«Rome, 25th June 2013 This paper was drafted by a working group, chaired by Prof. Rainer Masera (Università degli Studi Guglielmo Marconi), with the ...»
3. Third, there is a problem that needs to be better explained in the Commission document, and that takes on fundamental importance in many countries, notably in Italy. This is the link between public investment and the effective accumulation of tangible and intangible productive capital. One needs therefore, to also consider the quality and the efficiency of investment in infrastructures.
7 A few remarks on these three issues are offered in the following pages of this paper.
Lastly, the financing of long-term investment needs to be focused upon. Hopefully, long-term investment should be mainly supported by long-term financing, for two fundamental reasons: for its nature, long-term financing has a lower tendency to procyclicality compared to the shortterm one, and thus is best suited to support expansionary policies during a crisis. Furthermore, it significantly contributes to stabilizing the financial system, by avoiding excessive transformation of maturities1.
Question 2: Do you have a view on the most appropriate definition of long-term financing?
We endorse the common definition of long-term (LT) financial investment as “patient” capital that allows investors to access illiquidity premia (in particular from investment in assets such as infrastructure, real estate and venture capital), lowers turnover and its related costs, and avoids pro-cyclicality. Ultimately, therefore, long-term investment strategies, all else being equal, improve net investment returns, strengthen financial stability, and foster economic growth [Severinson and Yermo, 2012]. More specifically, LT finance refers to maturity over 5 years, including assets that have no specified maturity (e.g. equities).
The Green Paper defines, in broad terms, financing long-term investments or long-term financing as «the process by which the financial system provides the funding to pay for investments that stretch over an extended time period. Investors engaged in long-term financing are generally expected to hold onto the assets for a long time and are less concerned about interim changes in asset prices and are focused instead on long-term income growth and/or capital appreciation».
It correctly links long-term financing to long-term investment, on the basis of its features, and usefully underlines the need to support investment in productive capital, to boost innovation and competitiveness for a smart, sustainable and inclusive growth of the European economy.
The Green Paper, in particular, considers “long-term” investments those that participate in the formation of long-lived capital, covering tangible assets (such energy, transport and communication infrastructures, industrial and service facilities, housing and climate change and eco-innovation technologies) and intangible assets (such as education and research &development), which boost innovation and competitiveness. Long-term investments are 1 See Group of Thirty (2013).
8 measured by infrastructure expenditure, i.e. the expenditure for the formation of long-lived capital that supports the production capacity of an economic system. Tab 1 and Fig 2 depict the “enlarged” definition of infrastructure proposed in this document.
In defining long-term investment, two factors seem to be decisive: (i) the ability of the different types of investment in contributing to the productivity of a system and (ii) the need for publicprivate co-financing.
First, a distinction should be made among the various types of infrastructure spending; in particular, it must be taken into account the different impact that different types of investment have on growth and competiveness. Infrastructure expenditure may directly affect technological change and, consequently, total factor productivity; or it may raise GDP by increasing public and private fixed capital.
In this regard, no differentiation is made in the document of the Commission. Vice versa, we believe that such a distinction is useful in order to identify priorities in public spending, also taking into account the budget difficulties of many European countries and the resources available in the private sector. It must be stressed that productivity growth is linked to the 10 virtuous interaction among education, knowledge capital, research & development and basic research [Visco, 2009].
It must be also underlined that infrastructure cannot be limited to public capital. It also includes co-financed projects and privately financed projects, supported by fiscal/legislative measures or subsidies from the public sector. A particularly significant example of this combination is represented by the energy-consumption requalification of existing buildings (mainly private, but public also). The European Commission estimated overall savings coming from the implementation of energy saving measures (in line with the European 2020 targets) equal to about €50 billion a year. Different studies have come to the same conclusions: they highlighted that suitable combinations of private and public intervention generate very high benefits and release considerable economic resources at the global level. A broad definition of infrastructure requires the adoption of a systemic and synergic approach between public institutions and private agents to realize projects that, for their characteristics, cannot be realistically entrusted solely to public funding or to private funding.
As observed above, the Green Paper equally refers to long-term finance and the finance of longterm investments, by considering them synonymous. The relationship between the two variables is inherently desirable, but not automatic. Not all forms of capital accumulation can be considered a long-term investment. It depends on their ability to contribute to productivity.
The link between medium and long-term financing, and productive investment, must not be considered excessively binding when resources are collected on financial markets, where this relationship is not always so stringent. As an example, by taking the proposed approach, one could hypothetically conclude that an IPO is considered as an operation of long-term financing only if the financial resources are earmarked to specific productive investments for the creation of long-term instrumental goods, and not to an acquisition operation or, for instance, to the improvement of the internal reporting system of the company.
With its definition the Green Paper seems to play down the role of long-term financial investment by mixing the point of view of the economy with that of the end investors. Indeed it is well-known that from the point of view of the latter, a long-term commitment to remain invested in a given financial portfolio is by far the most common way through which long-lived productive capital goods are financed.
In order to avoid a possible misunderstanding on this point, we believe that the emphasis the Green Paper puts on the definition of long-term financing should be adjusted accordingly. For instance a clear distinction could be made between the economy, which is in strong need of
Question 3: Given the evolving nature of the banking sector, going forward, what role do you see for banks in the channelling of financing to long-term investments?
