This paper reviews economic developments in the United Kingdom during 1991–95. Following a brisk expansion in 1994, when the economy achieved a rare combination of above-trend output growth and historically low inflation, the pace of economic activity in the United Kingdom has moderated in the course of 1995. Real GDP growth picked up to an annual rate of 4 percent in the first half of 1994, moderating to 3½ percent in the second half. Real GDP growth slowed further to just more than 2 percent in the first half of 1995.

Abstract

This paper reviews economic developments in the United Kingdom during 1991–95. Following a brisk expansion in 1994, when the economy achieved a rare combination of above-trend output growth and historically low inflation, the pace of economic activity in the United Kingdom has moderated in the course of 1995. Real GDP growth picked up to an annual rate of 4 percent in the first half of 1994, moderating to 3½ percent in the second half. Real GDP growth slowed further to just more than 2 percent in the first half of 1995.

IV. Fixed Investment: Performance and Prospects 1/

1. Introduction

A puzzling feature of the current upswing in the United Kingdom has been the apparent sluggishness of fixed investment. The current investment rate of less than 15 percent of GDP is low by historical standards (Chart 4.1), and also considerably less than the average OECD investment rate of 20 percent. These observations raise several questions. First, should the recent performance of fixed investment be regarded as weak? Second, what accounts for the recent sluggishness in investment? Should it be a cause for concern?

This chapter examines the contention that investment in the United Kingdom is in some sense below its optimum levels. It first reviews the recent behavior of total and non-residential fixed investment, placing it in a historical context and contrasting its pattern in the current upturn with that of previous recoveries. Second, it sheds some light on the factors underpinning the behavior of non-residential investment during the current expansion. Results from an estimated error-correction model of a neo-classical investment demand equation suggest that investment in the current recovery is being held back by such factors as uncertainty, capacity utilization and a non-neutral corporate tax system.

2. The evolution of fixed investment

a. Long-term trends

A fundamental question which arises in examining the recent behavior of fixed investment in the United Kingdom is whether its recent performance should be viewed as weak or strong compared to historical averages. One way of viewing the data in addressing this issue is to examine movements over time in ratios of investment to output. Chart 4.1 plots the ratio of private non-residential fixed investment to GDP since the early 1960s. It shows that the investment share of GDP has experienced a gradual long-term decline, moving from an average level of 15.8 percent in 1970-73, down to 14.4 percent by 1978-79, and then to just over 11 percent in 1995. Business investment, which had gradually trended upward since 1960s, has declined quite sharply in the 1990s (Chart 4.2). More striking is the trend growth of manufacturing investment; partly reflecting the decreasing importance of manufacturing output, manufacturing investment as a proportion of GDP has been on a trend decline since 1965 (see Chart 4.2). The ratio of manufacturing investment to GDP (in 1990 prices) remained relatively stable at around 3 percent through 1962-70, then falling to slightly over 2 percent by 1979 and reaching 2 percent by 1990-93.

CHART 4.1
CHART 4.1

UNITED KINGDOM NON–RESIDENTIAL INVESTMENT

(In percent of GDP)

Citation: IMF Staff Country Reports 1995, 130; 10.5089/9781451814057.002.A004

Sources: CSO, Economic Trends; and IMF. World Economic Outlook.
CHART 4.2
CHART 4.2

UNITED KINGDOM BUSINESS INVESTMENT

(In percent of GDP, 1990 prices)

Citation: IMF Staff Country Reports 1995, 130; 10.5089/9781451814057.002.A004

Sources: CSO, Economic Trends.

