Investment for the Future—Higher Investment for Stronger Growth, Rencontres Economiques d’Aix-en-Provence, By Christine Lagarde, Managing Director, International Monetary Fund
July 6, 2014Rencontres Economiques d’Aix-en-Provence
By Christine Lagarde
Managing Director, International Monetary Fund
July 6, 2014
As prepared for delivery
Good morning. As always, I am pleased to be back in Aix en Provence, a bright city where art and mind join in all seasons. I would like to thank Le Cercle des Economistes for inviting me to speak before you today and Pierre Jacquet for his kind introduction.
Marcel Pagnol famously said: “The reason people find it so hard to be happy is that they always see the past better than it was, the present worse than it is, and the future more complicated than it will be.”
The crisis was deep and long. It left behind long-lasting scars that still need to heal. At the height of the crisis, bold responses by policymakers helped prop up activity by sustaining demand. Yet, more than five years into the crisis, the fragility of the ongoing recovery points to a role for supply side policies to support stronger growth.
As the theme of the meetings this year suggests, we need higher investment today for stronger growth tomorrow. Today, there are investment shortfalls in virtually all countries. Public investment took a hard hit during the crisis in many economies, and private investment has not crowded in. With private investment also lower, public cutbacks in investment are likely to hold back growth prospects. In emerging market and developing economies, infrastructure constraints are already hurting growth.
To be sure, the constraints to growth vary considerably across countries. Decisions to scale up public spending (be it on infrastructure, education, or health) and to what extent, should be made on a case-by-case, country-by-country basis. And with a careful analysis of trade-offs—public financial sustainability comes first.
Some countries, not all of them, may qualify. In the current environment of weak growth prospects and low borrowing costs, scaling up of judicious public investment can provide a much-needed boost to growth, especially in advanced economies. The permanent increase in output from such investment could possibly offset the increase in debt, so that the public debt ratio does not rise. Of course, this opportunity is not open to each and every country.
Borrowing from Pagnol’s framing, I would like to share my perspectives on three aspects:
First, to take stock of the present—and give a tour d’horizon of the global economy and near-term risks.
Second, and relatedly, to explore the impact of the crisis on investment—the past; and
Third, offer some suggestions on how we can increase investment levels, especially public investment, to support stronger growth in the future.
Tour d’horizon of the global economy—the present
Let me start with a brief overview of the global economy. We will be releasing our updated forecasts in just a couple of weeks, so I will focus on the broad trends.
Global activity was unexpectedly weak earlier in the year, in part due to temporary factors, but is expected to gain momentum in the second half of the year, and to accelerate further in 2015.
Advanced economies are strengthening, although their recovery remains tepid and uneven.
In the United States, after a more disappointing than expected first quarter, a meaningful rebound in activity is now underway, and we expect growth to accelerate over the coming few quarters. Of course, this hinges on a careful withdrawal of monetary support by the Fed, and agreement on a durable medium-term fiscal plan.
The euro area is also slowly emerging from recession, although the recovery is not strong enough to reduce unemployment and debt. Following through and completing ongoing reforms, especially on banking union, remains critical for a durable recovery. Reforms need to be sustained at the country level as well.
In Japan, underlying momentum is strengthening, but greater structural and fiscal reforms are still needed for growth to be sustained.
Turning to emerging market and developing economies, growth in many of these countries hit a soft patch earlier this year, in part due to weaker exports. Even so, these countries will continue to provide the bulk of global growth, albeit at a slower pace than before.
Emerging Asia in particular is expected to remain a global powerhouse, pushing ahead with the world’s highest growth rate in 2014-2015. China will be a key driver of this performance, growing at a slower but more sustainable pace of about 7½ percent in 2014.
Sub-Saharan Africa will also contribute to global growth. Many African countries have managed to weather the crisis well and sustain an expansion of around 5 percent per year on average—the second highest after Asia. The forecast is for this growth to continue, provided that risks from debt accumulation and erosion of fiscal space are carefully managed.
So this is how we see the state of the global economy in the near term. Even so, we need to watch out for three major risks looming on the horizon.
