FINANCING THE NEXT TWENTY YEARS’ DEVELOPMENT-CHALLENGES FOR THE CAPITAL MARKET M. JOHNSON Introduction The question implicit in the title of this address is whether we will experience a “capital shortage” which will inhibit our ability to raise our standard of living or whether we will be able to finance reason- able aspirations from resources available to us. Expenditure on capital is required to increase productivity and to maintain high employment. Will Australia be able to meet this investment require- ment for the foreseeable future on acceptable terms, or will inade- quate financial resources limit improvement in our standard of living? Any “gap” between demand for investment capital and supply of investment capital will of course never actually show up. However, it will be evidenced by higher interest rates and restricted credit availability, conditions which will apply to all sectors of the economy. The thrust of this school is to examine the problems of industrial development. The basic conditions which affect all capital invest- ment will of course be greatly influenced by what we choose to save and what we choose to consume. Within what we choose to save, competition for funds exists between users of capital for industrial investment and users for other purposes-notably the government and household sectors. I am going to concentrate on the overall system of our markets where this competition takes place and where allocations are made. I will first look at some of the recent work on the capital shortage question. I will then venture some opinion on deficiencies in the markets and make some suggestions about what we should be doing. Approaching the Problem Much of the examination of the capital shortage issue has taken place in the United States over recent years and has been stimulated by the publication of projections by a variety of organisations, most of which show gaps between the “required” or “desirable” level of investment, and the savings available to finance that investment. The appropriate levels of investment are usually derived from certain 42
Transcript
FINANCING THE NEXT TWENTY YEARS’
DEVELOPMENT-CHALLENGES FOR
THE CAPITAL MARKET
M. JOHNSON
Introduction The question implicit in the title of this address is whether we will
experience a “capital shortage” which will inhibit our ability to raise our standard of living or whether we will be able to finance reason- able aspirations from resources available to us. Expenditure on capital is required to increase productivity and to maintain high employment. Will Australia be able to meet this investment require- ment for the foreseeable future on acceptable terms, or will inade- quate financial resources limit improvement in our standard of living?
Any “gap” between demand for investment capital and supply of investment capital will of course never actually show up. However, it will be evidenced by higher interest rates and restricted credit availability, conditions which will apply to all sectors of the economy.
The thrust of this school is to examine the problems of industrial development. The basic conditions which affect all capital invest- ment will of course be greatly influenced by what we choose to save and what we choose to consume. Within what we choose to save, competition for funds exists between users of capital for industrial investment and users for other purposes-notably the government and household sectors.
I am going to concentrate on the overall system of our markets where this competition takes place and where allocations are made. I will first look at some of the recent work on the capital shortage question. I will then venture some opinion on deficiencies in the markets and make some suggestions about what we should be doing.
Approaching the Problem Much of the examination of the capital shortage issue has taken
place in the United States over recent years and has been stimulated by the publication of projections by a variety of organisations, most of which show gaps between the “required” or “desirable” level of investment, and the savings available to finance that investment. The appropriate levels of investment are usually derived from certain
42
desired objectives such as growth rates or levels of employment. Unless this gap is made up by a variety of measures, it is argued that housing and business will suffer, unemployment will increase, produc- tivity will decline and severe financial difficulties will be experienced in the economy.
A number of approaches to the issues have been used. At this stage there is little consensus on the definition, or indeed the existence, of the problem, let alone its causes and the merits of alternative solutions. Some approaches have been based on projec- tions of capital requirements and measured against likely savings flows to determine the possible “real” size of the capital shortage. Other approaches have been based more on the ability of the capital markets to meet requirements; that is, they have focused more on the supply of investment funds rather than the demand side.
One example of this “real” approach (i.e. a physical gap between investment required and savings) is provided in “Capital Formation Perspective for Australian Resource Development” [4]. This study examined private sector capital formation, leaving aside the accom- modation of government deficits.
Dulan’s model suggested that Australia could sustain real growth in GNP at a rate of about 5.5% a year for the decade to 1985 based on a savings rate of about 10.1% of GNP. Dulan also suggests that GNP growth rates of 8% to 10% are possible for Australia but that capital formation will be deficient by between $5,240 million or $1 3,634 million respectively for these targets to be attained.