The current long-term recessionary phase in Europe is no doubt influenced by the fiscal austerity measures and by the simultaneous tightening of regulatory requirements on banks and other financial institutions. They represent two composition fallacies.
Capital requirements are a cornerstone of financial regulation. They produce social benefits by reducing moral hazard and the cost of bank failures, which would otherwise fall on taxpayers.
But, at the same time, excessive capital requirements on banks in a recessionary phase reduce their ability to create credit and liquidity and to perform the socially important function of maturity transformation.
A trade-off, therefore, is at play here: micro and macro prudential considerations should weigh appropriately in shaping the desirable trade-off, which clearly also depends on cyclical factors.
Risk capital requirements are inherently procyclical. The procyclicality is enhanced by the interaction of capital and fair value accounting, which is often – incorrectly - interpreted as mark-to-market accounting.
The use of VaR approaches in CAD IV inherently increases the procyclicality of the system and makes it difficult for banks to extend long-term finance. These problems are heightened because VaR models are based on the assumption of exogenous risk. Instead, endogenous risk may be relevant (shocks to the system may be amplified by the system itself [Danielsson and Shin, 2003]). The Basel approach leads all banks to react in the same way to financial shocks, thereby amplifying financial instability.
Additionally, VaR models can be played by highly sophisticated banks, as witnessed for instance by the case of JPMorgan (see Chart 1).
The change in VaR methodology effectively masked the significant changes in the risk portfolio. US Senate Permanent Committee on investigations (March 15, 2013).
Finally, the European banking and sovereign bond networks are strongly intertwined, and are thus subject to the possible sudden shift from normal distributions to power distributions.
13 The considerations above are also highly dependent on institutional factors. Europe is characterized by a very high relative importance of banks (and insurance) compared to the US, where credit markets and the shadow banking system perform a key role, as exemplified by the following tables and charts.
It is, therefore, evident that the restructuring of capital requirements and bank deleveraging have much more significant implications for the European economy compared to the US.
Taking into account the relative size of banking flows and the resilience of bond markets and of shadow intermediation, restrictive capital requirements may have an adverse short-term impact on the real economy potentially three or four times higher than in the US. This helps explain why the long-term investment contraction has been especially strong in Europe compared to the US.
In addition, without a properly functioning banking union, a vicious negative loop between bank and sovereign credit has manifested itself. Peripheral countries are especially affected also because of the very high importance of SMEs, which are heavily influenced by bank deleveraging.
In any event, we suppose that, in Europe, the banking sector would continue to play a fundamental role in financing long-term investment. Particularly in Italy, the banking sector is already operating in a context characterized by growing constraints set by prudential reforms to long term financing and will continue to play a key role in supporting the real economy, not only through the traditional activity of savings and the provision of funding, but also through their efforts to enable the direct access of companies to equity and bond markets, as well as the investment in risk capital of unlisted enterprises.
In many European countries the banking sector plays a central role in the financial product distribution system: any new way of channelling savings from retail investors to long-term
In addition, the expertise banks have acquired in the evaluation of creditworthiness of long-term projects will likely be important even in the development of new non-bank financing vehicles for this purpose.
Question 4: How could the role of national and multilateral development banks best support the financing of long-term investment? Is there scope for greater coordination between these banks in the pursuit of EU policy goals? How could financial instruments under the EU budget better support the financing of long-term investment in sustainable growth?
The quality of investment determines their efficiency and effectiveness and makes them more attractive to the private sector. It is, therefore fundamental to carefully evaluate the link between public investment and effective productive (tangible and intangible) capital accumulation. The great challenge in economic analysis, in empirical research and in the economic policy itself is in identifying the good proxy variables for public capital adjusted for efficiency. It must be noted that public infrastructure spending registered under the current accounting procedures does not fully translate itself in productive capital assets. Many studies by academics and researchers of international financial institutions, and by the Banca d‟Italia for the Italian economy, show the relevance of these problems2.
2 See for example Prichett (2000), Gupta et al. (2011). Dabla-Norris et al. (2011), Arslnap et al. (2011), Balassone (2011) and Banca d‟Italia (2012). The issue is particularly relevant in Italy. In this regard, it is useful to remember that, according to the OCSE, between 1970 and 2008, the expenditure on transport investments and energy in Italy was equal to 3,2% of GDP, lower than the average OCSE data (3,7%), but in line with that of Spain (3,3%) and higher that those of France (2,5%) and Germany (2,9%). Yet still, the Global Competitiveness Report (2012–2013), elaborated by the World Economic Forum, places Italy in 28th place (in a classification of 144 countries) for competitiveness of the infrastructure system, with a considerable detachment from Germany (third place), France (fourth) and Spain (tenth). As Banca d‟Italia in the above mentioned studies show, with reference to the measures of public capital in Italy based on investments reported, the accounting/finances are misleading, in that only a fraction of that is translated into capital value. This contributes in explaining why the measures based on financial flows would assign public capital to Italy in line with that of the main European countries. Vice versa, if we move to the measures of physical equipment, Italy appears to be in a worse situation compared to the main European countries. The gap increases even more when the level of use of infrastructures is taken into account, and 16 Public capital accumulation is justified by and requires net positive externalities; it must be characterized by a higher economic rate of return than the financial one. But the passage from public investment to capital accumulation with high social returns is far from being automatic.