While longer-term investment trends in the United Kingdom have been relatively flat or falling, caution must be exercised in interpreting the data. The picture of the evolution of capital formation may be distorted due to the omission or significant tinder-measurement of important components of the capital stock. In many industrial countries, prices of investment goods such as computers have tended to rise by less than overall prices over the longer term. In the United Kingdom, this measurement problem can be illustrated by examining the behavior of aggregate investment as a proportion of GDP both in current and constant prices (see Chart 4.1). On both measures, the investment to GDP ratio rose up until the mid-1960s and then levelled off. While the two series rose roughly in tandem through the 1980s, a large gap between them has emerged in recent years. The OECD (1995) reckoned that the divergent trends of real and nominal measures of business investment shares in the United Kingdom might be partly due to the recorded decline in the price of computing investment. As the chart reveals, when measured in constant prices, the investment picture for the United Kingdom looks less unfavorable. 1/

Viewed from an international perspective, the United Kingdom has devoted a smaller proportion of economic activity to investment than almost all its main competitors (see Chart 4.1). Table 4.1 shows gross domestic fixed capital formation as a percentage of GDP in the OECD countries from 1960 to 1993. On average over this period, the United Kingdom had the lowest investment output ratio of all industrial countries. Currently, despite its favorable relative cyclical position, the United Kingdom still fares badly when compared with other G-7 countries in terms of its overall investment performance, although its business investment performance is broadly comparable with that of most other major industrial countries (except Japan) (See Table 4.2.)

Table 4.1.

Fixed Capital Formation in G-7 Countries

(As a proportion of GDP)

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Source: OECD.
Table 4.2.

Business Investment in G-7 Countries

(As a proportion of GDP)

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Source: OECD.

b. Recent investment developments

A salient feature of the current recovery has been the sluggish response of investment to activity. Chart 4.3 shows the behavior of investment in recent recovery phases. As charted, the share of total investment in GDP in this recovery has lagged that of the 1981-83 recovery. Compared with the recovery in the early 1980s during which total fixed investment grew by 16 1/2 percent, fixed investment grew by only 4 1/2 percent from the 1992 trough to the end of 1994, a period of comparable output growth (8 percent). And despite indications from survey figures that investment will grow strongly in the near term, official statistics continue to show only a moderate pick up in business investment, particularly in the manufacturing sector.

Investment was slow to pick up in the initial stages of the current recovery, but has shown some signs of firming since late 1993 in response to lower interest rates, the strength of demand and an improvement in corporate financial positions. After peaking in 1989, investment tumbled by over a fifth over the next three years. It then edged up by a mere 0.3 percent in 1993, and is estimated to have risen by a relatively modest 3.2 percent in 1994. 1/ The second half of 1994 witnessed a modest recovery in business investment following a period of relatively subdued investment demand. Overall, business fixed investment rose by 2.2 percent by end-1994 with the largest jump in capital spending in the fourth quarter coming from the manufacturing sector.

Understanding how the individual components of investment have moved over the last three years is helpful in interpreting the performance of total investment over the recovery. Table 4.3 shows how different industrial sectors contributed to investment growth through 1994. As shown, manufacturing investment was slower to recover than other non-energy industries and total business investment was held back by a collapse in capital spending by energy companies. Investment in the oil and gas sector and public sector dwellings, which are largely autonomous to the general business cycle, have contracted during this expansion, in contrast to their brisk expansion in the early 1980s. Outside the energy sector, total investment in 1994 grew by a healthy 5.2 percent with plant and machinery investment rising at a similar rate.

CHART 4.3
CHART 4.3

UNITED KINGDOM BUSINESS INVESTMENT DURING EXPANSIONS

(Trough = 100)1/

Citation: IMF Staff Country Reports 1995, 130; 10.5089/9781451814057.002.A004

Source: Central Statistical Office, Monthly Digest of Statistics.1/ 1981 02 for 1980s expansion; 1992 02 for current expansion.2/ Business investment excluding manufacturing and energy sectors.
Table 4.3.

Contributions to Growth in Gross Fixed Investment by Sectors (1994)

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Source: Bank of England.

3. Determinants of investment

As documented in the previous section, the aggregate investment performance has been weak although its business component may not be unduly low by international standards. Another way of assessing whether the investment performance is unusual is by econometric estimation. If investment is being held back in this recovery by some inhibiting factors, one would expect an equation containing several important determinants of investment demand to over-predict its behavior over the current recovery.