B. L. Hamley [5 ] has made an assessment of the ability of the Australian capital markets to finance possible development of petroleum and mineral resources over the next decade or so. Subject to a number of qualifications, Hamley takes the view that there will have to be continued reliance on overseas equity and debt, but that Australian markets should be able to supply sufficient funds to meet the government requirements of a 50% equity interest in new mineral development.
Dulan [4] recognised that his model had “weaknesses and inflexi- bility”. Without canvassing this whole area extensively, projections similar to those made by Dulan have been criticised on a number of grounds. These include the problem of definition. Most pro- jections focus only on physical capital investment and ignore invest- ment in education, training, research and development and health. There is an increasing body of evidence that investment in skills is a major factor in productivity growth. There can also be serious reservations about the multitude of assumptions that must be made in projections of this type, particularly in relation to capital output ratios, the size and composition of the government deficit and in the light of recent experience, of savings ratios. Projections which extend over any period of time must generally ignore technological develop- ments and institutional changes.
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Particular problems exist in making these kinds of projections for Australia. There is little apparent political consensus about the appropriate share of GNP to be absorbed by the government sector. Only the broadest aspirations exist for manufacturing investment, although there is a high probability of far-reaching restructuring. Mineral development is largely contingent on the uncertainties of world trade, and its costs are subject to great variation. Allowances for escalation, contingencies and interest during construction may well amount to 40% of the total cost of major mineral developments in Australia.
Another approach to the capital shortage issue is to examine the ability of the capital markets to meet requirements; that is, to focus on the supply side rather than the demand side. An example of this approach applied to manufacturing industry is the section “Financing Industry” prepared by Geoffrey Bills, David Love and Graham Cocks for inclusion in the Jackson Committee Report. This study demon- strates the effects of inflation on companies, particularly in requiring increasing amounts of funds to maintain the same volume of activity. At the same time accounting concepts and tax laws of depreciation mean that the extent to which capital stock is being depleted is being disguised and aggravated. The study demonstrated that the real return on funds employed by manufacturing companies declined in the ten years between 1964 and 1973 from 5.7% to 3.8%. Further, the study indicates that the combination of taxation and depreciation based on historic cost accounting principles caused Australian non- finance companies as a group to actually lose more than $220 million after tax in 1974-75.
The study asserts that the (non-finance) companies “cannot generate sufficient funds internally even to maintain their operations. In this position they are not attractive to equity investors. Therefore they must borrow, but they are clearly nearing the limits of their borrowing capacity.” The thrust of this argument is that lenders (and equity investors) are much more conscious of changed risks in lending or investing. Riskier investments require much higher rates of return. The required rates of return are not available from the corporate sector, so savers are unwilling to supply them with funds. Small and medium size companies may find it difficult to attract funds on almost any terms. At the same time the corporate sector’s own savings through retained cash flow have declined precipitously. This position has almost certainly improved since 1974-75, and I will touch on this later.
A second aspect of the “ability” argument is raised by the increas- ing share of total borrowing requirements taken by the government sector, largely as a result of expanded deficit financing policies. This has raised the threat of the government “crowding out” the private sector in the competition for limited financial resources.
Cynics may suggest that the crowding out has been institutionalised for a long time. The government has created a large captive market
44
for its securities through the “3~l/20” legislation, which forces life companies and pension funds to hold 30% of their assets in govern- ment securities, and the requirement that savings banks hold 45% in liquid and government securities.
However, the massive subscription to Australian Savings Bonds in early 1976 can be brought forward as evidence of “crowding” outside those captive markets, in this case particularly at the expense of the savings banks and building societies.
There can be little argument with the proposition that, over the long term, increased government expenditure is going to have to be financed by increases in taxes, increases in interest rates or inflation. A11 or any of these will decrease resources available to other sectors. However, the proposition that an increase in the deficit will lead to “crowding out” is not necessarily sustainable, particularly in the shorter term.
The purpose of the deficit increase will be important. A deficit increased by a cut in corporate taxes has the effect of directly increas- ing corporate undistributed profits. A deficit increased by a cut in personal taxes may increase consumption, with a flow through to both personal and corporate savings. Arguments that a large deficit will automatically crowd out other borrowers are not quite as simple as they seem.
