfy shorter payback
periods and be approved at higher levels of management than was typical in the past.9
Other longer-term determinants?
The current weakness in non-mining business investment may reflect the effect of some
longer-run determinants of investment. One such candidate is (multifactor) productivity
growth. Relatively weak growth of productivity over much of the past decade would have
weighed on the return to capital and reduced the incentives to add to the capital stock in
nonmining industries (Graph 7). (In principle, this effect should already be reflected in levels of
Tobin's Q.)
If productivity growth were to remain relatively low, that would weigh on overall growth of the
economy. Low growth of investment would naturally follow from low productivity growth, but it
would not be the cause of weak growth of the overall economy. In any case, it's hard to know
exactly what productivity growth is likely to do in the future. More recently, multifactor
productivity growth appears to have increased a little. It is currently not far from growth rates
seen prior to the mid 1990s, which was a period of especially rapid growth.
In summary, some of these explanations have more merit than others. External finance is
generally readily available and at very low cost, so this can't explain the weakness in
nonmining business investment. Looking at the available data, it's hard to argue that heightened
uncertainty is playing much, if any, role. Rather, some combination of relatively low growth in
domestic demand, the effects of the high exchange rate, a lack of confidence and a lower
appetite for risk (than in the past) appears plausible. There are some metrics consistent with
this, and it aligns too with what businesses say is holding them back.
What do the data suggest about the future?
The Australian Bureau of Statistics capital expenditure ("Capex") survey provides a measure
of firms' investment plans for up to 18 months ahead.10
7
The saving rate has drifted down a little over the past couple of years, and the stronger growth of household
credit of late suggests that there has been some pick-up in the appetite for risk among households.
8
For a discussion of the experience of US firms, see Sharpe A and G Suarez (2014), "The Insensitivity of
Investment to Interest Rates: Evidence from a Survey of CFOs", Finance and Economics Discussion Series,
Working Paper 2014-02.
9
In a related vein, there is evidence that Australian listed companies have more risk-related meetings now than
in the early 2000s. It's possible that this is a response to an increased compliance burden, though such a
change may have reduced firms' appetites for risk nonetheless. (Special thanks to Gianni La Cava for
suggesting this measure and to Lara Bui who painstakingly constructed it.)
10
The survey needs to be adjusted for the fact that realised investment tends to vary predictably from what is
initially expected by firms. There are various ways to do this. For forecasting purposes, the most reliable
method is to adjust investment expectations by the average "realisation" ratio over the full history of the
The most recent survey implies a modest increase in nominal non-mining business
investment in 2014/15, in the order of 41⁄2 per cent. The survey suggests that investment is
likely to rise for a number of industries, including: rental hiring and real estate; information
media and technology; retail; and construction. This picture is consistent with the ongoing
recovery in household expenditure, including on dwelling investment, and in non-residential
building construction. Investment is expected to decline in the manufacturing sector and for
utilities.
Given that firms adapt their plans as events unfold, the early readings on investment
intentions for a given year often turn out to be wrong. We can see the extent of this by
comparing the early estimates for a given year with the final (seventh) estimates in the
Capex data. This is shown here based on the third estimate, which is what we currently have
to hand for this financial year (Graph 8). We can see that even over the course of just a few
quarters, business investment can turn out to be quite a bit higher, or quite a bit lower, than
the most recent reading from the survey suggests. For example, investment covered by the
Capex survey was much weaker than had been expected initially through the 1990s
recession and early 2000s slowdown. But it was stronger than initially expected through the
mid 2000s and a bit stronger than expected last financial year.
In short, if firms decide to undertake more investment than they had earlier anticipated, that
investment can come about relatively quickly.
Conclusions
In conclusion, non-mining business investment has been subdued and measures of capacity
utilisation remain a bit below average levels. Meanwhile, over the past year or so there has
been a gradual increase in the pace of growth of economic activity outside of the mining
sector, owing in part to the very low level of interest rates.
Subdued investment (outside the mining sector) has been consistent with a period of greater
uncertainty and below-average confidence. However, a number of indicators suggest that
uncertainty has declined to levels seen prior to the global financial crisis. Also, measures of
business confidence have picked up over the course of the past year to be a bit above
longrun average levels. While this is a welcome development, it may not be sufficient to spur
investment if businesses' appetite for risk remains relatively low. Moreover, the still-high level
of the exchange rate may be weighing on investment of firms in the traded sector.
Nevertheless, there are tangible indications that non-mining business investment will grow at
a modest pace this financial year. And if firms' willingness to take on risks improves,
investment could easily be stronger still. It's always hard to know if and when such a change
in sentiment might occur. But it is more likely to do so when the fundamental determinants of
investment are in place. The ready availability of internal and external finance, at very low
cost, is one element of that. The stronger growth of demand across the non-mining parts of
the economy over the past year or so is another. If history is any guide, eventually the period
of elevated risk aversion is likely to give way to a concern among businesses, not of losses,
but of lost opportunities and a loss of market share.
Graph 1
Graph 2
7
BIS central bankers' speeches
Graph 3
Graph 4
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BIS central bankers' speeches
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BIS central bankers' speeches
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Graph 8
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BIS central bankers' speeches