Investment and Rebalancing in Asia

Date October 26, 2010
Speaker Malhar NABAR(Economist, Asia and Pacific Department, International Monetary Fund (IMF))
Moderator HOSHINO Mitsuhide(Director of Research, RIETI)

Summary

Malhar NABARMalhar NABAR

Today we will be discussing rebalancing in Asia; in particular, exploring ways to rebalance Asia's growth model away from external drivers of growth to domestic drivers through investment. Rebalancing Asia's growth model is a very broad topic with many aspects. In some economies this would involve raising consumption, in others, boosting efficiency in services and non-tradables, in yet others, lifting investment.

In past regional outlooks, consumption and productivity in services have been examined, but the plan here is to look at investment more closely. The objective in this research is to evaluate the scope for investment led rebalancing in Asia. I will first discuss recent developments in investment patterns and identify where there is scope for investment led rebalancing in Asia, then talk about factors that lie behind these trends in investment and finally draw policy implications from our empirical analysis.

For a comprehensive picture, we will be looking at recent developments both at the aggregate level as well as at the level of sectors. At the aggregate level there is a divergence across two groups of Asian economies: domestically oriented economies that have large bases of domestic demand, mainly China and India, and export-oriented Asia, such as Japan, newly industrialized economies (NIE), and ASEAN economies. While investment has taken off in the domestically oriented economies, it has declined after the Asian crisis and has never really recovered in the export-oriented economies. In combination with relatively stable savings in the export-oriented economies, this has been a big contributor to the widening of current account surpluses in these economies and the widening of global imbalances in the years leading up to the crisis.

For export-oriented economies, what stands out is the decline in private investment. Public investment has fallen a little bit as well from the last decade, but the decline has mainly been in private investment. One story often told about this is that this is related to a decline in construction, and that this is appropriate given the large excesses leading up to Asian crisis, and thus shouldn't be a concern. However, that is not the case. The decline has been broader, extending beyond construction. In public investment, despite strides in infrastructure, there seems to be a gap in infrastructure with other emerging regions like Latin America, both in terms of phone connections and electricity generation. Overall this translates into relatively low investment in some parts of the Asia-Pacific region, specifically in the ASEAN-4, compared to other emerging regions such as the Middle East, emerging Europe and Latin America, countries which are at about the same level of development in terms of per capita income.

A slightly less well known development is that the composition of investment in some other parts of the region has become increasingly skewed. Investment has been more dominated by manufacturing and export sectors at the expense of service and non-tradable sectors, which tend to be more domestically oriented. This has been the case with economies like Japan, the NIEs (Korea, Taiwan Province of China, Hong Kong SAR, and Singapore). In these economies, overall investment seems to be in line with comparator economies outside the region, but in terms of composition it is becoming increasingly skewed to the export sectors. In Japan, investment in manufacturing has increased, but the same is not true for say Germany, the United Kingdom, or the United States, where the share of investment in manufacturing has actually fallen. Some might say this is not surprising because the United Kingdom and the United States had construction booms, but the pattern holds when excluding real estate. Another way of looking at the increasingly skewed nature of investment is to look at the NIEs. A gap has opened up over the 2000s between services and manufacturing. The manufacturing median has risen compared to the service median, and this is especially true when comparing small and large firms (Large firms are usually more oriented towards exports or manufacturing).

To summarize, from the data over the past 13-14 years, we see scope for investment-led rebalancing along two dimensions: 1) the investment share of GDP is lower compared to other regions at similar development stages, especially in the case of the ASEAN economies, and 2) even in parts of the region where investment is in line with comparator economies, there is still the issue of composition.

In order to correct these trends through policy, we need to understand the factors that lie behind them. At the aggregate level, one story that people have put forward is that the decrease of nominal investment in nominal GDP is just a reflection of the decline in relative prices of capital goods. Because several countries around the world are more efficient at producing capital goods, the price of products such as computing goods has fallen dramatically in the last 10-15 years, so these economies are now investing less into these areas but getting more computing power and capital service from smaller nominal expenditure. If that were true, you would expect that the economies with the biggest decline in terms of relative price of capital goods would also see the biggest decline in the share of investment in GDP, in other words a positive correlation. But from the data, there is not much of a correlation, and if you do find any, it is a negative correlation. At best, falling prices are not a complete explanation of the change in nature of investment composition.

