Friday 21 October 2016

Companies are still investing, despite our broken banks

Published 10/04/2016 | 02:30

When companies spend money on productive capacity, it is usually a healthy sign for the businesses involved.

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It is good for economies too. The more that businesses invest, the more capital each worker has to work with. And the higher the capital-to-worker ratio, the more productive people tend to be.

That could hardly be more important - productivity growth is, after all, the reason we no longer live short, miserable lives in caves.

While there tends to be a lot of talk about the need for public investment, private companies account for 7-10 times more investment than governments in developed economies. Although public and private investment can overlap (privately built schools, roads and hospitals are quite common in many countries), they tend to have different functions - with business investment going in to making goods and services more efficiently and cheaply, while public investment usually goes into public goods, such as roads, parks and education.

In recent years across the developed world, there has been a dearth of investment. Too low public investment in many countries has been the result, among other things, of weak public finances.

The low levels of corporate investment are much harder to explain, particularly in an era of very low interest rates.

Private investment in Ireland has been bucking the trend recently, something that is somewhat surprising, given that new bank lending to businesses has only started rising, and from a very low level.

Last year saw investment (or, in economist-speak, 'fixed capital formation') surge in Ireland. Around three-quarters of the eye-widening 7.8pc GDP growth recorded in 2015 was accounted for by investment, both private and public.

A recent paper* by Central Bank economists James Carroll, Paul Mooney and Conor O'Toole has provided some interesting new insights into one important aspect of private investment - that of small and medium-sized enterprises (SMEs).

SMEs, which account for two-thirds of employment, make up the vast majority of enterprises in Ireland. As such, how much they invest is a good indicator of how the real economy is faring.

Despite this, too little is known about SME investment levels and trends. To fill the gap in official statistics, the economists at the Central Bank use an opinion poll of SMEs, which has been carried out every six months since 2012.

In line with other economic data and surveys, the poll is positive in almost every respect, illustrating the broad nature of the recovery. The share of SMEs investing has increased steadily since 2012, with about a third investing, according to the latest survey carried out last year.

The level of investment differs by firm type. Medium-sized companies (classified as having 50-250 employees and turnover of less than €50m) are more likely to be spending on productive capacity than smaller ones. This is not surprising.

Larger firms have more resources and tend to have more capital that needs to be replaced as it depreciates.

By sector, 42pc of manufacturing firms are beefing up their capital stock. Widget-makers are also the largest median investors, at €100,000.

They are followed by businesses in the hotel/restaurants and services sectors, with 30pc of such firms investing. As these sectors are not so capital-intensive, their median spend is half or less than that of manufacturing companies. Wholesale and retail has the lowest share of firms investing, at a lowly 20pc (this may explain why, despite soaring retail sales, employment in this sector has barely started to recover).

There are large differences between exporters and non-exporters. Median investment among companies with foreign sales is €100,000. It is just €35,000 among businesses focused exclusively on the domestic market. Exporters are also twice as likely to invest as non-exporters.

Unsurprisingly, innovators - firms creating new goods, services or production processes - are more likely to invest than non-innovators.

While the proportion of ICT firms which spend on investment is above non-ITC ones, the former's median investment is lower. This may be because the survey only covered fixed assets and not intangibles, such as software.

Since the crash, concerns have abounded about how SMEs are financed - particularly given the ongoing problems in the Irish banking system.

With regard to investment, the survey suggests that credit growth from banks has been sluggish, reflecting harder data on the aggregate balance sheets of the banks mentioned above.

Moreover, the overall stock of outstanding credit has declined as loan repayments outpace new borrowing. Worse again, Irish firms pay some of the highest interest rates on bank loans in the euro area.

The majority of investment is financed through internal funds or retained earnings. That is no real surprise, as profitability has always been the main source of investment funding. But that only 10pc of investment financing is from banks - the same percentage as it was three years ago - is shockingly low.

Recognising the lack of bank credit for investment purposes, the Government set up the Strategic Banking Corporation in March 2015. As of December, some €172m had been distributed in 4,600 loans.

Other bodies were set up to deal with credit issues for SMEs - such as the Credit Review Office, the Credit Guarantee Scheme and Microfinance Ireland.

Although indebtedness is falling, about a fifth of SME loans are in default. No doubt this legacy of the crash puts a break on business investment levels.

The European Commission and ECB also carry out an SME survey each year. As the chart shows, in 2015, Ireland had one of the highest rate of SMEs who increased investment in the EU.

On the other hand, Irish SMEs reported one of the lowest rates for using external finance for investment.

The European Commission has noted** that barriers to investment are moderate in Ireland, but highlights some impediments. As well as the problems with accessing finance, the Commission notes high legal costs, planning permission and a fragmented tax incentives as possible challenges to the investment environment.

Getting SMEs to grow and prosper must be one of the priorities of next government - and for that matter, all others in the future.

Their performance is central to the Irish economy's sustained success. Indeed, one of the big questions about our economy is why so few indigenous small-medium sized firms have not developed into larger ones.

Sunday Indo Business

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