CIBC Economists, Helen Lao and Avery Shenfeld, unpack half-truths and myths surrounding capital spending and investment in Canada from the relationship between investment and growth to the role of foreign capital and government financing.
Introduction: Welcome to Eyes on the Economy by CIBC Capital Markets, a podcast series dedicated to addressing current issues in a concise format, helping to make sense of the evolving economic complexities, so that you can take action.
Helen Lao: Welcome to another episode of CIBC Economics Eyes on the Economy Podcast. I'm Helen Lao, Senior Economist at CIBC, and today I'm joined by our chief economist Avery Shenfeld to discuss his recent report on half-truths and myths surrounding capital spending and investment in Canada. Issues that will most likely come up in discussions at a major investment summit being held in Canada this month. So, Avery, before getting into some of the misconceptions, are there areas of investment where your views, along with those of other economists and commentators, are all generally on the same page?
Avery Shenfeld: Yes, there certainly are. And they’re almost motherhood statements at this point. I think that just about everyone agrees that Canada has had too little capital spending, and that's been one reason why our growth has been sluggish. There's a general agreement on the factors that may have caused that, including the fall in oil prices in 2014, some of the regulatory policies we took after that, perhaps our smaller tech sector. And of course, in manufacturing, we did face tough competition from the likes of China and Mexico and so on. So it's become difficult to justify a lot of that capital spending. And even on the areas where we could see more productivity-enhancing investment, there's a general understanding that the defense sector, for example, could be attractive. Some elements of technology, power utilities could be a very important area of capital spending. So there are broad agreements on some of these big picture issues, but when you get into the details, that's where we start to see some truths and half-truths and myths.
Helen Lao: So now let's turn to a couple of those truism that you believe are only half true, which is the idea that business investment drives economic growth and that therefore the more investment spending, the better off we are. What's not quite right in those two statements?
Avery Shenfeld: Well, first it's because while it's true that business investment contributes to growth, it's also true that growth drives business investment. So there's actually a two-way relationship there. When your economy for various reasons is growing sluggishly, that could be slow population growth, for example, could be other headwinds, then you don't get a lot of opportunities for capital spending that look attractive to investors. So it's that two way relationship that we have to bear in mind when we think about the factors behind the sluggish growth in investment spending, and what could turn that around. That anything that drives economic growth higher can also then promote more capital spending. And on the more the merrier idea, the reality is that we do have to remember that in all areas of economics, we think of opportunity costs. So the money that you're devoting to capital spending could have been used in some other purpose. If, for example, you're increasing household savings to finance that capital spending. That's money that people could have consumed in the here and now, and they need the right return on that investment to make that worthwhile to delay that self-gratification. Government money that pours into projects is also not manna from heaven. It comes from taxpayers, or it diverts money from other projects that the government could have undertaken. So, famously in Canada, we've had some big public projects that were huge, lasting successes. I think of the James Bay Power Project or much earlier, the St. Lawrence Seaway. But I was around when we built Mirabel Airport, which for those who live in Montreal now, you can't find it anymore, although there's a few highway signs still directing you to this airport that doesn't exist. It never really served any purpose. So we need to bear in mind that when you think of an economic impact study and it touts all the jobs that are going to be generated with a big capital project that is funded by government, remember that the government could have spent that elsewhere and also generated jobs. So, you need the right economic return. That's true for the private sector as well. They could return money to shareholders. So it's not the more the merrier in terms of an economic lift overall.
Helen Lao: That's true. And some people have argued that one reason for weak business capital spending in Canada was the result of too many investment dollars going into the housing sector. You call that idea an outright myth. Can you explain your thinking on that?
Avery Shenfeld: It's because Canada isn't a closed economy in terms of our financial system. So there isn't a fixed amount of savings that can be spent on either residential or non-residential investment, because we can tap into foreign funds if there are viable capital projects that offer a good return on investment. The money will flow to them. Might not flow from Canadians, but it could flow by tapping into funds abroad. Canadian companies, of course, can raise money in foreign markets, they have foreign shareholders, they can issue debt at home or abroad. And also foreign companies can undertake these projects in Canada. So there isn't a fixed pool of capital, and I would argue that if anything, when you underinvest in housing, you can actually deter capital spending by the business sector, because we need to actually have enough housing to sustain population growth. And we need that population growth in some markets to generate the demand for the product that the capital spending is going to, or to supply the workers that of course the corporate world will need if they increase capacity in Canada, they'll need workers along with a source of demand. So underinvesting in housing, which I would argue is what Canada has done actually in recent decades, can actually be, if anything, an impediment, to corporate capital spending if it creates either too tight a labor market, or if it makes Canada a non-competitive place for people to live and work.
Helen Lao: Yeah, so you talked about foreign investment. So I want to turn to that. Some see it essential that we have more inbound investment than what Canada invests abroad, while others actually are opposed to more foreign ownership of Canadian assets. You see both these views are only half true at best. Why is that?