Our analysis points to three factors. The first is lower returns to investment captured by lower average GDP growth in export-oriented Asia in the 2000s compared to the 1990s. The second is an increase in volatility in aggregate GDP growth as the Asian crisis gave way to the tech boom and bust, then seven years of solid growth, followed by the current crisis. Much more volatility than in the past has made firms more cautious. The third factor is that, although Asia's export economies have undertaken structural reform over the past decade, more still needs to be done. Furthermore, it might be the case that perception has not caught up with the current reality and this is leading businessmen and entrepreneurs to be more cautious.

Turning to the issue of composition at the sectoral level, there are two main aspects. The first is that after the Asian crisis, there has been a greater sensitivity to investment in fundamentals when comparing domestic-oriented sectors to export-oriented sectors or services to manufacturing. The second aspect is that domestic-oriented firms now face stronger headwinds to investment compared to export-oriented firms. The same can be said for services compared to manufacturing. There are three main features to this headwind. One is a relative decline in internal cash resources. The problem with this is that, with limits to external sources of finance, internal resources (cash flow) become that much more important. And domestically-oriented firms have seen a relative worsening compared to exporters in their internal resources to finance investment. Another aspect is leverage and debt overhang of past borrowing, because now a larger portion of the revenue stream is devoted to paying off debt and interest payments. Moreover, debt overhang has grown more for domestic-oriented firms than for export-oriented firms, and similarly for firms in the service sector, compared to those in manufacturing. The third feature is that domestic-oriented firms are now operating in more of an uncertain environment, similarly with service sector firms relative to manufacturing companies. This uncertainty is exhibited by the volatility of their sales and has further contributed to the skewing away of investment from service sector firms toward manufacturing firms.

Now we shall discuss the main channels for correcting these biases. At the aggregate level, in the parts of the region where investment spending has been held down by lower returns to investment, there is a positive payoff to boosting infrastructure. Analysis shows that there are strong complementarities between increases in infrastructure and increases in private investment. There is a tendency for it to crowd in private investment, perhaps by boosting the returns to private investment. This is a fairly well known result at a conceptual level and the belief is that it enhances connectivity, matching firms with resources, and also facilitates productivity gains through agglomeration effects brought about by similar firms clustering together and benefiting from knowledge spillovers from one another. But what is interesting is that these links at a conceptual level have also been supported by data, suggesting that there is a real benefit to investing in infrastructure, particularly in parts of the region where investment is low relative to comparator economies.

There is a lot of interesting work related to this that is being conducted in various industries. A good example is one which argued that the increased use of cell phones in the fisheries industries in southern India has contributed to huge gains in terms of efficiency and returns on private investment. The idea is that fisherman out at sea can now call in to the shore and head for the location with agents offering the best price. At the same time, agents know exactly how many boats are coming in and can prepare the docks accordingly for transporting the fish, and in general this has contributed to an enhancement of price discovery and minimized wastage, and has led to more efficient use of resources.

Moving on to correcting the imbalance in the composition of investment, it is evident, when digging deeper, that increasing access to external finance, especially for domestically oriented firms, could help with rotating composition towards domestic-oriented companies and firms operating in the non-tradable sector. This is true both for Japan and NIEs. Judging from regression based results, a 10% increase in access to external finance leads to, on average, a 2% increase in firm level investment rates. That is a pretty good payoff to boosting access to external finance and this result holds even after controlling for several other determinants of investment spending.

The Asia-Pacific region has made great strides in financial reforms in the last decade, and there have been some noticeable improvements in the structure of financial markets and the nature of financial intermediation, but it seems that more can be done. Corporate bond markets in emerging economies, apart from in Korea and Malaysia, have a tendency to be very small. This results in a lack of alternatives for corporate finance and heavy reliance on bank financing for investment. Boosting the penetration of corporate bond markets would provide alternative means to raising finance and could better intermediate the huge savings in the region to investment towards domestically oriented firms. This would be true even higher up in the value chain, for Japan or maybe also Korea, which operate in a region of the value chain that needs access to venture capital to support new growth areas. Compared to other economies that do a lot of R&D, the amount of venture capital investment in these countries is relatively low. This is true both in terms of funds for expansion and at the start-up stage. It appears there is the capacity for deeper financial markets to support activity at various stages of the value chain.