The empirical framework used here is the one that relates investment to its proximate macroeconomic determinants, namely aggregate demand and the cost of capital. 1/ Assuming that output is produced under competitive conditions and that the production function is of the Cobb-Douglas type, the desired capital stock will be given by

(1)K*=a(Y/C)

where K* is the desired stock of capital, Y is output, C the real user cost of capital and a is a constant.

The flow of net investment is the change in the actual capital stock as it adjusts toward a new desired level. Because the actual capital stock adjusts only gradually over time, net investment will depend on current and lagged values of the desired capital stock. Combined with the assumption that replacement investment is proportional to the lagged capital stock, this approach yields an equation for gross investment as follows:

(2)I=A(L)Δ(Y/C)t+δKt1

where A(L) is a polynomial in the lag operator and δ is the rate of depreciation.

Equations based on (2) have been commonly used in empirical studies of investment behavior. Given the distinct information content of the long-run and short-run behavior of investment, any econometric estimation of the determinants of investment should take this distinction into account. This can be done by setting up a long-run model that can be solved for the level of investment and which can also be re-parametrized to explain the growth of investment, i.e., to obtain its short-run determinants. 1/ The proposed short-run version of the model consists of the fourth-quarter differences of investment, output, and the (ex-post) real interest rate. This equation also includes an error-correction term defined as RES, which is the lagged residual of the long-run equation estimated by the Johansen method (see annex). A fairly simple OLS procedure produced the following equation (Δ indicates first difference):

ΔLOINR=4.28(1.15)+0.71(0.32)ΔLOGDP0.03(0.52)IREAL(1)+0.57(0.10)ΔLOINR(1)0.25RES(0.06)(4)
R2=0.87DW=1.54F(4,55)=46.61

Estimation period: 1970q1-1994q4

Only limited experimentation with specification and variable definitions was carried out. Further lags were not significant and using different definitions of the variables such as total fixed investment, manufacturing investment and investment to GDP ratios did not alter the main conclusions. The estimated coefficient on output growth is positive and significant, but the coefficient on the cost of capital is small and almost insignificant. Overall, the regression seems fairly well specified: the R2 is high and diagnostics test on the residuals reveals little signs of either autocorrelation or a structural break. 1/ By actually picking up the correlation between the growth rate of output and the growth rate of investment, the estimation results provide support for the accelerator hypothesis. This evidence tends to support the view that investment would grow during the present recovery on account of both a strong output growth and a low cost of capital induced by low interest rates. Yet, even in 1994 when investment recorded its best performance in the current recovery, its growth rate was slower than that predicted by this equation.

4. Factors constractining investment in this recovery

Our estimated equation is found to overpredict actual investment quite substantially over the last six quarters of the sample period. 2/ As argued in section 2.a, it is quite possible that the disappointing performance of the overall investment demand equation could reflect to some extent the inability of that equation to account for the recent surge in high-tech component of investment, but the evidence on that is rather sketchy. 3/ Given the failure of the estimated neo-classical investment demand to account for the current weakness of the investment performance, other determinants of investment demand are considered below.

a. Uncertainty

Uncertainty affects investment decisions in the sense that when faced, with uncertain prospects, risk-averse firms tend to reduce the value they place on returns to investment and thus will tend to delay investment decisions in order to accumulate more information. There is little empirical work measuring the quantitative importance of uncertainty on investment demand. However, several proxies can be used to assess the climate for investment decision-making. An ex-post measure of uncertainty is the variability of key macroeconomic variables, on the presumption that higher volatility implies larger forecast errors. 1/ Compared with most of its major industrial competitors, the United Kingdom has been characterized by a relatively high variability of both its growth and inflation. Table 4.4 presents some summary statistics which illustrate the long term inflation record of the United Kingdom and its high variability during 1960-94. Growth in the United Kingdom has also been quite volatile. While uncertainty rather than variability is more likely to damage investment, the latter cannot be discounted since there would be no uncertainty if the variability in the economy were predictable.

Table 4.4.

