INVESTMENT, GROWTH AND CAPITAL MARKETS UNION INDEPENDENT ECONOMISTS GROUP JUNE 2015 TheCityUK represents the UK-based financial and related professional services industry. We lobby on its behalf, producing evidence of its importance to the wider national economy. At home in the UK, in the EU and internationally, we seek to influence policy to drive competitiveness, creating jobs and lasting economic growth Financial and related professional services are the UK’s biggest exporting industry. We make a £67bn contribution to the balance of trade, helping to offset the trade in goods deficit. TheCityUK creates market access for its members through an extensive programme of work on trade and investment policy. To achieve this, we work closely with governments and the European Commission to represent member views and help deliver the best outcomes in international trade & investment negotiations. Allied to this, we have a country-focused programme to build relationships and to help open markets where our members see significant opportunities. We also have a strong focus on ways of influencing and delivering regulatory coherence through dialogue with regulators, governments & industry bodies internationally. INDEPENDENT ECONOMISTS GROUP TheCityUK’s Independent Economists Group (IEG) was established in April 2012 as a forum to bring together leading economists in financial and professional services. The IEG meets quarterly with the aim of providing independent and informed analysis of macroeconomic issues as well as key issues that the industry is facing both in the UK and internationally. Analysis incorporates implications of these issues for financial and professional services and for authorities in the UK and EU. Members Dr Andrew Sentance Senior Economic Adviser PwC Andrew Smith Chief Economist KPMG Barry Naisbitt Chief Economist Santander UK plc Chris Cummings Chief Executive TheCityUK Jeremy Fern Head of City Affairs City of London Corporation Dr Gerard Lyons Chief Economic Adviser Greater London Authority Ian Craston Group Investment Director RSA Group Ian Stewart Director, Research Deloitte LLP Dr John Llewellyn Partner Llewellyn Consulting Justin Urquhart Stewart Director & Co Founder Seven Investment Management Kitty Ussher Managing Director Tooley Street Research Ltd Mark Cliffe Chief Economist ING Bank N.V. Mark Gregory Chief Economist UK & Ireland EY Melanie Baker UK Economist Morgan Stanley & Co. International plc Alderman Nick Anstee Senior Director King & Wood Mallesons LLP Paola Subacchi Research Director, International Economics Chatham House Patrick Foley Chief Economist Lloyds Banking Group Philip Rush UK Economist Nomura International plc Sarah Hewin Regional Head of Research, Europe Standard Chartered Bank plc Stephen Boyle Head of Group Economics Royal Bank of Scotland Willem Buiter Chief Economist Citigroup Economic consultant to the IEG Dr Rebecca Driver Director Analytically Driven Ltd Dr Driver provided the analysis underpinning the IEG’s discussion and drafted their final report. CONTENTS 03 CONTENTS Foreword 4 Executive Summary 5 1 Introduction 6 2 Why focus on financial markets? 8 3 What influences investment? 10 3.a Firm size and innovation 11 4 Links between investment, growth and financing costs 12 5 The financing decisions of firms 14 5.a Shifting financing patterns in the UK 18 5.b How much does the cost of capital matter in practice? 21 6 Capital Markets Union 24 Appendix 1. References 26 INDEPENDENT ECONOMISTS GROUP | JUNE 2015 04 FOREWORD FOREWORD The poor performance of European economies since the financial crisis is rightly a major issue for concern. Among the major EU economies, the UK, Germany, Poland and Sweden have bucked the sluggish growth and high unemployment trend. But average growth across the EU has been disappointing and unemployment rates in most countries remain far too high. Against this background, it makes sense to consider ways in which supply-side reforms might facilitate faster European economic growth and spur job creation. Financial markets have an important role to play in channelling investment to productive enterprises and supporting growth more broadly. This latest research from TheCityUK’s Independent Economists Group examines what drives both investment and financing decisions. The research has been stimulated by recent proposals to establish a stronger Capital Markets Union across the EU. This is potentially a catalyst for stronger growth, particularly in terms of its impact on small and medium-sized enterprises (SMEs) which can find it harder to access capital than larger companies. SMEs have a particularly important role to play in creating new jobs, and tapping new market opportunities. Countries with dynamic and growing SMEs tend to have better growth