Considering the different dimensions possible for rebalancing, policies need to be appropriately tailored depending on which situation prevails. If the issue is boosting the aggregate level of investment, this may be facilitated by spending more on infrastructure, helping crowd in private investment by raising returns. The region has already started to take steps in this direction by relying more on public-private partnerships to finance investment, which is increasingly important when demands on public budgets are intensifying, and additional resources need to be brought in from the private sector.

Financial reforms would help address the skewed composition of investment, specifically by admitting a wider range of collateral for advancing finance, and deepening the coverage of credit bureaus. These are steps that have been taken by Japan and the Philippines to help lenders screen potential borrowers more easily. Finally, more can be done in terms of restructuring and merging nonviable companies and making space for additional investment. Overall, with the advanced economies likely headed for a period of prolonged sluggish growth, it is clear that Asia's export dependent economies will have to invigorate other models of growth, to find alternative sources of growth to drive their economies forward. How these economies adjust to what some investors have been calling the "new normal" of suppressed external demand relies very crucially on creating conditions that are conducive to investment-led rebalancing.

Questions and Answers

Q: I enjoyed your statement, but for the policy conclusion, the Renminbi should be substantially appreciated. Investment in NIEs is lower because all investment is going to China. You defined China as a domestic-oriented country, but China is an export-oriented country. Its investment dominates nearly 50% of GDP, with exports also dominating 50%. China has diversified its currency assets and other countries have lost their competiveness as a result. That's why these countries have low investment.

Malhar NABAR
It is true that it seems a bit strange to label China as domestically oriented, but the reason we did this is to do with the sheer size of its 5 trillion dollar economy. In terms of just the numbers, China does have a large domestic base. However, that does not contradict your point that China undeniably relies very heavily on exports as well. With regard to the broader point about the role of currency appreciation, in previous work on rebalancing we have argued that currency appreciation is an important component of the package of reforms that needs to be put in place to help with the rebalancing. It is true that, holding everything else fixed, an appreciated currency would help lower the cost of imported capital goods and boost investment spending, and also lift household disposable income, encouraging households to spend more, aiding consumption, which will also have an accelerator effect on investment. However, currency appreciation by itself is not going to get the appropriate amount of rebalancing. The aforementioned structural reforms also need to be implemented to help.

Finally, regarding the point that China is crowding out some of the investment that previously went to other emerging Asian economies, this point has also been examined in previous work at the IMF. In some economies where firms have been shifting operations to China to benefit from lower unit labor costs, the issue is less about aggregate investment. These economies have moved up the value chain and investment levels have remained high. However, the export-oriented sector seems to have expanded at the expense of the domestic-oriented sector.

Q: You mentioned that investment in the manufacturing sector in Japan is rising compared to developed countries in Europe and to the United States. I found that a little strange. Many Japanese companies are trying to benefit from the appreciation of the yen and are therefore investing in emerging markets like China and India. In light of this, which sectors do you think have benefited from investment in the manufacturing sector and what kind of trends can you see for the future of Japanese manufacturers.

Malhar NABAR
The first thing to point out is that the cross country data set we have used for this analysis only allows us to go as far as 2007 or 2008. It is therefore still too soon to analyze this most recent appreciation and the way it is affecting manufacturers, in terms of investment decisions and locations. I think the second part of your question about the relative growth performance within manufacturing and the outlook for that goes slightly beyond the scope of what we have looked at. However, I think the IMF view is very similar to that in Japan, which is that more needs to be done to find new growth areas, and it seems the government has been focusing on green technologies and also on healthcare related industries, which makes sense, based on trends in terms of demographics and the emphasis on low carbon technologies.

Q: When talking about rebalancing things, everyone may have a different perspective on what balance is. In your analysis, what does balance actually look like?

Malhar NABAR
I think it all feeds up to the same concept of the current account balance. Looking at global current account balances in absolute terms, from 2001 onwards there has been a massive increase and I think this is what people have in mind when they talk about the widening global imbalances in the years leading up to the crisis. I doubt that anyone would argue that all countries need to move to a position of zero current account balance, because some of the imbalances reflect the reallocation of capital in search of profitable growth opportunities. It also makes sense for resource producers to have a different level of balance compared to non-resource producers. The point here is that, starting from the same concept, it is important to understand what is contributing to that widening current account imbalance, because different countries contribute to it in different ways.