Variability of Growth and Inflation

(1960-94)

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Source: Fischer (1994).

Uncertainty about future price levels may distort the allocation of resources by discouraging economic agents from entering long-term nominal contracts. This may inhibit investment when the return is a long way ahead and therefore may reduce investment rates and encourage investment in shorter-lived assets. Other evidence suggests that uncertainty about inflation may damage investment by sustaining high nominal hurdle rates or target rates of return.

During the 1970s and 1980s, both average inflation and inflation volatility were quite high. This made it difficult to determine the discount rate that should be applied in order to calculate expected real returns on investment, as companies not only attempted to allow effectively for inflation in their calculations, but also required a higher return due to the additional uncertainty and risk accompanying unpredictable monetary conditions. With the transition to an environment of lower and more stable inflation, it would seem normal to expect a lower cost of capital as uncertainty about the value and cost of money become less critical in investment decisions. However, the process of adjustment may be more difficult for firms if they have become accustomed to high and variable inflation.

Studies by both the CBI and the Bank of England (Junankar (1994), Wardlow (1994)) suggests that due to uncertainty, there might be long lags for firms in adjusting internal “hurdle rates” to a low inflation environment. Wardlow argued that firms had set high target rates of return for investment projects in the 1980s to reflect the risk associated with high and volatile inflation and were slow to reduce these rates of return in the 1990s because they were not yet convinced that they had entered a new stable and low inflationary environment. 1/ An informal inquiry conducted by the Bank of England in early 1994 found indeed that the process of adjustment was not very advanced. Seventy percent of firms questioned had yet to adjust their target rates of return. Many firms reported that their current tendency was to leave their target rate of return and nominal discount rates unchanged over long periods (see Tabulation below).

Tabulation: Adjustment to date

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Source: Bank of England, Quarterly bulletin.

b. Profitability and firms’ financial positions

Profitability influences investment decisions by acting as incentives for firms to invest. 1/ Profit or cash-flow models have been found to perform no worse than standard investment equations. Causality tests using the growth of profit rate and investment reveal that in the United Kingdom the rate of profit Granger causes investment. This result is supported by the recent studies by Sentence and Urga (1995) on the determinants of business investment, which found a long-term relationship between the profit rate and the ratio of investment to GDP. 2/

A concern during the current economic recovery in the United Kingdom has been the apparent unwillingness of firms to invest despite being in a relatively strong financial position. For instance, in 1994 firms’ total profits were around 30 percent higher in real terms than in 1990, and their balance sheets were healthier; the average ratio of liabilities to assets, a telling measure of financial strength, had fallen to less than 1 from 1.15 in 1990. And firms were flush with cash, increasing dividend payouts by a third on average since 1990. One possible explanation could be that the process of corporate balance sheet adjustment was still incomplete.

It has been argued 3/ that British firms have been slow to invest in this recovery partly because the debts they took on in the late 1980s and a legacy of the recession put a severe squeeze on their financial position. After the investment boom at the end of 1980s, the financial balance of firms deteriorated sharply during 1990-92 as a result of shrinking profits due to the recession (Chart 4.4). These record financial deficits (over 4 percent of GDP) in 1989 and 1990 were unusual initially reflecting the lagged effects of booming investment and dividend pay-outs on cash flow. Boosted by mergers and acquisition activity, firms’ net borrowing requirement rose above levels seen in the previous recovery. 4/ Faced with problems of indebtedness and massive financial deficits, firms were unable to restore financial balance until mid-1993 on the back of a pick up in activity, higher capacity utilization, lower debt service, on-going cost cutting and a big rise in retained earnings. Concomitantly, they reduced their levels of bank debt significantly and turned increasingly to the capital markets for external finance. In contrast with previous recoveries, bank borrowing were actually lower and firms made significant net repayments to banks up until 1994 1/ thereby continuing to restructure their balance sheets rather than invest.