The timing of the deficit increase will also be important. This is particularly the case if the deficit is incurred when the economy is slack and demand for investment funds is low from other sectors. However, if some of the effects of crowding out are not to be felt, the government sector should be capable of moving towards a balanced budget as the rest of the economy nears capacity.
In this context it should be noted that an increasing proportion of government expenditure in recent years has in fact been going to finance consumption expenditures, particularly health education and other social services. The community may well expect a continuation or improvement in these benefits. The government may in fact have a restricted ability to cut the deficit as the economy moves towards full employment of resources.
Crowding can also take the form of increased taxes, either on corporations or individuals, so short-circuiting the savings/investment flow. Alternatively, the captive markets for government securities that have already been imposed on the life assurance companies, pension funds and savings banks may be adequate to meet govern- ment requirements.
What Emerges? What generalisations can be drawn from this admittedly brief and
selective evidence to indicate whether we face a capital shortage, or whether our existing capital markets system will be able to meet the likely future requirements?
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Hamley’s [5] study indicates that Australian sources may be able to supply about 50% of the equity requirements of possible mineral developments over the next decade. Dulan’s [4] projections indi- cate that Australian capital resources will be inadequate to meet the investment requirements if GNP growth much above 5% is to be obtained (arising substantially from mineral development) or if the government sector makes significant demands on the markets.
Both these studies then imply a reasonable probability of a capital shortage. Put another way, interest rates should rise and credit should be restricted unless overseas capital is available to alleviate this situation, or unless savings are increased, or other measures are taken to achieve the same results.
The pattern of capital inflow over the decade of the 1960s indicates that Australia would still need to be reliant upon overseas capital to sustain the growth rates that applied in that decade, unless our savings ability had been substantially increased (or unless we are willing to accept considerably slower growth rates).
Our household savings rate has increased quite dramatically in the last few years, from a rate of around 5 6 % of GDP in the 1960s to around 10% in 1976 (the rate used in Dulan’s projections), though there are now some signs that this recent level may be declining (Table 1 ) .
An increasing proportion of those savings has flowed to inter- mediaries which may be classified as “depositary”-the banks and building societies-as distinct from “contractual” intermediaries-the life companies and pension funds (Table 2). The significance of this for industrial development is that the depositary intermediaries are either regulated towards specific investment purposes such as housing, or have lending policies that are restricted to short or medium term advances. The contractual intermediaries have patterns of cash flow allowing them to supply long term debt capital and equity. They have grown relatively more slowly than other financial intermediaries (Table 3).
One of the major users of long term capital-the government-Kas emerged as taking an increasing share of investment funds (Table 4). Another major user of long term capital-the corporate sector-is saving a decreasing proportion of its own requirements and, in real terms, may have bzen a dissaver in 1974/75 (Table 5).
These demand patterns are of course subject to change. Current government policy is directed to reducing the government’s deficit. The savings ability of the corporate sector has been substantially improved through improved profit levels and tax measures relating to stock values and investment allowances. The stated government objective is to restore corporate profits to 173% of GDP at factor cost, as compared with around 13% in 1974-75 and 1975-76 and 14% in 1976-77 (but before adjusting for the effects of inflation).
Without pretending to be precise about its magnitude, does any of 46
Source: Australian Bureau of Statistics, Q ~ ~ r t e r l y Estimates of National Income and
TABLE 2 USES OF HOUSEHOLD SECTOR SAVING
(Selected years from 1964-65 to 1973-74)
Expendifure, various issues.
1964-65 1969-70 1973-74
$ Million Housing 1,727 2,333 3,705 Bank Deposits 764 804 1,527
Life Insurance Premiums 207 315 438 256 525 Shares in Co-operatives etc. 61
Ordinary and Preference Shares -* Other Uses 139 246 2,430
Debentures, Notes and Deposits 61 494 753
-* 158
Total 2,959 4,448 9,536
* In 1964/65 and 1969/70 the household sector was a net seller of shares with the result that, in these years, snares were a net source of funds to the tune of $40 million and $19 million respectively.
