UK Investment Past and Prospects: A Framework for Analysis
Professor Catherine L. Mann is an External Member of the Monetary Policy Committee of the Bank of England and Professor of the Practice at Brandeis University. This blog was first published by NIESR, as part of its work leading the UK Productivity Commission. Catherine has also been a guest on two Productivity Puzzles podcast episodes – Global European and Global and European Productivity Outlook 2023-2030 and The Productivity Policy Agenda: Short-Term Priorities and Long-Term Commitments.
By various assessments, UK investment has been weak for decades and has been the most sluggish of the advanced economies since the global financial crisis, worsening further since Brexit and Covid. Anaemic business investment is one source of the sluggish productivity growth that limits improvements in living standards in the UK. We need fresh research to assess the past and offer perspectives on how to support UK business investment in the future.
My forthcoming paper will consider investment from three perspectives: the economist, the CEO, and the financier. If we think about it, when these three perspectives align, they determine how much, what kind, and the geography of investment. That can be ‘real’ business investment, such as capital equipment, real estate, or intangibles; or ‘financial’ investment such as mergers and acquisitions, buybacks, or dividends; and can be in regions at home or someplace abroad.
UK business investment has been, to some degree, considered from these perspectives, particularly using the economist lens. Marshalling research on other economies, considering the data and methods for the UK, and a synthesis of these three perspectives could provide important new insights about UK investment challenges and what needs to be done to support investment, productivity, and living standards in the UK.
The economist perspective looks at both macroeconomic and microeconomic data. Underpinning both is the canonical relationship: when the present discounted value of the future stream of earnings from an investment exceeds the cost of financing that investment, the investment will be undertaken. However, complications immediately arise in any empirical assessment of investment drivers using this relationship. How should the future stream of earnings be measured? What is the cost of capital? What is the discount rate and horizon?
A very recent paper from the IMF (2023) investigates UK business investment using both macro and micro economics perspectives and data. Sluggish growth in market demand (in the macro assessment, proxied by GDP growth and in the micro regression, proxied by a firm’s sales growth) and a higher cost of capital (measured by the policy rate in the macro assessment and higher debt burden or lower retained earnings in the micro investigation), as well as Brexit and Covid, are important factors associated with low business investment in the UK. In the macro regression, low public investment also constrains private investment.
This assessment helps the broad understanding of UK business investment, but there remain important questions about market demand (which is a proxy for the cash flows of any investment) that warrant additional consideration. For example, higher concentration and less competition in the marketplace might reduce business investment (Gutierrez and Philippon, 2017, using US data).
Growth in the domestic market seems to matter most, but foreign demand matters as well, as do many types of structural policies (OECD, 2015, panel data analysis). Uncertainty is relevant, but what kind of uncertainty? In market demand, price variability is seen to be less important than quantity variability for investment in the Euro Area. Uncertainty in the policy environment (regulation, tax, and political) is very important. Product type seems to matter too, with tradeable products associated with more robust investment in UK regions.
Most businesses engage in a variety of lines of activity. Of increasing interest to researchers is the balance between returns from financial activities within a firm and the revenues from the primary activity of the firm, e.g. production of ‘widgets’. If the return to financial activities exceeds that of business investment, for whatever reason associated with cost of capital, time horizon, uncertainty, competing objectives, then investing resources into the financial activities could take priority over real business investment. Research suggests this could be an important issue for UK firms but also for UK banks.
All told, these observations from current work using macro data, panel analysis, and firm level data point to how factors relating to market demand might affect UK investment dynamics. What about the cost of capital or the investment horizon? Granular assessments of the cost of capital show it to be a complex variable, mixing manager incentives, institutional investors, and the policy landscape.
The CEO perspective is a second one relevant for business investment. Increasingly it is recognized that CEOs (or other managers) have their own objective function that affects business investment, among which CEO tenure and compensation packages matter. There is intense research on the relationship between the transparency of ownership, earnings reporting, and business investment dynamics. In the UK, about half of 1 percent of firms, nearly all of which are multinationals, account for 60 percent of all investment; making this topic particularly salient.
Central to both the CEO and the economist perspectives is an intermediary: the financier. The financial landscape is increasingly complex, but to simplify for the moment: for a banker, bond holder or equity investor, the expected return to the extension of finance to a business for an investment must be greater than a risk-free alternative use of the funds. This follows the economist lens. A key evolution in the financial landscape is that the intermediary is no longer making financing decisions in an atomistic way.
Institutional investors are an increasingly important class of investors owning firms. In the UK, institutional investors account for 60 percent of market capitalization; the third highest share among the OECD countries. About half and half foreign and domestic institutions. The top three institutional investors own about 23 percent of each of the listed firms in the UK.
Research suggests that institutional ownership matters for productivity outcomes, importantly through investment decisions. Institutional investors with a large stake and long time horizon for a company may support business investment, but this is unlikely if the institutional investor holds high shares in the firm’s competitors as well. Foreign institutional investors may pursue financial merger or buyout deals more aggressively, particularly when they already have familiarity with the local market. The consequences for business investments after the deal is done is less clear, with either a stronger combined firm supporting more robust investment or a combined firm investing less on account of less market competition.
My forthcoming paper develops and synthesizes these three perspectives – economist, CEO, and financier – drawing out insights from current research, whether specifically about the UK or from other countries, and panel analysis. The objective is to offer research direction to and data requirements for a deeper analysis of the hurdles facing UK business investment.