First, in the advanced economies, and particularly in the euro area, there is the emerging risk of “low-flation,” which can harm the incipient recovery. The recent proactive stance by the ECB is welcome, and it is encouraging that it is prepared to take further action if inflation remains stubbornly low.
Second, in emerging market economies, favorable market sentiment seems to be restored. Yet there is the risk of renewed market volatility associated with monetary normalization in the U.S. Good communication among central banks is essential, along with continued strong focus on policy fundamentals in emerging markets.
Third, we need to keep an eye on issues that have been with us since the crisis—scars that have been slow to heal: high debt levels in many countries; the need to complete the financial reform agenda; and, most worryingly, stubbornly high unemployment in many countries, especially among young people.
Together with these economic risks, geopolitical risks are also rising in various places around the world, which we are also watching, from Ukraine to the South China Sea or the Middle East.
So, on balance, global activity is strengthening—but could be weaker than we had expected,as potential growth is lower and investment remains depressed.
Investment during the crisis—trends and prospects
This brings me to my second topic—how has the crisis affected investment across the world?
The crisis has inflicted a heavy toll on output and investment, which remain well below their long-term trends. As of last year, we estimate GDP for the G-20 as a whole to be 8 percent lower than it could have otherwise been—that is relative to its long-run trend. The shortfall in investment is even higher—nearly 20 percent below trend.
To a large extent, investment levels were weak because consumption was weak. But there were other factors at play. Investment in three key segments faltered during the crisis.
First, business investment took a deep hit. This was especially the case in the euro area after the sovereign debt crisis in 2011, where deleveraging by the corporate sector and financial constraints became major hurdles. Beyond that, business investment in many countries washeld back by economic and policy uncertainty or lack of trust.
Second, housing investment took a nose dive during the crisis. In countries experiencing domestic housing booms before the crisis such as Spain, the decline in housing investment reflects a correction and is therefore likely to persist. In other countries, the decline may be more temporary—tighter lending conditions and changes in household income may be the causes.
Third, public investment went through different evolutions since the crisis. In the early stages, public investment increased as many countries implemented on fiscal measures to counter the recession. In later stages, public investment declined sharply as the focus shifted to sovereign debt levels and the need to consolidate, and financing became more expensive.
Even then, some of these factors are reinforcing trends that have been playing out well before the crisis. Over the past three decades, public capital stocks as a share of GDP have been falling in both advanced and developing countries. At present they are about 10 percent below what they were in the 1980s for advanced economies, and 20 percent below for developing economies.
In advanced economies, capital stocks were depleted as public investment was steadilyscaled back by a quarter, from about 4 percent of GDP in the 1980s to 3 percent of GDP at present. It is no surprise that aging infrastructure is now a major concern, with road and electricity networks in need of greater maintenance and repair on both sides of the Atlantic.
Just think of the District of Columbia, where the IMF is located. According to the American Society of Civil Engineers, 99 percent of the District of Columbia’s major roads are in poor or mediocre conditions. By their estimates, additional infrastructure needs for the whole country are more than US$ 200 billion over the next four years.
In developing economies, a pickup in public investment in recent years helped arrest the decline in the public capital stock—but has not been sufficient to increase it. Infrastructure gaps have been, or are, becoming a major constraint on growth in many countries, where population growth, urbanization, and rising per capita incomes are driving the demand for roads, power stations and water delivery systems.
How much power and transport bottlenecks are acting as a brake on growth in key emerging markets such as Brazil, India, Russia, and South Africa is well documented. Think about India, where more than 300 million Indians still live without electricity, and even those with electricity connections are subjected to frequent outages. In Mexico and Jamaica, which I recently visited, it was clear how access to internet or mobile communications could bring more people into the formal network of the economy. At the same time, countries like China need to fine tune their investment strategy—not only to reduce investment levels but also improve spending efficiency and geographic allocation.