HOUSEHOLD SECTOR (Sources and Uses of Funds: Ten Years Ending 1973-74)
SOURCES $IM USES $M Gross Savings Non-Trading Bank Advances Trading Bank Advances Sale of Shares Capital Transfers Net Redemption of Aust.
Govcrnrnent Securities Other Sources
26,462 1 1,706 3.477
557 . 310
1 6,087
Fixed Capital (mainly
Savings Bank Deposits Other Bank Deposits Debentures, Notes and Deposits Life Insurance Premiums Shares in Building Societies and
Trade Credit
Housing)
Credit Unions
Increase in Stocks Asset Formation Overseas Local and Semi-Government
Securities Other Uses
23,325 6,718 5,640 4,757 3,379
2,706 888 534
74
15 584
$48,620 m $48,620 m
Source: Reserve Bank of Australia Statistical Bulletin, Financia2 Flow Accounts Supplernent Jury 1976.
47
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.
this indicate a likely capital shortage in Australia? After all GDP has risen over the last several years but capital investment in real terms has been relatively static (Table 6).
There are a number of reasons, I think, why that static pattern of capital investment is unlikely to be sustained in the future. New resource and energy developments will require considerably greater investment than in the past as a consequence of inflation, environ- mental considerations and the compound effect of interest during construction. Many sectors of manufacturing industry will require major investment in new plant and technology if they are to be made competitive. Alternatively new capital investment at current cost levels will be required in new industries to absorb workers displaced from uncompetitive industry. Pressure for continued investment in “intangible” capital-education and research-is likely to continue.
* Retained earnings, depreciation allowances and increase in provisions. Source: Reserve Bank of Australia, Statistical Bulletin: Financial Flow Accounts
Supplement, July, 1976.
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TABLE 6 GROSS DOMESTIC PRODUCT AND GROSS FIXED CAPITAL FORMATION
AT AVERAGE 1966/67 PRICES ( 0 Million)
Gross Fixed Capital Formation Gross Domestic Product
Source: Australian Bureau of Statistics, Quarterly Estimates of Notional Income and Expenditure, various issues.
Our national aspirations for increased ownership of new develop- ments seem unlikely to diminish.
On the other hand, savings may well return to the levels that prevailed in the 1960s and early 1970s if the complex of factors presumably associated with accelerating inflation and unemployment weigh less heavily on individual households. The pattern of direct savings in the future may also be affected by the extension of super- annuation to more members of the workforce.
Particular pressures may develop on the corporate sector if this possible situation of increased demand for funds for capital invest- ment eventuates combined with a decline in the savings rate. There is some evidence that the credit worthiness of the corporate sector has declined and its equity base needs to be restored. Alternatively, on Hamley’s projections [5] we will only be able to meet half the equity required for possible new mineral developments.
Returns available from the corporate sector appear inadequate to attract significant direct investment from individuals, who have shown an increasing propensity to hold their savings in the form of debt, particularly in claims on banks and building societies. These inter- mediaries do not make long term debt for equity capital available to the corporate sector. The intermediaries which are best equipped to make long term capital available-the life companies and pension funds-are growing relatively more slowly than other institutions.
The institutions that transform savings into long term capital for industrial development may therefore be working less effectively, or may be at a competitive disadvantage compared with other institu-
50
tions which transform savings into capital for housing or for govern- ment expenditure, neither of which can be called procreative invest- ments in the sense that they will produce more than they cost.
In the event, I concur completely with the statement by the Governor of the Reserve Bank, Mr. H. M. Knight, quoted by Hamley, that “there will be need for further change and adaptation in the financial system to make possible the assembly in Australia of large blocks of equity and fixed interest capital”.
This means that we should look to the efficiency of our capital market system. The challenge to our capital markets and hence to our ability to finance industrial development is in how well we analyse its deficiencies, and how effective we are in implementing solutions and policies to overcome those deficiencies.
Have We Got an Efficient Capital Market?
The 1972 Winter School was entitled “Reform of the Aus- tralian Capital Market” and papers were delivered by Dr. D. W. Stammer [15] and Professor R. R. Hirst [6]. In his paper Dr. Stammer noted that in recent years the Australian capital markets had broadened, were handling a greater volume of funds, that new institutions had emerged and new financial arrangements had been introduced. He also noted that while in general “the capital market has become a more efficient one, important barriers to efficiency remain”.