CHART 4.4
CHART 4.4

UNITED KINGDOM CORPORATE FINANCE

(Four-quarter moving average)

Citation: IMF Staff Country Reports 1995, 130; 10.5089/9781451814057.002.A004

Sources: CSO, Economic Trends, Financial Statistics.1/ Industrial and commercial companies’ stock of sterling borrowing from banks and building societies as a proportion of their post-tax income.

While the process of balance sheet adjustment might now have reached a mature stage, the question of how much of the disequilibrium is corrected remains an empirical one. More generally, firms adjust their indebtedness in response to changes in the incentive to corporate borrowing. Adherents of the Modigliani-Miller view that companies’ real decisions on investment are taken independently of their financial decisions, would expect adjustments to the stock of debt to be brought about by corresponding adjustment to the outstanding stock of equity by changes in dividend payments and net equity issues. However, a popular alternative view that applies, particularly when companies have too much debt, is that they are forced to reduce their expenditures by cutting back on investment.

c. Non-neutrality of corporate tax structure

It is fairly well known that the structure of the tax system can distort saving and investment decisions. By raising the required rate of return on investment projects above the level required by savers, the tax system can contribute to reducing investment below the socially optimal level. This means that some projects which would be worthwhile in the absence of taxes do not go ahead.

A review of empirical research into the relationship between investment and tax incentives in the United Kingdom suggests that there is a statistically significant effect but that such effects are small in magnitude, 2/ 3/ However, a number of analysts have persistently called attention to the theme that the corporate tax system is biased against investment. For example in its 1995 Green Budget, the Institute for Fiscal Studies argued that the system of corporate taxation creates: “a significant tax bias against investment, and distorts the allocation of investment between different forms of capital spending; corporation tax favors debt finance over equity finance and encourages firms to pay out dividends”.

By encouraging companies to pay dividends rather than retain profits, the existing tax structure might have contributed to reduce investment. 1/ And despite a major tax reform in the mid-1980s 2/, there still remain two fiscal non-neutralities in the current corporate tax system. First, firms are entitled to deduct interest payments from taxable profits but there is no equivalent allowance for the opportunity cost of using equity capital. Second, around 70 percent of equity holders can reclaim a large part of the corporation tax paid on distributed profits, but retained profits bear the full rate of corporation tax. Because a high proportion of the equity market is owned by tax-exempt investors, mainly pension funds, the total (corporate and personal) tax on distributed profits is on average only about two-thirds of that paid on retentions. Both of these non-neutralities tend to make the use of retained profits less attractive as a source of investment finance. If companies respond to this tax incentive by increasing dividends, this may in turn lower investment, especially for companies whose capital spending is already limited by shortage of internal finance.

d. Capacity utilization

The investment boom in the late 1980s added considerably to capacity and consequently, with the deepness of the ensuing recession in the 1990s, created large amounts of spare capacity which needed to be worked off. Faced with under-utilized capacity, manufacturers were rather striving to improve efficiency at their plants. Until late 1994 when firms in several sectors such as export and the service industries were not facing capacity constraints, improvements in productivity seem to have come about through organizational changes and restructuring, such as more flexible working patterns and better utilization of both labor and capital, rather than by investing in plants and machinery. Much of the service industry suffered from extremely low level of capacity utilization in the last recession, and as in the rest of the economy, investment in this sector boomed at the end of the 1980s while services output contracted in 1991.

Recent CBI surveys indicate that efficiency has been the dominant motive for manufacturing investment in recent years, though the need to expand capacity has been growing in importance over the past year and half. Most respondents to a CBI survey replied that investment was targeted at rationalization and improving efficiency rather than increasing capacity (see Tabulation below). However, capacity utilization, particularly in manufacturing industry as reported by the CBI, has risen sharply over the last two years following a sharp decline in the early 1990s (Chart 4.5).

CHART 4.5
CHART 4.5

UNITED KINGDOM CAPACITY UTILIZATION IN MANUFACTURING

(Percent of firms not working below capacity)

Citation: IMF Staff Country Reports 1995, 130; 10.5089/9781451814057.002.A004

Source: CSO, Economic Trends.