Looking forward, the brakes are gradually lifting and conditions for private investment are improving, which bodes well for a stronger recovery. Consider the following factors:
Cost of capital. The user cost of capital has fallen substantially, thanks to accommodative monetary policies. This should provide a major impetus to investment.
Deleveraging. Corporate leverage has declined substantially since the onset of the crisis. Going forward, investment is less likely to be held back by deleveraging pressures.
Uncertainty. Economic and political uncertainty, which was pervasive during the financial crisis and the euro area sovereign debt crisis, is also receding. This is key to restoring business confidence and boosting investment, even though new geopolitical uncertainties are emerging.
Higher investment for stronger growth in the future.
So we have seen how the crisis has hurt investment in various countries, and we know that the global recovery is in need of a booster shot from higher investment. This brings me to my third topic for today—how can we increase investment to support stronger growth in the future?
To begin with, it should be clear that the scope for increasing public investment will vary from one country to another. First, because infrastructure needs will vary across countries; and second, because some of the countries with infrastructure needs could face fiscal, financial and capacity constraints. In general, countries need to protect the hard won gains from fiscal consolidation over the past few years.
Here, macroeconomic policies can play an important role—on both the demand and supply side.
In advanced economies, given still large output gaps, macroeconomic policies need to remain supportive of growth. By boosting demand and keeping the user cost of capital low, accommodative policies can help stimulate private investment. In emerging market economies, the focus should remain on addressing imbalances and vulnerabilities, including by improving the quality of investment.
Beyond supporting demand, policies also need to consider the supply side of the economy, especially infrastructure investment. According to the World Economic Forum, global spending on basic infrastructure—transport, power, water and communications—currently amounts to US$2.7 trillion a year when it ought to be US$3.7 trillion. The US$1 trillion gap is almost as big as South Korea’s GDP. These are huge numbers.
Fiscal policy can certainly help. If appropriately designed, it can support long-run growth potential, including by enhancing infrastructure investment.
How? Given low borrowing costs and under the appropriate conditions—manageable debt levels, large output gaps, and high implementation capacity—higher public investment would raise long-run potential output.
Can countries currently consolidating afford it? It depends on implementation.
If public investment is properly designed and done effectively, a must in the context of tight budget constraints, the increase in GDP could possibly offset the rise in public debt, so that public debt relative to GDP does not rise. And these positive effects tend to be stronger during periods of economic slack, when resources are underutilized—precisely the situation several advanced economies find themselves in today.
Even so, an increase in infrastructure investment should target high quality spending if it is to boost productivity. The efficiency of public investment management is crucial to derive the growth benefits from additional infrastructure investment, especially in developing countries.
For example, for emerging market economies, reducing all inefficiencies by 2030 would provide the same boost to the capital stock as increasing government investment by 5 percentage points of GDP. The boost to capital would be even larger for low-income countries where inefficiencies are higher—equivalent to increasing government investment by 14 percentage points of GDP.
Still, structural policies and business climate improvements also have a strong potential to improve investment prospects, and can be a powerful complement to macroeconomic policies. True, structural issues are not exactly at the core of our mandate, and we have to rely on expertise elsewhere, such as the World Bank or the OECD on these issues.
Nevertheless, a few things are clear. First, policies to increase competition in product markets, including via global trade negotiations, can boost investment, especially private investment. Studies have shown that anti-competitive product market regulations lower investment and capital accumulation.
Countries such as Germany, France and Italy, for which we have published or will publish shortly our annual assessments, have considerable scope to open up domestic services and reduce regulatory burdens.
Beyond that, there are other policies that can support the financing of infrastructure investment. These include public-private partnerships and efforts to deepen local capital markets as a source of long term financing. These are issues that are being looked at by MDBs and also by the G-20 under Australian chairmanship this year.
Let me conclude. Despite massive and unprecedented policy responses to the crisis over the past five years, the recovery remains modest and fragile. Demand support policies can only go so far. We now need to step up supply side policies and reforms to boost investment and reinforce the recovery.
We have a window here—afforded by still accommodative macroeconomic policies—to boost investment and growth with limited risk to fiscal sustainability. We should use this window wisely.