Dr. Stammer’s paper dealt at some length with the impact of regulation on Australian capital markets. He concluded that in a number of cases the “official regulation has, at best, only partly achieved its desired objective, and this at some cost in terms of the efficiency of financial markets”.
Professor Hirst examined the implications for Australia of over- seas enquiries into capital markets and identified five principal issues:
(i) interest rate ceilings should be abolished; (ii) instruments of monetary policy should not discriminate; (iii) restrictions preventing institutions from diversifying should
be released; (iv) competitive solutions to allocation problems do not neces-
sarily agree with social priorities; (v) public welfare goals should be financed by direct subsidies
and should not be achieved as a by-product of official constraints on competition in money and credit markets.
I think it fair to summarise Professor Hirst’s conclusions as being that imperfections arising from all these issues were present in signifi- cant degrees in Australian markets.
An impending capital shortage or not, it appears that the efficiency of our capital markets can be improved. This would alleviate the shortage, if it emerges, or lower the costs to all sectors if it does not. I would therefore like to briefly deal with some examples of “barriers
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to efficiency” or “imperfections” in the markets. Information Regulations
There are, I suggest, two broad types of regulations which govern the functioning of any capital market. The first broad group of regulations can be categorised as information regulations and have as their major objective the provision of reliable and accurate informa- tion to investors and other participants in the capital market. These types of regulations include, for example, regulations aimed at ensur- ing the continued solvency of the major financial institutions through which people deal and company laws relating to financial informa- tion.
( 1 ) Solvency Regulations Few would argue that the size and importance of the major com-
ponents of the financial system makes their continued solvency essential. Regulation to this end is well developed and fully accepted in the case of the banks, the life companies and the official dealers. The Financial Corporations Act will allow solvency regulations to be extended to most other financial institutions (as well as poten- tially regulating the volume and terms of their lending).
State solvency regulations have been shown to be completely inadequate, as demonstrated by wide public doubts about the SOL vency of some building societies. While concern has probably not been as widespread, it has extended also to some finance companies and merchant banks.
Detailed arguments can be made about whether solvency should be “guaranteed”, for which types of institutions it should be provided, and how it should be provided; that is, to the institution or to the depositor.
Whatever the end result of these arguments, I suggest that one area where current regulation is totally inadequate is solvency regulation as it applies particularly to the building societies, which have now grown into major financial institutions dealing with a majority of the Australian community.
(2) Financial Information Mr. Justice Brandeis described sunlight as the best disinfectant.
His metaphor of course applied to the disclosure of information in the securities markets. Standards of disclosure have improved in recent years, despite the problems of first determining the accounting standards which should apply. Nevertheless, the trading banks only strike their results after undisclosed transfers to provisions. The life companies do not report the overall return of their policyholders’ funds; the building societies in some States do not make it clear that an investment with them is actually in the nature of a shareholding rather than a loan, and the merchant banks price loans on bases that are often obscure.
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Corporate reporting can hardly be called timely, and standards of reporting are well behind countries such as the United States and Canada. Despite the work of the Rae Committee we have yet to see any clear policy objectives established for standards of disclosure in the securities industry.
Now is not the time to evaluate critically the provisions of the Companies Act relating to information except to say that concern about the adequacy and accuracy of information disclosed under the existing laws is widespread. The resolution of these problems is a complex matter and one that will involve (and is involving) the combined resources of Government, the market, and the accounting and legal professions. As I will suggest later, there seem to be strong reasons for resolving these problems of information in the capital market on a systematic basis.
As a further example of the problems in this country, no debt rating system similar to Moodys or Standard and Poors exists here. Most corporate borrowings are made under Trust Deeds, the com- plexity of which seems to substitute for the need of the subscriber to undertake any detailed credit analysis. Standard ratios and tests are applied limiting the flexibility of borrowers to obtain funds on terms suited to the requirements of their industries.
