Policy Panel:
Investment and growth in advanced economies
Remarks given by
Mark Carney, Governor of the Bank of England
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 (Chart 2).
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).
1
This Time is Different: Eight Centuries of Financial
See, for example, Reinhart, C. and K. Rogoff. 2009. Folly. Princeton: Princeton
Jorda, O., Schularick, M. and Taylor, A. (2013), 'When Credit Bites Back', Journal of Money, Credit
University Press, and and Banking,
Vol. 45, Issue s2.
2
Bank research (Franklin, Rostom and Thwaites, 2016), finds that the reduction in bank credit supply had an economically and
statistically significant effect on companies: a 10% fall in the amount a firm could borrow is estimated to have reduced capital per
worker by around 5-6%, labour productivity by 5-8% and wages by 7-9%, and increased the probability of bankruptcy by around 60%.
3
See page 52 of the Bank for International Settlements 87th Annual Report, available at http://www.bis.org/publ/arpdf/ar2017e.htm.
Zombie firms are defined as those with a ratio of earnings before interest and taxes to interest expenses below one, with the firm aged
10 years or more.
2
All speeches are available online at www.bankofengland.co.uk/speeches
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
4
Identifying the effect of increased uncertainty is complicated by the fact that it is usually accompanied by a tightening in financial
conditions. In this regard, the pickup in uncertainty following the referendum on EU membership in the UK was unusual, as financial
conditions eased, helped by a series of monetary and macro-financial policy measures taken by the Bank of England.
5
'Uncertainty, the economy and policy', speech given by Mark Carney, 30 June 2016, available at
http://www.bankofengland.co.uk/publications/Documents/speeches/2016/speech915.pdf.
6
For individual firms, the standard variation of annual earnings was around 30 percentage points in the period before the crisis. See
'Uncertain times', speech by Ben Broadbent at the Wall Street Journal, 5 October 2016, available at
http://www.bankofengland.co.uk/publications/Documents/speeches/2016/speech929.pdf.
7
For example, estimates by the Bank for International Settlements suggest that between 1990 and 2016, the investment rate in fixed
assets declined from around 8% to 31⁄2% of total assets, while the investment rate in intangible assets increased from around 7% in
1990 to 10% in 2016.
8
Various papers find evidence that intangibles investment is less responsive to changes in demand than investment in fixed assets. For
example, Masayuki (2015) estimates an accelerator-type investment model, where growth of the firm's sales is included as regressor,
together with a measure of cash flow. The estimated "accelerator" coefficient is small and not statistically significant for intangible
investment, suggesting this effect might be absent. Estimates from regression analysis by BIS show that the sensitivity of investment to
Tobin's Q) is approximately three times more sensitive for physical investment than for intangible
investment opportunities (proxied by
investment - a result that the BIS suggest could be explained by "the structural lumpiness of intangible investment". In a similar vein,
Ryan and Taylor (2017) also find that intangible capital responds more slowly to changes in investment opportunities. They conclude
that, compared with physical capital, intangible capital's convex adjustment costs are roughly twice as large.
9
See https://www.oecd.org/eco/growth/OECD-2015-The-future-of-productivity-book.pdf.
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
10
See Rachel, L and Smith, T (2015), 'Secular drivers of the global real interest rate', Bank of England Working Paper No. 571 and
'Resolving the climate paradox', speech by Mark Carney at the Arthur Burns Memorial Lecture, Berlin, 22 September 2016, available at
http://www.bankofengland.co.uk/publications/Documents/speeches/2016/speech923.pdf.
11
Among companies responding to the Bank's Decision Maker Panel survey between February and April 2017, Brexit was the largest
current source of uncertainty for 10%, one of the top two or three sources of uncertainty for 30%, one of many drivers of uncertainty four
40% and not important for the remaining 20%.
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
expectations of lenders' underwriting standards
higher 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.
12
See the statistical annex to the Bank for International Settlements 87th Annual Report, ibid.
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.
III. Conclusion
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.
Chart 1: G4 non-residential investment weak since the crisis
Percentage changes since 2007
15
United Kingdom United States
10
Euro area Japan
5
0
-5
-10
-15
-20
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Sources: Eurostat, ONS, OECD and Bank of England calculations.
Notes: The data for the UK, the US and Japan are for private non-residential investment; the data for the euro area include public
nonresidential investment.
Chart 2: Weakest UK business investment in half a century
Indices, peak in GDP = 100
160
Range of previous recessions
150
140
2008
130
Average of previous recessions
120
110
100
90
80
70
60
-20 -16 -12 -8 -4 0 4 8 12 16 20 24 28 32 36
Quarters relative to date when GDP peaked
Sources: ONS and Bank calculations.
Notes: The chart plots real business investment. The range includes the recessions of 1973, 1979 and 1990.
Chart 3: UK real business investment to GDP ratio is falling
Percent of GDP
12
10
8
6
4
2
0
1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
Source: ONS.
Chart 4: Investment consistently weaker post-crises
Average financial recession
Cumulative change
Average normal recession
(per cent)
20
15
10
5
0
0 1 2 3 4 5
-5
Years
-10
-15
-20
-25
-30
Source: Jordá, O., Schularick, M. and Taylor, A. (2013), 'When Credit Bites Back', Journal of Money,Credit and Banking, Vol. 45,
Issue s2.
Notes: The chart shows the cumulative change in per capita investment. The grey shaded area shows a 95% confidence interval
around the average normal recession.
Chart 5: UK, US and euro-area capital overhangs being worked off
Euro area capital to output ratio
UK capital to output ratio Euro area trend capital to output ratio
Per
US capital to output ratio
cent
UK trend capital to output ratio
Per cent
US trend capital to output ratio
130
340
120
320
110
300
100
280
90
260
80
240
70
220
60
50 200
1995 1999 2003 2007 2011 2015 1995 1999 2003 2007 2011 2015
Sources: BEA, OECD, ONS and Bank calculations.
