Secrets of Investment Dynamics
November 23, 2006
By Serhan Cevik and Katerina Kalcheva | London, London
The investment behaviour of the corporate sector is key for sustainable output growth. Turkey has become the fastest-growing OECD country, thanks to structural changes and prudent policies that have lowered macroeconomic volatility and set the stage for a private sector-led recovery after the 2001 crisis. Although output growth will likely remain robust in the foreseeable future, global imbalances make the task of maintaining the above-trend expansion more challenging. The sudden burst of global financial volatility earlier this year, for example, has shown us that despite all the underlying improvements, financial conditions are still sensitive to global sentiment and risk appetite. However, the question in our mind is the vulnerability of the Turkish economy to adverse shifts in financial markets. Will the consequences of the global volatility shock bring an abrupt slowdown in economic activity? To assess the economy’s post-volatility performance, we started our analysis with the behaviour of consumption expenditures — the largest component of aggregate domestic demand. Using an error-correction model, we found that tighter financial conditions are unlikely to bring a contraction in consumer spending (see Secrets of Consumption Dynamics, September 4, 2006). But what about the most important driver of sustainable growth — business investment spending? Can the corporate sector maintain its appetite for capital accumulation, which has shaped the country’s astonishing performance in the last five years?
Business investment spending has become a leading engine of growth in the post-crisis period. The financial meltdown in 2001 led to a collapse in private fixed investment spending. After growing at a steady pace in the second half of the 1990s to 20.7% of GDP, private capital expenditures declined by 34.9% in 2001 and 5.3% in 2002 to 12.8% of GDP. Although investment growth has always been more volatile compared to output growth, the intensity of the investment downturn reflected structural shortcomings rather than just cyclical factors, in our view. This is why we have kept focusing on productivity growth and other behavioural changes in the economy. Indeed, as Turkey moved away from the vicious boom-and-bust cycles, the corporate sector has responded by pushing the rate of capital accumulation to a higher plateau. Real private investment spending soared by 138.3% on a cumulative basis to 28.1% of GDP in the second quarter of this year. And the composition of capital expenditure has become more favourable, as outlays for machinery and equipment grew by 20.2% in the first half of this year on top of the 196.2% increase in the previous four years. Even though these are all encouraging developments that improve Turkey’s growth potential, we still cannot ignore the risk of heightened uncertainty disrupting the expansion phase of capital accumulation. In fact, after the recent financial tremor, the business confidence index kept declining to the lowest level in the last 12 months. But is this just a knee-jerk reaction or the beginning of a trend shift? Domestic final demand is the most important determinant of investment spending. To uncover the major determinants of private sector investment expenditures, we apply an error correction model based on seasonally adjusted data for the 1990-2006 period in Turkey (for technical details, please refer to the appendix in Secrets of Consumption Dynamics). Given Turkey’s continuing structural transformation, we prefer to model real business investment spending on machinery and equipment instead of gross fixed investment spending, which also includes private expenditures on new buildings as well as the public sector’s capital expenditure. Therefore, the model uses explanatory variables such as domestic final demand, domestic bank lending to the private sector, real interest rates and output and currency volatilities. After running thousands of regressions, we know that the explanatory variables we used are not enough to explain fully the corporate sector’s investment behaviour. Unfortunately, because of the lack of reliable data, we could not include external funding and retained earnings as explanatory variables. Nevertheless, despite the data-related shortcomings, our empirical findings confirm that the lagged behaviour of domestic final demand is a key determinant of corporate outlays on machinery and equipment. The past behaviour of demand as well as bank lending influence investment decisions. The duration of two quarters gives the best fit to our model, which also confirms that private firms base their future investment decisions on the past behaviour of demand and expectations. Interpreting the log coefficients as elasticity shows that a 1% increase in the lagged domestic final demand corresponds to an approximate 0.67% rise in private investment expenditure. In other words, the strength of domestic demand is the leading driver of corporate spending on machinery and equipment in Turkey. Private credit is the other factor that has a positive and significant impact on investment growth. This is not surprising and will become more pronounced, in our view, as macroeconomic normalisation helps to develop credit channels and the banking sector keeps replacing government securities with loans to the private sector. In fact, after collapsing to 16.7% of GDP in 2002, bank lending to the private sector has already expanded rapidly to 26.3% last year and 30.7% so far this year. As a result, our model suggests that a 1% increase in private credit leads to a 0.62% surge in business investment expenditures. Macroeconomic stability is key to long-term fixed investment decisions. Real interest rates enter into our model with the correct negative sign, which suggests a negative impact on investment spending. However, we could not find a significant effect of interest rates on private capital expenditure. In