In addition, the mechanics of the prospectuses provisions are such that new issues of debt or equity cannot be priced at the last moment, meaning that issuers must accept a penalty for the uncertainty asso- ciated with this delay. Many institutions will not enter into binding commitments to subscribe, both because they must in the absence of a rating system examine each proposal as unique and because the final investment decision is often reserved to board of directors who meet infrequently. Activity Regulations
The second broad group of regulations which cover the Australian capital markets are those under which the authorities directly affect the borrowing and lending behaviour of financial institutions. These regulations have been imposed upon financial institutions at different times over the years for different reasons and by different authorities. Let me list some of them:
( i ) Interest rate controls are imposed on banks by the Reserve Bank and on building societies by State Governments, though to a lesser extent now than, say, 10 years ago. Nevertheless these controls still extend to many deposit and lending rates.
(ii) Quantitative lending restrictions are still utilised as a tool of monetary policy.
(iii) Reserve requirements are used in Australia much more as a tool of liquidity policy than as a measure of ensuring the continued solvency of financial institutions.
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(iv) The present Exchange Control Regulations were introduced as a temporary measure in 1939 to meet the exigencies of the Second World War. Since that time they have grown more complex and far-reaching, and although they have normally been administered on a proper professional basis, a disturbing trend towards political manipulation of Exchange Control power has recently emerged.
(v) Regulations also provide strong barriers to entry in many fields. Notable examples include the monopoly on banking and foreign exchange held by the licensed trading banks, the prevention of entry by strong financial groups into building societies in many States, and the restriction to individuals of membership of the Stock Exchanges.
(vi) Then there are what may be called the “privileged circuit” regulations. The 30/20 regulations require the life com- panies and pension funds to invest 30% of their total assets in government securities. The savings banks are required to invest 45% of their deposits in liquid assets and government securities and most ot the remainder of their funds in housing. The government, the largest and most credit-worthy of the three major users of funds, has created a captive market for itself at below market rates, a privilege which is paid for by depositors or savers with these institutions or by taxpayers Other users-companies and mortgage borrowers-have a restricted pool of funds to attract and must pay market rates for them, a discipline to which the government is not subject. There may be some correlation in the slower growth of these captive institutions relative to other intermediaries, even though the latter have had smaller bases from which to grow. Some privileged circuits have been removed in recent years, for example the substitution of a general tax rebate in place of the specific deduction for superannuation and insurance contributions.
(vii) A seventh area is that of stamp duty legislation. Liquidity and depth are two characteristics of efficient securities mar- kets. Stamp Duties have inhibited the growth of secondary markets in debt securities and mortgages. This defect is well recognised by the highest authority. A memorandum issued by the Treasury to the Secretary of the Life Offices Association on 22 October 1973 in relation to the pro- posed AIDC bonds said “Marketability will be assisted by exemption of the (investment) bonds from stamp duty, on subsequent transfer as well as original issue”. Credit arrangement taxes have limited the financial arrangements open to borrowers. Dodging amongst the variations of State legislation has made avoidance of these duties and taxes a growth industry probably second only to income tax avoidance, with the effect that smaller borrowers who
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cannot avoid are subsidising the larger borrowers who can. Regulations also exclude financial institutions from pro- viding services for which there is a clear demand. There is no forward market for foreign exchange transactions for capital items, nor is there a currency futures market. The market provided by the banks for forward cover in relation to trade transactions is both limited and uncompetitive. Regulations also impede the flow of investment capital both to and from Australia. These regulations have been changed, rightly or wrongly, by the authorities on frequent occasions in recent years and, whatever the objectives of the authorities may have been in making these changes, they can hardly have facilitated efficient fund flows to Australian industries. Finally, let me refer to the behaviour of the authorities in conducting exchange rate and monetary policies. The management of both these areas has been directed to con- trols over prices; that is, to interest rates and the exchange rate. It is unarguable that one of the results of this approach has been large and sudden shifts in both interest rates and the exchange rate from time to time, more often than not preceded by intense (and virtually always success- ful) activity by speculators. It is worth asking whether these large scale shifts in the major variables determining borrowing costs have been conducive to capital market efficiency, compared to the alternative of an interest rate and exchange rate structure influenced much more by the market.