Tabulation: CBI survey evidence on investment

(Percentage of manufacturing firms)

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Source: Bank of England, quarterly bulletin.

5. Investment outlook

The discussions on the determinants of investment demand in the previous section have identified a number of factors that are likely to influence the future behavior of investment in the United Kingdom, namely demand prospects, costs of capital, financial constraints affecting the availability of internal and external finance, profitability/competitiveness and the degree of pressure on existing capacity. Indications from all these factors point to a strong recovery in investment in the near term; the economy is expected to continue on its non-inflationary growth path; the process of corporate balance sheet consolidation has reached a mature stage and companies profits have risen sharply; the degree of under-utilized capacity has fallen over the past two years and capacity utilization in industries as reported by the CBI is well above long-run average; business confidence has strengthened reflecting expectations of steady export-led output growth and firms are reported to be awash with cash available for investment, primarily as a result of strong profits; and hurdle rates may also now be adjusting to a low inflation environment, albeit slowly.

The CBI survey shows that levels of capacity utilization are above both their historical average and the levels seen in the mid-1980s. The proportion of companies reporting that they are no longer working below capacity has risen from just over 20 percent in early 1993 to near 50 percent in 1995. Such a rise in the capacity utilization is likely to encourage investment for two reasons. First, with existing machines and/or buildings being used more intensively, the amount of replacement investment needed to replace, renovate or repair assets worn out by age or use is likely to increase. The second reason that rising capacity utilization is likely to be met by higher investment is that greater pressure on existing capacity is likely to increase the confidence of managers that future business volumes will justify investment in new production facilities.

There is also a strong pick-up in investment intentions partly reflecting the fact that the climate for investment continues to be favorable, with the economy continuing to strengthen and profitability remaining high. ICCs’ gross trading profits increased by 16 1/2 percent in 1994, following a 14 percent increase in 1993 (Chart 4.6). As measured by the real rate of return on capital, profitability has recovered to levels last seen in the mid-1980s. The proportion of firms reporting internal finance as a constraint on investment showed a slight increase in the latest quarterly CBI Industrial Trends Survey, after falling steadily since the end of 1993. But cash flow and liquidity are not expected to be significant constraints on investment. In addition to factors related to the growth of output and demand, manufacturing investment should be supported by a favorable competitive position. Outside the manufacturing sector, however, pressure on existing capacity, output growth and competitiveness effects will be less supportive of investment.

b. Conclusions

This chapter has documented the puzzling fact that fixed capital investment has contributed little to the current recovery of the economy of the United Kingdom. It has been shown that the investment performance to date is weak both from historical and international perspectives and a number of inhibiting factors impinging on investment growth have been identified. The chapter has argued that the sluggish performance of investment so far over the recovery is explicable in terms of recovering profitability, uncertainty, capacity utilization, and the corporate tax system. Most indicators point to a strengthening of investment in the period ahead.

CHART 4.6
CHART 4.6

UNITED KINGDOM COMPANY PROFITABILITY

(In percent of GDP)

Citation: IMF Staff Country Reports 1995, 130; 10.5089/9781451814057.002.A004

Source: CSO, Financial Statistics.1/ Gross trading profits of industrial and commercial companies.

Annex

This annex describes the methodology used in this chapter to estimate a version of the neoclassical investment demand function for the United Kingdom.

In light of the problems of “spurious” estimation and inferences often associated with the non-stationarity properties of macroeconomic variables--in particular when standard OLS estimation is used--the proposed estimation strategy follows the two-step estimation procedure as suggested by Granger and Engle (1987). This procedure, which is shown to give coefficient estimates which converge on the true parameter values, involve the following steps. First, a prior levels regression of fixed investment against output and the cost of capital is performed, which allows the hypothesis of cointegration to be tested. Then the residuals from this regression are entered into an error correction model in place of the levels terms. This intuitively has the effect of imposing a set of parameter values on the levels terms which give the minimum least squares errors in this part of the equation.