and employment prospects – and many European countries look enviously across the Atlantic to the US as a successful role model for innovation and entrepreneurship. Our research into investment drivers and the idea of a single market for capital in Europe highlights some potentially counter-intuitive facts – such as that total funding for SMEs has been higher in the EU than in the US, which is often held up as a model of a markets-based funding environment. Our analysis also shows that use of capital markets can bring important non-financial as well as financial benefits. Given the diversity of economies and corporate cultures across the EU, improving information flows and encouraging best practices will be critical to ensure than companies of all sizes derive maximum benefit from the CMU initiative. There are many impediments to growth and employment which need to be addressed within the EU – including labour market regulation and high levels of government spending and taxation. But changes to integrate capital markets and improve their functioning could have an important role to play in the policy mix, and this report aims to shed light on how this might be done most effectively. Andrew Sentance Chair, TheCityUK Independent Economists Group INDEPENDENT ECONOMISTS GROUP | JUNE 2015 EXECUTIVE SUMMARY 05 EXECUTIVE SUMMARY • In the wake of the financial crisis, governments are looking at ways to boost growth, including ways to encourage investment and improve the financing of corporate activity. This has led the European Commission to launch the Capital Markets Union initiative to identify how to improve access to finance for all businesses, but particularly for small and medium-sized enterprises (SMEs), as well as for infrastructure projects across Europe. The aim is to remove barriers to cross-border investment to help diversify funding and reduce the cost of capital, in an effort to promote growth and investment. • The evidence indicates that the cost of capital may not be the most important factor explaining investment activity in the EU. Other factors, such as uncertainty, may be more important and investment activity may well be unresponsive to changes in funding costs. • Although SMEs are an important part of the economy, in practice it is internationally active firms that tend to be the most innovative, as well as the most productive – and these tend to be larger firms. Therefore, it will be important not to neglect the needs of internationally-orientated firms when considering the needs of fundraisers. Furthermore, bank finance may well remain the most important funding channel for many SMEs, so it is important to be realistic about the extent to which non-banking initiatives can help this segment of fundraisers. • As well as tax and bankruptcy effects, there is some evidence to suggest that financing choices can also influence firm outcomes through the role of corporate governance and management monitoring activities. • The evidence shows that although the rationale for Capital Markets Union is a perception that certain funding channels are more effective in the US, in practice total funding for both infrastructure projects and SMEs has been higher in the EU than in the US. This does not mean that it is not possible to learn from the US and elsewhere about how to strengthen financial markets. However, the aim of Capital Markets Union should not be simply to adopt a US-style model. • Although the rationale for Capital Markets Union is to address the needs of fundraisers, if it is to be successful it will also need to deal with the needs of funders, as these can have a big impact on funding patterns. • Overall, for Capital Market Union to be successful the Independent Economists Group recommends that it should focus on five work themes: – Reducing (not adding to) regulatory barriers that inhibit firms’ access to funding; – Ensuring that the EU is open to innovative sources of capital; – Facilitating the role of capital markets in corporate restructuring; – Improving information flows, as well as communication about different options; and – Encouraging best practice through the use of mutual recognition and more effective enforcement of EU rules on competition and the single market. In each case, to be successful, it will be important that any initiatives do not come at the expense of raising capital from the rest of the world. INDEPENDENT ECONOMISTS GROUP | JUNE 2015 06 1: INTRODUCTION 1: INTRODUCTION Long-run economic growth is determined by the rate of growth of the labour force; the rate of change of the capital stock (investment, adjusted for Not all SMEs are alike depreciation); and the growth of total factor productivity (TFP). In the wake and size will influence of the financial crisis, governments