Other Structural Problems Besides the regulatory influences on the Australian capital there are
two other areas worth mentioning which are directly related to the subject of this paper. ( i ) Taxation Defects
The impact of taxation on the pattern of corporate saving has been touched on earlier. Our tax system (if it can be dignified with a term implying coherence) has two other important effects on cor- porations :
(a) It encourages the use of debt through the deductibility of interest payments. Corporations’ abilities to survive down- turns are thereby decreased.
(b ) In public companies it probably encourages retention of earnings for reinvestment, because the returns the company can earn are considerably higher than alternative earnings to shareholders after they have borne tax on their divi- dends. In private companies it leads to intricate and involved corporate structures, which while they may minimise tax, often damage the credit worthiness of those companies.
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Integration of the tax system (i.e. the elimination of double tax on dividends) would tend to make the tax system neutral as between equity and debt. It should encourage sounder corporate structures, and widen the markets open to companies in attracting funds. Most importantly, it may provide equity investors with a rate of return which will encourage them to invest. The earning rate of the cor- porate sector is insufficient to provide ap acceptable return to equity after the second layer of tax.
The tax structure distorts economic activity in other ways. Besides biasing investment to activities which can be classified for tax pur- poses as “capital appreciative” rather than income earning, it pre- sumably biases investment to activities which can be carried on out- side the corporate form, where at least only one set of taxes will
(ii) Market Defects Except for securities issued by the largest borrowers, liquidity in
the semi-government market is poor, if not non-existent. Again, this inhibits fund raising ability in this market and penalises smaller subscribers forced to sell on the open market. In principle it would not seem difficult to have rather more homogenous securities issued by each State, rather than by the individual authorities, with con- sequent improvement in marketability.
For this and other reasons, it is probably opportune to re-examine the outer Loan Council system under which funds are raised for Government and semi-Government capital programmes. What Should We Be Doing?
There are many other examples of deficiencies and imperfections, some serious in an economic sense and others merely administrative shortcomings. The examples used here are to demonstrate three propositions.
(i) Regulations which have been introduced by different authorities at different times to achieve specific objectives have led to inefficiencies and impediments in the markets. These regulations have restricted the ability of financial intermediaries to respond to change. They have led to resources being allocated on a basis other than costs and returns, in such a manner that it is difficult to measure the costs of regulation.
(ii) The capital markets are part of a complex and dynamic system on which many other sectors of economic life intrude-Commonwealth-State financial relations, taxation policy, accounting standards and legal restrictions on insti- tutions as well as the changing requirements and behaviours of savers and spenders of capital resources.
(iii) Many of the impediments cannot be cured by legislation. They require public exposure of the deficiencies, a direction to show that there is a better way, and an emerging con-
apply
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sensus to follow that better way. You cannot legislate to make a man make up his mind quickly.
There would probabIy be considerabIe agreement on a number of specific measures to improve the efficiency of the markets, yet if we deal with issues on an ad hoc basis we run the risk of increasing unforeseen side effects and increasing biases.
How then can we improve our markets? I suggest the basic step should be a national enquiry into the capital markets along the lines of the Jackson Committee report.
There is a case to take an overall critical view of the effect of the multitude of regulations. There is a need to draw together the avail- able statistics and to assess their adequacy. There is a need to generate a wider awareness or‘ the problems that exist and to concen- trate efforts on finding solutions.
If these objectives are to be met there is a need for an independent enquiry. Discussion in this area is normally confined to the bureaucracy (the Treasury and the Reserve Bank) or to interest groups representing certain segments of the market.
An enquiry of this type would not of course solve all our problems. The system is dynamic, structural change takes time, and the political will and electoral pressure to grapple with problems of this nature is not great. Nevertheless the return could be substantial; compare the cost of an enquiry with an extra 1% increase in GDP per annum. Depending on your preferences this could buy you ten Opera Houses or one nuclear power plant.
All of those of us who are interested in our ability to finance industrial development should be asking Mr. Fraser to redeem his campaign promise of “a comprehensive examination of ways in which the efficiency of the Australian capital market can be im- proved, with special reference to the availability of finance for the expansion of small business investment”.
The authorities might also be reminded of the words of the Vernon Committee: “The importance of the credit system to the development of the economy is so great that, in our opinion, the subject warrants a full scale study in its own right.”
REFERENCES 1. Carnegie, R. H., “Australia: Capital Markets-Are the Arteries Hardening?’