our view, this is likely due to the fact that the real interest rate is only a partial proxy for the cost of capital and excludes important determinants such as taxes and rents. Furthermore, as mentioned above, external debt and retained earnings (on which we do not have a comprehensive set of historical data) provide alternative sources of funding for investment projects. In our model, we also take into account the volatility of output and the exchange rate in order to capture the effects of uncertainty on the corporate sector’s investment behaviour. Both variables appear to have negative effects on private capital expenditures, confirming the role of macroeconomic stability in shaping the investment climate and determining the optimal stock of capital. As we have long argued, the volatility moderation in the last five years has had an overwhelming influence on long-term investment decisions in the private sector and thereby become one of the most important drivers of economic expansion (see Stabilisation as Innovation, May 9, 2005). Investment spending is more sensitive to transitory shocks and exhibits greater volatility. Our short-run model is specified with the difference of log private investments as the dependant variable and the lagged difference of demand, the real interest rate, volatility variables and contemporaneous differences of private credit. The loading coefficient is relatively low (0.21) and indicates that the adjustment to the long-term equilibrium takes place slowly but steadily. The impact of private credit and the past real interest rate (lagged one period) is significant on capital expenditure. Therefore, we expect the recent tightening of financial conditions to lower the growth rate of gross fixed investment spending from 24% last year to 12.5% in 2006 and 10.5% next year. This is not an alarming development, but simply reflects higher volatility of investment growth relative to the variability of output. That said, the volatility of fixed investment expenditures has moderated in the post-crisis era, thanks to fiscal consolidation, lower inflation and structural changes in the economy. Furthermore, the sustained surge in capital spending is not just a cyclical phenomenon, but also a result of increasing foreign direct investment and structural shifts away from labour-intensive sectors to more capital-intensive businesses. This is why we still believe that Turkey will remain on a robust growth path, as long as the authorities do not deviate away from prudent policies.
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Liquidity Turning Less Favorable
November 23, 2006
By Sharon Lam | Hong Kong
In a surprise move, the Bank of Korea (BOK) announced today that it would raise the deposit reserve requirement ratio for commercial banks, effective from December 23, 2006. Specifically, the demand reserve requirement ratio will be taken up to 7% from 5%. Currently, demand deposits account for approximately 12% of total deposits. At the same time, the BOK cut the long-term time deposits reserve requirement ratio to 0% from 1%. However, these long-term time deposits have a negligible share in total deposits. It is calculated that the average reserve requirement ratio for all deposits will now be raised to 3.8% from 3%. Banks are now short of reserves. Before the announced increase in the reserve requirement ratio, Korean banks were already barely meeting the requirement by holding 3.1% of reserves versus the required 3%. Now, however, they will be under the required ratio of 3.8%. At latest count, Korean banks held only W35 billion in excess reserves. To make up for the 0.8% increase in required reserves, the banks will need to come up with additional funding of around W4.7 trillion, on our estimates. In addition, banks will also need to cut lending going forward. Liquidity growth to recede. While the immediate impact on banks may not be significant, today’s move by the BOK will reduce liquidity in the economy as it effectively brings the reserve requirement above what the banks are currently holding. If not overtly negative, today’s move undeniably caps the positives in next year’s economic outlook through reducing liquidity, which has been a growth driver in the past two years. On top of that, added pressure comes from an expected decline in the trade surplus, in our view, as we believe that Korea is heading into an export slowdown. Korea’s overall liquidity conditions will be less favorable in the year ahead. Yet, less chance of imminent interest rate hike. By effectively reducing available liquidity to curb loan growth, the increase in the reserve requirement reduces the chance of another interest rate hike, at least in the next three months. In our view, the BOK opted for cutting the supply of loans rather than increasing interest obligations for all lenders in the economy to strike a balance between a slowing economy and surging housing prices. Different segments of growth next year. We believe Korea is entering an export slowdown as demand from both China and US appears to be cooling. As a result, we also expect capex to slow due to the anticipation of weaker corporate earnings. Currently, loan growth is still accelerating but all the forward-looking indicators and a series of changes in policies (including the tightening of mortgage loans announced last week and today’s measures by the the BOK) prompt us to believe that loan growth will slow next year. While the outlook for exports, capex and lending looks dimmer next year, we believe that consumption will stay relatively stable. Indeed, the government’s recent policies all seem to be sustaining consumer sentiment, in our view. For example, increasing the housing supply would create jobs, and a likely reduced chance of interest rate hikes would be welcomed by the general public. With the presidential election due at the end of 2007, we think that keeping consumers happy will top the policy agenda.
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