Q: Do you have any numbers about how much your policy recommendation could contribute to reducing imbalances?

Certainly with the financial reforms, we have a number from the analysis that is also backed up by simulation exercises we have done in previous research. The spring regional outlook had a chapter that covered many different aspects of rebalancing and is available on our website. The numbers from the simulation done there are also relatively in line with these figures, that a 10% increase in access to external finance would lead to about a 2% increase in the investment rate. Scaling this up to the aggregate level is a little bit more difficult but the simulation exercises find magnitudes of a similar order. Again, this is just one component of the rebalancing. It needs to be complemented with other reforms to form a comprehensive package that will help with the rebalancing.

Q: You suggested the importance of the crowding-in effect and the agglomeration effects and knowledge spillover that would bring. Can you explain the situation in other Asian countries?

Malhar NABAR
Yes, there are other economies in the region that are following similar strategies. One example is Malaysia and the development of the Klang Valley. But it is true that when there is a political economy constraint, it can limit you somewhat, because that clustering might actually pull away investment from other regions which could lead to inequalities and political problems down the line. Again, this is an aspect that policy makers are very aware of. In Malaysia's case they are trying to create these investment corridors in other parts of the country to help make sure that those inequalities don't widen tremendously. However, I think the idea of starting where the most highly skilled individuals are and making that even more of a focal point for drawing in talent and skills, attracting physical capital, and creating high value-added jobs, seems to be quite a reliable template that is being tried elsewhere as well.

Q: You have offered policy recommendations for Asia in general. Do you have any recommendations for Japan? These can be personal views.

Malhar NABAR
Personally, I think the emphasis on green technologies is a good idea and not just for Japan. It is clearly an area with a lot of interest, as there is a need for technologies that will help move our carbon-dependent economies to low carbon economies and there is potential for huge payoffs there. However I think Chad Steinberg from the regional IMF office here in Tokyo would have a better idea.

Chad STEINBERG
(Senior Economist, Regional Office for Asia and Pacific, International Monetary Fund (IMF)/Consulting Fellow, RIETI)

The main objective is to raise the return on investment. Some recommendations that we have mentioned in the past include lowering the corporate tax or accelerating the depreciation allowance for industrial buildings. Additionally, on the financing side of things, the venture capital sector is quite small and there is much potential for Japan to grow in this area.

Q: You suggested assisting the exit of nonviable companies as a possible policy. I think that is very important because Japan's entry rate and exit rate are quite low compared with other advanced countries. Do you have any specific policy proposals to enhance the smooth exit of non-profitable companies?

Malhar NABAR
My impression is that part of the reason why more action is not taken with lingering nonviable companies is because it is a way of providing social welfare. Closing down these companies would displace workers, creating unemployment and hardship. That is quite an inefficient way of delivering social protection because in net welfare terms for the economy as a whole, that is probably a drain. Governments need to search for alternative ways of providing social welfare in those circumstances through enhanced trade adjustment assistance programs, like in the United States, that help displaced workers from companies that close down with acquiring skills for a high growth area and finding a job in those areas. These schemes tend to work best when local governments collaborate with local educational institutions, such as community colleges in the United States, to provide the training that will attract new growth industries into the area. Maybe Chad Steinberg would like to comment?

Chad STEINBERG
After the bubble and in the early 2000s, there was a lot of corporate restructuring, but this was mostly for large corporations. So, in Japan, concerns with nonviable companies are mostly in the small and medium enterprises (SME) sector. These are the firms that need to restructure or exit. Therefore, any policies that would aid the restructuring process - for example, easing either out-of-court workout or bankruptcy procedures - would help firms exit. In terms of entry rates, enlarging the venture capital sector is a good idea.

Q: How do public-private partnerships aid the enhancement of investment?

Malhar NABAR
The idea is that the ability of governments to finance huge infrastructure is becoming increasingly limited, given the intensifying demands on public budgets. There have been examples of success where the government has had a partnership with a private concessionary, with the government taking on regulatory risks, clearing the initial obstacles for the private sector to come in, sometimes with additional government guarantees, to ensure there is enough cost recovery after incurring the up front fixed costs.

*This summary was compiled by RIETI Editorial staff.