Before proceeding to test the set of variables for cointegration, the statistical properties of the individual series are first examined with a view to determining the order of integration, i.e., how many times the variables require differencing in order to induce stationarity. In order to test the level of integration of these variables, Augmented Dickey-Fuller (ADF) tests were performed. According to these tests reported in Table A, all three variables (in log terms) investment, output and cost of capital are integrated of order 1, i.e., I(1).

Table A.

Time Series Properties of the Variables Augmented Dickey-Fuller (ADF) tests 1/

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Critical values in brackets.

The cointegration tests amounted to a unit-root test on the residuals of a “cointegrating” regression of investment against output and the cost of capital (with all three variables being in logs). Intuitively, if there is a long-term linear relationship among the variables, the residuals should be stationary. If not the residuals will have a unit root because the variables in the cointegrating regression have unit roots. A convenient method for estimating and testing cointegrating relations in the context of vector autoregressive (VAR) error correction models is provided by the Johansen Maximum Likelihood approach. 1/

Our proposed long-run equation for investment is a version of equation (2) in which the growth rate of the capital stock is regressed against output growth and the growth rate of the cost of capital.

LOINR=aLOGDP+bLORPOK

where LOINR is the log of non-residential fixed investment in 1990 prices LOGDP is the log of GDP measured in constant 1990 prices LORPOC is the log of relative price of capital. 2/

Table B. provides estimates for equation (3) based on the Johansen cointegration method. The table provides log-likelihood ratio test statistics for determining the number of cointegrating vectors using the maximal eigenvalue procedure described in Johansen (1989). The statistics in the table confirm the conclusion that there is only one cointegrating relationship among the three variables. The estimated parameters of the cointegrating vector indicate plausible values for the long-run elasticity of investment to GDP and the relative price of capital. All coefficients have the expected signs.

Table B.

Johansen Maximum Likelihood Estimates of Long-run Equation for non-residential Fixed Investment

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Having achieved a suitable specification of the cointegrating equation, we proceed to the second stage of the Granger and Engle procedure. Defining RES to be the derived residual from equation (3), we include these residuals in a standard error correction nodal. A fairly simple OLS procedure produced the following equation (∆ indicates first difference):

ΔLOINR=4.28(1.15)+0.71(0.32)ΔLOGDP0.03(0.52)IREAL(1)0.25(0.06)RES(4)
R2=0.87DW=1.54F(4,55)=46.61

Estimation period: 1970q1-1994q4

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1/

Prepared by Ousmane Doré.

1/

While economic theory suggests that the constant price investment numbers are more important for judging how the real productive potential of the economy is growing, the accuracy of such numbers is more open to question. For instance, the Central Statistical Office (1985) admits that it is extremely difficult to measure movements in the prices of capital goods given that it is extremely difficult to make allowance for changing quality.

1/

In contrast in the United States, investment rose by more than 15 percent at the same stage of the cycle and has been the driving force behind the economic recovery in that country.

1/

The specification is based on the standard neo-classical theory according to which the determinants of investment demand can be conveniently broken down into two parts: the accelerator, which captures the relationship between output and capital as determined by a production function, and the cost of capital effect, which captures the substitutability between capital and other factors of production. While there is a broad consensus that the former is a robust relationship, there is considerable controversy about the role of the cost of capital. Most economists believe that it has a small effect on investment demand, but others (e.g., Clark, 1979; Blanchard, 1986) have concluded that there is little or no empirical evidence that the cost of capital affects investment demand.

1/

The model in levels has been estimated in this paper by the Johansen cointegration method (see annex), and the short-run behavior examined on the basis of a simple OLS regression in first difference with an error correction term.

1/

However, as the current and lagged values of the change in investment and output are among the explanatory variables, a problem of simultaneity bias remains. This however can be handled by performing Granger causality tests which amount to regressing investment on its own lags and against the lags of output. If the latter are collectively significant, one concludes that output Granger causes investment.

2/

This is an ex-post forecast obtained by substituting known values of exogenous variables looking back to generate the model predictions.

