Question

Which concept would you use to explain why investment spending did not grow strongly between 2011 and 2014 although interest rates were very low? Think about what drives investment spending and use a certain principle we covered in the chapter titled [Income and Expenditure] ( Around150 words)

Answer 1

Amid low interest rates and easily available capital market financing, two major reasons have been given for the downturn of business investment. The first refers to the perceived disparity between desirable financial circumstances and investment incentives. In fact, it may be that businesses with the best acquisition prospects do not have adequate internal funds or easy access to external funding. A second, more plausible, explanation is that even if firms do have funds to invest, they are too uncertain about future economic conditions and so whether the possible return on investment will justify its cost.

An inability to fund investment means companies have insufficient internal funding and are forced to borrow foreign funds. Companies also use internal financing to support expenditure, because it can be cheaper than foreign funds.

Cash deposits are not eligible for investment as they are biased towards only few markets, such as technology and manufacturing, or represent a new degree of liquidity self-insurance that is required. Financial financing is easily available and inexpensive for businesses with direct access to capital markets, but is comparatively more costly and often more difficult to acquire for businesses reliant on bank funding.

Low interest rates and high risk appetite have reduced the cost and increased the availability of capital market funding.

Nevertheless, increasingly flexible monetary policy and risk-taking in financial markets have transformed the expense and quality of bank credit to a lesser degree. For most countries, though still very weak, the cost of bank loans has fallen below the level of capital-market financing.

A second reason for sluggish growth in capital development, although perhaps more likely, is a lack of viable investment incentives. More precisely, companies may not foresee returns from expanding their capital base to surpass their risk-adjusted capital expense, or returns from more flexible financial assets that they may receive. This could be because firms are particularly uncertain about future demand, and so are not willing to commit to irreversible physical investments.

Given the strong growth of debt and equity issuance, it is hard to see that a shortage of funding has significantly constrained aggregate investment. Many companies, especially in the United States, can issue debt on such favourable terms that they have used new debt to finance share buybacks. In addition, while business credit growth is low globally, it is not clear that this is because of a restricted supply of credit rather than weak demand. A lack of demand for credit is surely a large part of weak credit growth, so this is probably a consequence rather than a driver of weak investment.

Although traditionally small companies are the most financially limited, their contribution to gross investment is usually fairly small. Moreover, if only small firms had good investment prospects but only large companies had access to capital, then it could be anticipated that some sort of cascade capital would grow.

That may be achieved by large companies with exposure to the stock market offering financing to smaller firms, either by export credit, or by large firms purchasing small firms to leverage their investment opportunities. Yet such a wave of support doesn't appear to exist on a wide scale.