(a)
Chart 6: Zombie firms rising in AEs, falling in the UK
Per cent of firms Per cent of firms
12% 30%
10% 25%
8% 20%
(c)
UK measure (RHS)
6% 15%
(b)
Global measure (LHS)
4% 10%
2% 5%
0% 0%
2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: European Commission, AMECO database; IMF, World Economic Outlook; Datastream Worldscope; The Conference Board;
BIS calculations; Bureau van Dijk and Bank calculations.
(a) Zombie firms are defined as firms with a ratio of earnings before interest and taxes to interest expenses below one.
(b) Sample includes listed firms aged 10 years or more. Shown is the median share across AU, BE, CA, CH, DE, DK, ES, FR, GB, IT,
JP, NL, SE and US.
(c) Sample includes both publicly listed and private UK firms. Only firms whose turnover reached £1 million in one of the past ten years
are included. There are around 17,200 firms per year in the sample.
Chart 7: UK companies facing multiple uncertainties
Geopolitical risk index UK Policy uncertainty Standard deviations from mean, 2
UK Economic uncertainty
2.5
Iraq invasion
9/11 Paris attacks
2.0
Madrid bombings
Gulf war
Ukraine/ISIS
London
1.5
bombings
USS Cole bombings
Kuwait invasion
1.0
US bombs
0.5
Libya
0.0
-0.5
-1.0
Transatlantic
aircraft plot
-1.5
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Notes: economic policy and geopolitical uncertainty indices are de-meaned and shown relative to their respective standard deviations.
Chart shows two-year centred moving average for each measure. See 'Uncertainty, the economy and policy', speech by Mark Carney,
30 June 2016, available at http://www.bankofengland.co.uk/publications/Documents/speeches/2016/speech915.pdf, for more details.
Chart 8: Greater uncertainty drives hurdle rates up
Option value of waiting (percentage points)
30
25
20
15
10
5
0
0 5 10 15 20 25 30 35 40 45 50
Earnings volatility (percentage points)
Notes: the chart shows a simple Black-Scholes model of the required hurdle rate given earnings volatility. For individual firms, the
standard variation of annual earnings was around 30 percentage points in the period before the crisis.
Chart 9: Hurdle rates for UK businesses remain high
Percentage of respondents
40
35
30
25
20
15
10
5
0
<5% 5%-10% 10%-15% 15%-20% 20%+
Source: Bank of England Finance and Investment Decisions Survey, as reported in Levina, I., Melolinna, M., Saleheen, J., and
'The financial system and productive investment: new survey evidence',
Tatomir, S. (2017), Bank of England Quarterly Bulletin, Vol. 57,
No. 1, available at www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2017/q1/q1pre.pdf.
Chart 10: Diffusion of productivity stalling?
GVA per worker, £,000
30
Total
Frontier Firms
25
Laggard Firms
20
15
10
5
0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Sources: ONS Research Database and Bank calculations. See Productivity puzzles - speech by Andy Haldane at the London School of
Economics, 20 March 2017, available at http://www.bankofengland.co.uk/publications/Documents/speeches/2017/speech968.pdf.
Chart 11: Investment intentions picking up globally
Standard deviations from mean (2002-2017)
2
UK US
1
0
-1
-2
-3
-4
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Sources: BCC, CBI, CIPS, Business Roundtable CEO Survey and Bank of England.
Agents' survey measures of investment
Notes: the line for the UK shows the average of the BCC, CBI, CIPS and Bank of England
intentions. The line for the US shows the Business Roundtable CEO Survey measure.
Chart 12: UK financial system much more resilient
Per cent
Per cent
20 16
Basel II core Tier 1 weighted average (left-hand
18
scale)
14
Basel III common equity Tier 1 weighted average
16
12
(right-hand scale)
14
Basel III definition of capital
10
12
CET1 ratio adjusted for 2016 stress test
8
losses (right hand scale)
10
6
8
4
6
2
4
2 0
01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17
Sources: PRA regulatory returns, published accounts and Bank calculations. See June 2017 Financial Stability Report for details of
series.
shows major UK banks' capital ratios as a percentage of their
Notes: The chart risk-weighted assets.
Chart 13: Corporate bond spreads below historic averages
Basis points
3000
Dashed lines: averages since 2000
Sterling
2500
2000
Euro
1500
1000
US dollar
500
0
Sources: Bank of America Merrill Lynch Global Research and Bank calculations.
Notes: Option-adjusted spreads. The US dollar series refers to US dollar-denominated bonds issued in the US domestic market, while
the sterling and euro series refer to bonds issued in domestic or eurobond markets in the respective currencies.
Chart 14: Stylised monetary policy responses
Chart 15: Monetary policy trade-off lessening
4.0
Preferred trade-off
Inflation (%)
if λ=1
3.5
November 2016
Preferred
3.0
trade-off
May 2017
if λ=0.1
February 2017
2.5
Output gap (%)
2.0
-2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0
1.5
August 2016, no
August 2016, with
stimulus
stimulus
1.0
Source: Bank of England.
Notes: the chart shows Inflation Report projections for inflation and the output gap at the year 2 horizon. A value of 0.1 gives an
approximate lower bound on estimates of lambda over the post inflation targeting period. A value of unity would correspond to a
"balanced approach" which weighs inflation stabilisation and output gap stabilisation equally. For more information, see 'Lambda',
speech by Mark Carney at the London School of Economics, 16 January 2017, available at
http://www.bankofengland.co.uk/publications/Documents/speeches/2017/speech954.pdf.