3/

It has been argued that different types of investment should not be aggregated. For instance Norotte and Bensaid (1987) and Evans (1989) have suggested that the unusually rapid growth of computer investment poses a problem for econometric estimation of aggregate investment equations. In the United Kingdom, further complications arise due to the fact that the CSO investment data are not broken down into high-tech components.

1/

Direct evidence on the possible effects of uncertainty can be obtained by comparing actual investment expenditures with investment intentions, as measured by surveys. It is assumed that firms’ reported intentions are based on predictions of the factors relevant to the investment decision. As these factors become more predictable, the actual outcome should be closer to the intentions.

1/

Sentance and Urga (1995) have heavily discounted this “hurdle rates” hypothesis by offering the following counter-argument. Even if inflation expectations by firms were in some sense too high, this could have led them to conclude that the real cost of capital (the difference between the interest rate and inflation) was lower than it appeared to be, therefore this would have encouraged rather than discouraged investment.

1/

The relationship between profitability and investment can also be seen as a development of the theories of investment suggested by Keynes (1936) and formalized by Tobin (1969). According to Tobin’s “q” theory, business investment expenditure will be positively related to the ratio of the stock market valuation of the firm to the replacement cost of its existing capital stock.

2/

They found that in the long-run, for a given level of output, a one percentage point rise in the rate of return on capital will lead to a 4.2 percent increase in investment.

3/

See for example the OECD 1995 Economic Survey of the United Kingdom.

4/

The net borrowing requirement of the Industrial and Commercial Companies (ICCs) stood at £14.3 billion at end-1993 compared with an average of £3.7 billion between 1982 to 1984.

1/

For instance, in 1993 alone, companies repaid £11.4 billion to banks compared with average borrowing of £5.1 billion a year between 1982 and 1984.

2/

See for instance Deveraux (1989).

3/

The standard way of measuring the effects of investment incentives on the demand for capital is by the elasticity of substitution between factors of production. Under certain assumptions, the optimum capital demand of a firm can be written as K = b Y C-s, where K is the desired capital stock, b is a constant, Y is the expected output of the firm, C is the user cost of capital and s is the elasticity of substitution. Thus, if the user cost of capital goes up by x percent, the demand for capital at given levels of demand will fall by sx percent.

1/

This view is echoed by the Treasury: “the tax system tends to encourage distribution rather than retention of corporate profits and institutional rather than direct saving” (HM Treasury, Industrial Finance Initiative).

2/

The 1984 tax reforms reduced the standard rate of corporation tax from 52 to 35 percent and eliminated 100 percent first year allowances replacing them with depreciation allowances which were more closely related to average economic depreciation rates. They also broadened the tax base, removed much of the differential treatment of assets, but in doing so increased the post-tax cost of new investment.

1/

See Johansen (1988). This method provides estimates of all the cointegrating vectors which exist between a set of variables as well as test statistics for the number of cointegrating vectors which have an exact limiting distribution which is a function of only one parameter.

2/

For estimation purposes, the relative price of capital was proxied by RPOK = PK (NOM- INFL)/RWGE where PK is the relative price of capital goods to output, NOM is the nominal interest rate on a 3-month Treasury bill, INFL is the quarterly change in CPI and RWGE is manufacturing sector real wage. All data are from the CSO aremos databank.

United Kingdom: Recent Economic Developments
Author: International Monetary Fund
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    UNITED KINGDOM NON–RESIDENTIAL INVESTMENT

    (In percent of GDP)

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    UNITED KINGDOM BUSINESS INVESTMENT

    (In percent of GDP, 1990 prices)

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    UNITED KINGDOM BUSINESS INVESTMENT DURING EXPANSIONS

    (Trough = 100)1/

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    UNITED KINGDOM CORPORATE FINANCE

    (Four-quarter moving average)

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    UNITED KINGDOM CAPACITY UTILIZATION IN MANUFACTURING

    (Percent of firms not working below capacity)

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    UNITED KINGDOM COMPANY PROFITABILITY

    (In percent of GDP)