Why is non-mining business investment so weak and what is the outlook? CBA's Gareth Aird
For the past few years, economists and policymakers have assumed that a lift in non-mining business investment was forthcoming.
A trawl through RBA documents and speeches shows that policy officials have been anticipating a lift in non-mining investment for a few years. And yet despite incredibly low interest rates and a significantly lower AUD, the lift remains elusive. It has felt a lot like waiting for Godot.
Fortunately, however, there has been a greater than expected pickup in services activity which has generated a fall in the unemployment rate despite weak non-mining capex. This has supported the economy and employment growth over the past two years. But for the productive capacity of the economy to lift over the longer term, a lift in business investment outside of the resources sector is required.
In this note we ask the question why non-mining business investment has been so weak. We propose a number of reasons why we are yet to see a lift in capex. And we argue that the reason for a lack of investment goes beyond the level of interest rates and the AUD - these cyclical drivers of business investment are at levels that support rather than hinder investment. Rather, it is a range of other forces at play which are holding investment back. We then take a look at the outlook for business investment in 2016 and what it is likely to mean for growth and monetary policy.
What’s been happening?
There is no shortage of information and literature covering Australia’s mining investment boom. In a nutshell, Australia had a once in 150yr mining investment boom that saw business capex as a share of GDP soar to a record high. During the mining investment period, non-mining investment fell. But there was an assumption amongst policymakers and economists that non mining investment would lift again once mining investment peaked. Low interest rates and a lower exchange rate would help. The mining investment peak has occurred (late 2012), but since then there has not been a pickup in non-mining capex. RBA estimates conclude that in the year to QIII 2015, mining investment fell by 28.9% while non-mining investment fell by -0.1%.
So non-mining investment has been flat over the past year which means it has fallen as a share of GDP. Naturally, the question to ask is why? We explore a few possible explanations.
Expectations of demand are too weak
Basic economic theory suggests that investment generally follows demand. In other words, private investment is responsive to demand rather than supply creating demand. So it may be the case that expectations of future demand are too low to justify a lift in investment. The long-standing “accelerator” model of investment proposes that when demand levels result in an excess in demand, firms will respond in one of two ways – either an increase in prices to cause demand to drop or an increase in investment to match demand.
Capacity utilisation gives us a gauge for how we are travelling on aggregate demand versus the productive capacity of the economy. Excess capacity means that insufficient demand exists to justify expansion of output. And firms are unlikely to be able to push up prices by much when there is too much excess capacity.
Capacity utilisation, as measured in the NAB Business survey, implies that throughout most of the past few years capacity utilisation in Australia has been below its long run average. This goes some way to explaining why business investment has been weak. And also why inflation has been low.
From early 2014, capacity utilisation was moving in the right direction and rising towards the point where we could realistically expect to see a lift in business investment outside of the resources sector. However, on its own, it still looks to be at a level that implies demand will need to lift a little further to necessitate a lift in new capacity. On that score, the recent positive trend in consumer spending is encouraging.
You can’t turn the tap back on easily
Australia’s manufacturing industry suffered greatly because of the first and second stages of the mining boom. The huge lift in commodity prices and therefore Australia’s terms of trade meant that the AUD appreciated significantly. This was to the detriment of the manufacturing sector because a higher AUD makes imports cheaper and exports more expensive on the global market. The AUD was also driven up by interest rate differentials.
During the mining boom Australia’s interest rates were significantly higher than G7 rates. So domestic manufacturers had to cope with a high currency and also borrowing rates much higher than their international competitors. As a result, the longer term decline of manufacturing in Australia accelerated during the mining boom. There were similarities between the Dutch experience in the 1970s when a currency spike related to North Sea gas rendered their manufacturing sector uncompetitive. Aptly, the negative impact of a currency shock on the manufacturing sector has since been labelled the “Dutch disease”.
The problem, of course, for the manufacturing sector is that when the currency depreciates to more ‘normal’ levels, it’s not that easy to crank up manufacturing investment and output. Plants and factories close over time due to a reduction in competiveness and skills are lost. The reversal in the AUD works wonders for those firms that have kept operations going through the period when the exchange rate was elevated. But the high fixed cost component of manufacturing means for firms that are forced to close, recommencing operations is often not an option. This is quite different from the tourism sector where the fixed cost component is much lower. The ability of the tourism sector to recover and benefit from a lower AUD is much easier and immediate than for the manufacturing sector.
The hurdle rate is too high
Firms generally use Discounted Cash Flow (DCF) analysis (or a version of it) to estimate the attractiveness of discretionary capital investment. But a range of evidence indicates that hurdle rates are often much higher than the weighted average cost of capital (WACC). In a recent survey by Deloitte, it was stated that two-thirds of corporations indicated their hurdle rate was updated less frequently than their formal review of the WACC. And nearly half reported the level of their hurdle rate was changed ‘very rarely’. This has resulted in the vast majority of firms applying hurdle rates above 10% with almost half of all firms using a hurdle rate above 13%.
Such a return looks unrealistically high in a low inflation and low interest rate environment. If hurdle rates were reviewed more frequently, they would have declined in line with inflation and interest rate expectations. The ‘stickiness’ of business hurdle rates is in stark contracts to valuation methods employed by property investors. The investor segment of the property market has been highly sensitive to changes in interest rates. The fall in borrowing rates over the past few years gave rise to a big increase in investor activity in the housing market. Dwelling prices rose quite sharply as interest rates fell.
A review of business hurdle rates would be a positive step to see more projects get across the line.
