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No. 5: Capital Investment Challenges in Canada
by Ronald P.M. Giammarino, University of British Columbia, under contract with Industry Canada, 1998
The purpose of this study is to identify challenges that Canadians will face in generating and exploiting investment opportunities over the next 10 to 15 years. Investment is the activity that leads to capital formation and is an important contributor to productivity and output growth. Capital formation increases labour productivity and income levels by providing the tools with which effort is levered into greater output. This report first discusses the role of investment in the Canadian economy and then reviews trends in Canada and other countries.
The productivity of Canadian industry went through a sharp decline in the mid 1970s similar to most industrialized countries. This suggests that Canadian investment levels might have been low. However, while productivity has levelled off or improved slightly for other developed countries, labour productivity growth in Canada has been below average and total factor productivity has actually declined over the past 15 years. The reasons for this are not clear. Some of the decline could be attributed to lower overall investment and, more specifically, to low levels of investment in R&D. In addition, more recent evidence suggests that Canada's industrial structure has not moved towards higher value, high technology areas as rapidly as other countries have.
Neither a low investment level nor a particular investment composition per se need be cause for concern since it might be that investment opportunities in Canada are not as valuable as those found elsewhere. It would be counterproductive to encourage investment in low return projects. However, there are externalities and market failures that might impede investment. If the decline in productivity, especially relative to levels found in other developed countries, reflects such impediments, then opportunities for improvement exist. The objective of this study therefore is to identify specific problems that might impede investment now or in the future. This will identify the challenges that must be dealt with over the medium term.
There is one main trend and one important theme that underlines this study of the investment policy environment that Canada will face. The trend is the increased level of factor mobility and international integration that world markets are experiencing. The investment decisions made by Canadian corporations and the policy decisions made by government must deal with the problems and opportunities that globalization implies. The theme that provides a base for this paper is that in most cases specific investment decisions are best made by individuals responding to market signals. In the past it has been common for policy makers to look at specific areas that are important to economic growth and provide investment or savings incentives to stimulate activity in these areas. It is not likely that this strategy will be successful in the future. First, past experience does not indicate that such a strategy is effective. More specifically, in most cases there is little reason to believe that policy makers are better able to make investment decisions than private corporations or citizens. For instance, it appears that efforts to stimulate R&D investment have failed and that Canada has been slow to invest in new technologies. Furthermore, encouraging a specific sector has and will continue to run into challenges from our trading partners.
This does not mean that there are no opportunities for policy makers to improve investment; the sections below identify specific areas where opportunities do exist. However, the general point is that policy makers should be less concerned with specific decisions and more concerned with the decision-making environment. The challenge is to develop new ways of supporting investment. The appropriate steps in doing so involve less direct incentives and more international policy coordination, regulation, and public investment.
Following are key challenges resulting from areas where the market might not take full advantage of investment opportunities owing to externalities or market failures.
- Increased globalization will generate greater factor mobility: investment in particular will increasingly flow to the environment that offers the highest overall return. This return will include both pecuniary and nonpecuniary components so that many investments, especially those that rely on human capital, will be made where there are both low costs of operating and high quality of life. The challenge is to ensure that Canada makes the infrastructure investments needed to maintain a high quality of life and to increase the efficiency of capital and labour. The market might not meet this challenge on its own because increasing infrastructure provides a direct benefit to Canadians who use these investments and an indirect benefit by attracting investment. For instance, an increase in the education level of the work force not only increases the quality of life for the average Canadian, it also makes investment in Canada more attractive.
- It has been well established that investment, particularly in R&D, generates spillovers that benefit many firms besides the initial investor. As a result, the social value of some investment exceeds the private benefit, and this supports a case for investment subsidies. However, there is also evidence that the international knowledge spillovers are extensive so that subsidizing investment in one country could mean subsidizing a transfer of knowledge to another country. The challenge is to replace direct subsidies with international mechanisms that help investors capture more of the total returns from their investments. This could entail greater coordination and enforcement of laws protecting patents and other property rights. Alternatively, it could involve facilitating international collaboration in areas of basic research and R&D so that private networks take on the problem of protecting the benefits of investment.
- Environmental issues and their impact on investment decisions will increase in importance and complexity as Canada adjusts to more open markets. As a wealthy, developed country, Canada could wish to exceed international environmental standards by devoting more resources to improving and protecting its environmental endowment. However, imposing higher standards might place Canadian firms at a competitive disadvantage and could lead to flights of capital. The policy problem is how to support private sector investment and implement specific social choices at the same time. The challenge is to ensure that firms have a competitive cost base while simultaneously ensuring that Canadian political choices are implemented. This will require new ways of dealing with corporate incentives. For instance, if the political system encourages Canadians to exceed international environmental standards, then it might be better to subsidize firms that incur the cost of exceeding the international standards rather than simply impose on firms the standards and the attendant increase in the cost base.
- The specific problems of low investment in general, low R&D investment in particular, and a slowness in channelling resources from low technology to high technology activities can all be explained by the way in which Canadian managers assess investment opportunities. There is concern that Canadian managers underinvest in long-term, risky projects. One common explanation is that Canadian investors are too averse to risk. However, this is inconsistent with the diversification opportunities, both domestic and international, that exist. An alternative explanation is that today's managers tend to be myopic because they undervalue the long-run benefit of investments. Managers' response to this complaint often is that they do assess opportunities correctly but are inhibited from making long-term investments because of the behaviour of modern capital markets. The argument is that investment in a long-run venture will reduce current period profits and this will lead to a drop in share price and/or a hostile takeover of the firm. Consequently, some managers argue that they must reject long-term valuable investments (such as technological advancement) in favour of less valuable investments that have more immediate cash payoffs (such as resource extraction). There is no evidence that capital markets do not value long-term investment. Moreover, the threat of a hostile takeover has not been shown to have a large impact on long-term investments. There is, however, evidence that Canadian managers use evaluation techniques that are known to cause valuation errors. This might contribute to the failure among managers to recognize the inherent value of high risk, long-term ventures. The challenge is to increase competitive pressure on Canadian managers so that they will be induced to pursue valuable investment opportunities vigorously. This will require opening up investment opportunities to competition and making the market for corporate control (the takeover market) more competitive. Policy makers will need to review ownership restrictions, corporate governance guidelines, barriers to capital markets, and product market barriers to entry.
- Corporate decision making is also influenced by the regulation of financial markets. For instance, bank loans are a significant channel through which resources are invested; however, it is widely recognized that bank lending can be drastically distorted through deposit insurance regulations. The challenge is to implement a system that consistently and regularly evaluates and improves the regulation of financial markets.
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