Avery Shenfeld: So let's start with that balance of investment flows with the rest of the world. You'll often hear it cited, Canada has a perpetual net deficit in foreign, in capital flows. But if you remember your International Economics 101 course, you might remember that the capital financial account, which measures those capital flows, has to be exactly the opposite of what your current account is doing for the balance of payments to in fact balance. So when you have a country with a successful export sector, as Canada does, for example, during periods where resource prices are high, we will typically run a big trade surplus with the rest of the world. By definition, we will have a deficit in those capital and financial flows. We will be investing more abroad. The real issue here is not whether you're financing things with domestic savings or foreign assets, foreign money. it's really all about do you have enough capital projects that are profitable and viable to generate the economic growth you subsequently want? So remember that countries like China, for example, which have a huge pool of domestic savings, can manage to have a capital spending boom in manufacturing that really no other country has seen, while at the same time investing more abroad than inbound investment, because it just has enough domestic savings. If we have low domestic savings, we're going to need to tackle those investment projects with some foreign funding. And as far as foreign ownership are concerned, you don't tend to see any issues raised if it's a minority stake in a public company. It's where it gets into a controlling stake that there certainly are some legitimate political concerns. You might worry about the ability to regulate those companies in some sectors. You might worry about foreign ownership of critical resources, if it's a state-owned company and you fear, for example, that they will take key Canadian technology back to their home country and shut down on this side of the country. Less so, of course, if it's something like a mine, which you can't move out of Canada once you own it. But generally speaking, there aren't really a lot of issues with foreign investments. Yes, it's true that when foreigners own an asset. They will then reap the profits and dividends from that over time. But if we finance more capital spending with foreign investments in Canada, we will free up some Canadian savings to invest in other countries. And in some sense, that's what you want optimally for both sides. This is a win-win. Having Canadian pension funds, for example, with diversified portfolios globally, helps them ensure that their pensioners get the a risk-adjusted rate of return that paid the pensions. And similarly, foreigners can benefit by diversifying into Canadian assets if they're not as correlated with their home country. So we really want that two-way flow. We don't have an obvious bias, except in some rare occasions where there are regulatory issues or perhaps national security issues. Either financing things at home or abroad are fine. It's really all about having viable projects, having the economic backdrop, the policy and regulatory backdrop, the right tax system in place that makes those investments attractive to either domestic or foreign investors.
Helen Lao: Now, Canadian governments are also stepping with more dollars for either equity stakes or debt financing for business projects. How should we assess the merits of this project financing each case?
Avery Shenfeld: Well, the myth is that we need to judge them on their rate of return as if they were a private sector investment. That's really only half true if you don't think of the return, at least, as including what economists call positive externalities. So when the government builds a park, for example, we don't expect it to have a cash flow that yields a rate of return, because really we're measuring the economic benefit by the overall value of that park to Canadians. Even when they're involved in a corporate project, you have to think about the fact that that project might generate these externalities, some economic spin-offs that aren't captured by the ownership of the project, but captured by the Canadian economy as a whole, perhaps in a way that then generates some additional tax revenue for the government indirectly by those economic spin-offs. And the reason this is an important issue is the government is setting up a sovereign wealth fund that's going to invest in projects. On the one hand, they do talk about perhaps allowing Canadians to invest in that fund with their own money. I would caution that that would then restrict that sovereign wealth fund to investing things with a good risk-adjusted rate of return and not take those positive externalities into account. So I think, I do think we need to think through whether we want it to be wholly financed by the government and not necessarily only choosing projects with a strict rate of return calculation and thinking more about those positive spin-offs where they're there as to whether the project has merit for the government. It's also interesting that you hear people talk about the government perhaps selling some assets like airports to create the funding for that sovereign wealth fund. And on the surface, some might say: well, if you sell an existing asset, an airport that's already there, a bridge that's there or a road that's there and turn it into a toll road, you're not really accomplishing anything because you're not generating, in that step at least, some additional capital spending. But remember, what you are doing is you're freeing up some government money that was locked into one asset and potentially allowing it to be reinvested somewhere else that would generate new capital spending and additional economic growth. Of course, the government gives up the flow of revenue to the private investor who bought that asset. But if it's an asset in very high demand by foreign investors or domestic investors because it offers the right sort of profile for the returns and the risks, the government might get a very good price by selling those assets and then turn that around into something that actually, from a national economy point of view, has some merit. So even selling existing assets can generate economic activity given where the money might be recycled into.
Helen Lao: Okay, thank you, Avery. So we'll wrap things up here. If you want to read more on this topic, you can find the full report on the CIBC Economics website. We'll all be watching for the results of the upcoming investment summit in September, where some of the world's largest pools of capital will be in this country, and we hope, looking to put their dollars to work here in the coming few years. Thanks for joining our podcast today. Until next time, we’ll be keeping our eyes on the economy and calling it as we see it.
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