Monetary policy has been overburdened for too long
Much of the discussion around policy to stimulate the economy has centred on monetary policy. Indeed, record low interest rates have been assumed to be the panacea to get non-mining investment going. But monetary policy can only do so much. The interest rate lever can help smooth out the business cycle. But it cannot do anything to change the more entrenched and structural impediments to growth which are primarily related to the inefficient allocation of resources.
In Australia, for example, policies should be developed that encourage and channel capital into projects that improve the productive capacity of the economy over the long run. Establishing an efficient taxation system that incentivises innovation and productive investment is one area that could help lift business investment. In that context, the Turnbull Government’s recent spending boost to promote business-based research, development and innovation is a step in the right direction. But more needs to be done. The importance of fiscal policy, and in particular tax policy, in creating an environment that supports business investment cannot be underestimated.
Public infrastructure investment is also important. For example, greater investment in transport infrastructure will improve the productive capacity of the economy. And it supports private investment rather than crowding it out. At a time when the yield curve is at historic lows, there must be no shortage of viable projects where the costs of finance is less than the social rate of return.
Pressure on companies to return cash to shareholders Australian investors love dividends! And the pressure on companies to maintain or lift dividends in a low interest rate environment has intensified because deposit rates are so low. There is a risk that the pressure on companies to increase dividends has been paid for by cutting back on capital investment. According to the latest quarterly Henderson Global Dividend Index report, Australia’s dividends were up by 12.4% (underlying basis1) over the year to QIII 2015. As RBA Deputy Governor Philip Lowe commented back in May 2015, these firms are effectively saying to their shareholders, “here, you manage the money, as we do not have investment opportunities that satisfy our internal rate of return”.
If too many firms behave in this manner then too much cash is returned to shareholders rather than retained for the purposes of capital investment. In the long run, it suggests the investors will get a lower return on equity because there is only so far company profits can go without lifting investment.
The Modigliani–Miller theorem states that the division of retained earnings between new investment and dividends do not influence the value of the firm. But this theorem is based on rational behaviour by the investor whereby shareholders can create their own cash flow by selling some equity if the stock price rises because the firm retains its earnings rather than paying them out as dividends. In reality, though, this isn’t the case. Tax considerations around dividends and capital gains means that the majority of investors in Australia have a preference for dividends over capital gains.
Australia is not alone
At this point is it worth highlighting that Australia is not alone in waiting for a lift in non-mining business investment. There has been a decline in investment growth across advanced countries as a whole, despite policy rates at near zero. Many of the aforementioned possible reasons for the lack of a lift in non-mining investment in Australia are applicable to other advanced countries. The US is a case in point – and like Australia, the US has had strong employment growth which would normally be consistent with higher levels of capital investment.
What’s interesting, however, is that global investment as a share of GDP has been increasing over the past years despite it falling in advanced countries.
The mining investment boom is part of this story, but not all of it. Investment in emerging and developing countries has been rising as a share of GDP and this in part reflects the global supply chain. An increasing share of the production process in global supply chains occurs in developing countries.
Naturally, capital investment has lifted in these regions and often at the expense of capital investment in advanced economies. Uncertainty over what type of investment is appropriate. It is worth hypothesising that the one factor which could be weighing on the decisions of some firms to lift investment is uncertainty around what investment is prudent given the pace of technological change in the world.
Technological change has always been part of the economic landscape. But the pace of change, coupled with increased globalisation means that some firms may be holding back from lifting investment due to doubt around the relevance of such investment over the medium to longer term. This is certainly something worth considering, though we suspect that its impact on the lack of a pickup in non-mining business investment over the past few years is likely to be immaterial.
What can we expect in 2016?
As always, the outlook for business investment is uncertain. But the leading indicators suggest that non-mining business investment growth is likely to remain weak over 2016. The latest capex survey suggested that non-mining capex would fall over 2015/16. There are limitations with the capex survey because it excludes major sectors like health and education whose investment tends to be more structural than cyclical in natural. As such, non-mining investment is not expected to be as soft as the capex survey implies. But whatever way you slice it, non-mining investment is likely to be weak over 2015/16. Later this month we receive the first estimate on 2016/17 capex plans – so there is more information to come.
Notwithstanding the soft capex survey, the latest credit aggregates offer a glimmer of hope on the outlook for non-mining investment. Business credit growth has been lifting which an early sign of a lift in capital expenditure. It may reflect the supportive combination of low rates, a much softer AUD, robust employment growth and a lift in business confidence. Recent surveys put non-mining business sentiment back up at average levels. Policymakers will welcome these developments and will hope that the much anticipated lift in non-mining capital expenditure materialises in 2016.
What does it mean for monetary policy
As we have argued, the level of interest rates is not holding business investment back. Rather, it is supportive. In that context, we doubt the RBA will look to ease policy further in an attempt to engineer a lift in capex, particularly if it risks restimulating the housing market again.
Our views on the labour market and inflation underpin our expectations that the cash rate will stay at 2.0% in 2016. Inflation should drift a little higher as exchange rate pass-through continues, though we expect it to be at the bottom end of the RBA’s target band. On unemployment, we see enough evidence in the leading indicators of jobs growth to suggest that the unemployment rate peaked a little over a year ago.
One of the vexing issues in the Australian economy over the past year has been reconciling below trend economic growth with above trend employment growth. In 2016, we expect a similar theme to remain in play.
Namely that jobs growth should be decent while economic growth chugs along a little below trend. This is because we expect the labour-intensive services sectors to do well which is a negative for business capex. The low AUD should continue to play a key role in supporting the tradables services sector, particularly tourism. Markets, however, are still likely to price in the chance of further RBA policy easing this year. This essentially reflects the balance of risks in the global and domestic economy, coupled with the RBA’s conditional easing bias.
Gareth Aird is economist at Commonwealth Bank and can be contacted here.