Address to the Committee for Economic Development of Australia, May, 1977 (prjvately published).
2. Citibank Economics Department, “World-wide Capital Shortage? Some Perspec- tives 1972” (private1 published).
3. Department of the Jreasury, Recommendations for Change in the US. Financial System, Washington, D.C., 1973.
4. Dulan, H. A. and Greenwood, M.A., Capital Formation Perspective for Aus- tralian Resource Development, Fayettcville, Arkansas, 1974.
5. Hamley, B. L. “Financing the Development of Australia’s Petroleum and Mineral Industries”, The APEA Journal, 1977.
6 . Hirst, R. R., “The Implications of Recent Inquiries into Capital Markets in Australia and Overseas” Economic Papers No. 42 Sydney, 1973.
7. Johnson, Mark, “Legisiative Changes in Austrahan Capital Markets”, Growth 28, C.E.D.A., 1974.
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8. New York Stock Exchange “Institutional Implications of a United States
9. O&D. Committee for Invisible Transactions, Capital Markets Study, Paris, Ca ’tal Shortage”, Rescxch bepartment-1975.
1967. 10. Perkins, J. 0. N. and Sullivan, J. E., Banks and rhe Capital Market, Melbourne,
1970. 11. Policies for Development of Manufacturin Zndustry Report of Committee to
Advise on Policies for Manufacturing In&try (“The Jackson Report”, Vol. 111)-Australian Government Pubhshing Service-Canberra, 1976.
12. Reserve Bank of Australia. Sfarisrical Bulletin-Financial Flow Accounts Sup- plements.
13. Rose P. J., Australian Securities Markets, Melbourne, 1969. 14. Shahro, E. and White, W. L., Capital for Productivity and lobs, The American
Assembly, Columbia University, 1976. 15. Stammer, D. W., Causes and Effects of Changes in the Capital Market,
Economic Papers, No. 42, Sydney, 1973.
COMMENT
by
M. T. Skully
First, I would like to compliment Mr. Johnston on his address. Examining the challenges that financing the next 20 years’ development will mean for the eapital market is no easy matter, and to determine whether our existing system will meet the likely future requirements is even more difficult.
Mr. Johnston has provided us with a smorgasbord of ideas on both the problems and the potential ways of improving the existing financial system, and I should like to examine just a few of these. First, however, I would like to make a few comments of my own.
I think in most studies one examines, the conclusion is almost universal. We indeed face, and will experience, a shortage of investment capital in the future and will probably have to face some choice between a large importation of foreign capital or forego a certain portion of our potential economic growth.
When looking at this potential shortage, and this is the point !.want to emphasise, it is not sufficient to simply examine the amount of funds mobillsed. We must also look carefully at the type of funds raised and by what t pe of financial institution. By this I mean that our market is so structured that t i e funds raised by certam institutions are channelled into certain specified areas of the economy. The successful mobilisation of funds through, for example, our building societies and savings banks (together with some 17 million dollafs in assets) are only of the most indirect assistance in meeting our funding requirements If what we really need is risk capital for mineral development. Mr. Johnston alluded to a number of these “privileged circuits” during his address, and I suspect that a close examination of the merits of such arrangements would rate a high priority on his personal royal commission brief.
As I have already mentioned mineral development, I think that it is also important to stress that the success of these pstential projects is dependent on many more factors than simply the availability of financing. For example, there are many political uncertainties to be settled in the case of uranium development. Further- more, future mineral prices and the state of world economic recovery will be important factors as to whether these projects go ahead. Likewise, internal factors, such as our own future labour relations, foreign investment policies, and inflation rates both as experienced and as perceived from overseas will have a major effect on the ceoperation we receive from foreign mining companies and financial institutions.
If I can now move more specifically to the paper itself, I would like to comment on three points that were raised. They are by no means the most important ones, but still deserve some attention.
The first relates to the comment on the relative1 slow growth of life and super- annuation businesses compared to that of many .tier financial institutions and the suggestion that they are, therefore, perhaps less efficient in the mobilkation of available savings funds. Certainly part of their reduced growth is the result of the 1975 budget and the effective removal of m t tax concession benefits afforded life and
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