RDP 9308: Balance Sheet Restructuring and Investment 1. Introduction

A key feature of the most recent business cycle has been the importance of financial factors. During the upswing in the late 1980s, corporate profits, recourse to external sources of finance, asset prices and business fixed investment all grew rapidly. The corporate sector began to rely more heavily on debt as a source of external finance and consequently leverage increased sharply.

In the past few years, we have witnessed a partial reversal of this process: asset prices have fallen and corporate balance sheets have been strengthened by a decline in leverage. The process of deleveraging occurred during a period of weak cash flows, limiting the extent to which businesses could restructure their balance sheets using internal funds. This, coupled with the sluggishness of the economy and an uncertain investment climate, has meant that business fixed investment has been extremely weak. This paper documents the evolution of corporate balance sheets in the 1980s.[2] It also examines the process and extent of balance sheet repair and draws some implications for investment.[3]

The paper is organised as follows. Section 2 provides an analytical framework for considering the various influences on investment and the interaction between finance and investment. Section 3 provides an overview of the broad trends in corporate balance sheets and the state of balance sheet repair. Section 4 brings together this information and draws some tentative conclusions about the current pressures on investment.

An important conclusion of the paper is that many companies have significantly improved their balance sheets in the last few years. Leverage has been reduced. Nominal interest rates have also declined sharply with the progressive easing of monetary policy and the reduction in inflationary expectations. The interest cover and cash flows of the corporate sector have improved. Thus, the extent to which investment is constrained by the financial position of firms is much lower than it was a few years ago. There may be some incentive in the short term for firms to continue the process of financial restructuring, given: considerable excess capacity and hence subdued investment; a relative decline in the real cost of equity; and an apparent tendency for those companies that reduce gearing to have a better short-term share price performance.

Looking beyond the short term, it appears that the rate of return to investing in capital is relatively high, at least when judged against the standards of earlier periods of weak growth. This, coupled with the extremely low rates of investment relative to GDP at present, suggests that when some of these disincentives pass and confidence strengthens, investment could rebound strongly.


Also, see Lowe and Shuetrim (1992). [2]

The paper complements a more technical paper currently in production on the influence of financial factors on investment (Mills, Morling and Tease (1993)). [3]