Is NZ short of equity capital?
Low business investment is a problem for tech adoption. Interest rates don’t provide a convincing explanation of why NZ businesses are not investing. Let’s explore another possibility.
A shortage of equity capital?
Financial capital comes in two flavours: debt and equity. An important insight is that these are complements, not substitutes. And the price of debt (ie, the interest rate you pay) depends crucially on the amount of equity you have. Anyone wanting to buy a house learns this very quickly. If you can put up 20% of the house price as equity, then banks are keen to lend you the rest at a competitive interest rate. However, that loan becomes significantly more expensive if can only stump up 10%, and near impossible to get if your equity stake falls further.
There doesn’t seem to be any shortage per se of debt in NZ. But there could well be a shortage of equity, and this would make equity capital expensive. Not only that, it would make debt capital expensive too. An equity shortage is a more convincing explanation for NZ’s capital shallowness than is our comparatively high interest rates.
I’ll offer three arguments in support:
- NZ investment in assets in other countries (so-called outward direct investment) is very low;
- the residential property market competes with NZ businesses for equity; and
- a variety of government policies restrict the amount of equity in NZ.
Low levels of outward direct investment
Establishing a commercial presence in foreign markets via outward direct investment (ODI) is an important channel for firms to export. This is particularly so for exports that require co-location of the service provider and customer, such as an engineering consultancy.
ODI also allows firms to grow and better service global markets. Zespri, for example, is expecting to harvest almost 70,000 tonnes of kiwifruit from orchards throughout Italy, France and Greece, filling a seasonal gap in New Zealand production.
NZ’s ODI as a proportion of GDP is low compared with most other OECD economies. 1 In fact, I’ve omitted the five highest performing countries from the graph so that the NZ column doesn’t disappear completely! These are Belgium (118%), Switzerland (225%), Ireland (231%), Netherlands (270%) and Luxemburg (7297%).
Low levels of ODI are consistent with a shortage of equity for NZ businesses. This evidence is powerful but circumstantial. Other plausible explanations include low managerial quality in NZ firms, resulting in flaky business decisions or poor execution of overseas expansions.
The residential property market competes with NZ businesses for equity
Housing investment competes for a constrained supply of local equity capital. Government policies, in particular those restricting land use, have encouraged land price inflation. This shows up in house prices.2
Furthermore, untaxed imputed housing services and a reliable stream of (untaxed) housing-related capital gains have skewed local savings and investment towards housing (not to mention baches).3
Recent changes to the Overseas Investment Act exclude at least some foreign equity capital from the residential land market. To the extent that this gap is filled by local equity capital, even less is available for business investment.
The Commission has repeatedly found that high housing prices in New Zealand is entirely a policy problem. High housing prices have consequences throughout the economy. A future blog post will report on Commission research that links high housing prices to reduced labour mobility.
A variety of government policies restrict the amount of business equity in NZ
The Overseas Investment Act constrains foreign investment in New Zealand. This has the direct effect of reducing the supply of business equity. It also has the indirect effect of lowering the potential sale value of affected NZ-owned firms, which has the effect of reducing the equity of these firms’ owners, and the firms’ ability to borrow. Reduced potential sale values also weaken the incentives to invest in the first place – further improving attractiveness of investments in residential housing.
In addition, high corporate tax rates make ownership of NZ companies less attractive.4 This graph shows the effective marginal tax rate on corporate income for OECD and G20 countries in 2017.
New Zealand also taxes retained earnings at a relatively high rate, which makes it less attractive for firms to invest in expanding their own operations.
New Zealand has a high incidence of cooperatives, state-owned enterprises and council-owned enterprises. Firms with these corporate forms can struggle to raise equity to fund business expansion. This has at least two effects. First, it reduces competition for potentially scarce equity. But second, it may mean that such firms rarely proceed with capital-intensive, productivity-enhancing business projects.
Can we blame a shortage of equity capital for New Zealand’s poor tech adoption and productivity performance? The case presented here is not conclusive. But such a shortage might be making a significant contribution. I certainly think it is worth exploring this further.
1. ODI stocks from oecd.org/fdi/outward-fdi-stocks-by-partner-country.htm#indicator-chart. GDP figures from https://data.oecd.org/gdp/gross-domestic-product-gdp.htm. The proportion for Luxemburg looks dubious to me. It could be an artefact of that country’s financial sector.
2. From newsroom.co.nz/@pro/2019/07/17/686320/our-armour-plated-housing-bubble.
3. “Imputed housing services” describes the benefits a person gains from living in a house they own. These benefits are not taxed. One way to understand this is to consider two people, Ada and Bruce. If they live in homes they own, they pay no (housing-related) tax. However, if Ada rents to Bruce and Bruce to Ada, then both pay tax on the rental income they receive.
4. See Figure 4 in govt.nz/sites/default/files/2018-09/twg-bg-3985467-appendix-a--productivity.pdf.</small
Photo: Dave Heatley