DECEMBER/JANUARY 1986-1987 - VOLUME 7 - NUMBER 15 / VOLUME 8 - NUMBER 1
B R I T A I N ' S T W I L I G H T
Capital Flight Threatens British Industry
by Peter Rodgers
LONDON, England - In 1979 the Conservative government of Margaret Thatcher lifted Britain's exchange controls. Investing institutions no longer risked penalties for investing overseas and capital flooded out of the country. Today, as a result of that move, Britain is the world's second largest creditor nation - only Japan is larger.
At the end of 1985, Britain's net foreign assets - investments abroad minus the amount of foreign capital invested in Britain - amounted to nearly $115 billion, only $15 billion less than Japan's.
As the British economy continues its downward drift, Thatcher's removal of exchange controls has sparked a heated debate and is expected to be a key issue in the next general election, which must be held by June of 1988.
The Labor Party claims that this seven-year hemorrhage of capital brought on by the lifting of exchange controls is starving British industry of investment funds and is driving the economy further into a recession.
Each year British investing institutions take in about $22 to $28 billion from pension contributions, insurance premiums and private investors. Last year $6.86 billion, a quarter of those funds, were then sent overseas.
The behavior of the investing institutions which sent the capital abroad - pensions funds, insurance companies, investment trusts (the British version of mutual funds) - will also play a central part in the opposition's campaign for the general election.
Up until 1979 British exchange controls were rigorously administered by the Bank of England. In the two-tiered currency market foreign currency funds for investment abroad often were obtainable only at a large premium to the commercial rate, and violators of the law were subject to criminal penalties. Institutional investment abroad was less than 5 percent of total assets.
When Thatcher removed exchange controls, there was a predictable flood of funds abroad. This flood of investment funds out of the country coincided with the worst recession in British manufacturing since the 1930s.
In the short term, it is unlikely that the flight of investment funds affected the intensity of the recession, which was made worse by the strong pound and therefore uncompetitive exports. Indeed the loss of investment funds may have helped prevent the pound from getting stronger and causing still more damage - though it almost certainly forced interest rates above the level they would otherwise have been.
The government said the initial flight of investment funds was a one time adjustment, and at least superficially, this has been born out. The government maintains that the proportion of British institutional funds invested abroad has stabilized at about 16 or 17 percent, the level found in the last detailed assessment by the Bank of England.
But the government's claims fail to consider that the jump in funds invested overseas in 1985 was offset by a fall in the dollar which reduced the value of the holdings already abroad. Thus the totals were kept stable but the figure did not reflect the greater recent movement of funds.
And although the flow of investment funds overseas had dropped sharply in 1984 to 7.5 percent of institutional investment, it shot up in 1985 and accelerated to new all-time records in the second quarter of 1986 when the total hit $6 billion - not far short of the whole of the previous year.
The Thatcher government blames this most recent jump on worsening British economic prospects and speculation that Labor might win the next election.
Investment fund flight is larger and less predictable than that of direct investment by corporations. Although Britain has $113.4 billion of assets in manufacturing and services held abroad, foreign companies have over $56 billion invested in Britain. Indeed, all the political parties have encouraged multinationals to invest in Britain.
The picture is quite different for total financial - including institutional.- investment, where the more than $100 billion held abroad is offset by less than $25.2 billion of investment in Britain by similar institutions abroad. So, while the longstanding policies of individual corporations such as ICI to diversify out of the relatively small British economy into Europe and the United States has not been a serious political issue, institutional investment is. .
To justify the loss of these investment funds, proponents of free exchange point to the higher returns such investments receive abroad. Over the last 16 years real rates of return on foreign institutional investment have averaged 1.25 percent a year, while similar foreign investment in the United Kingdom has incurred a loss of about .5 percent a year, including currency and inflation effects.
Since the end of exchange controls, returns on domestic and foreign investment have shot up, due in large part to the good performance of international markets. Over the last five years they averaged 12 percent-both ways, including currency and inflation effects. But Bank of England calculations show that last year, because of the fall in the dollar, the return on overseas investment suddenly became negative while there was a small positive return on domestic investment.
Institutional investors argue that these short-term changes are irrelevant because the pension and insurance funds in particular are dealing with customers whose returns are measured over 20 to 40 years. A balanced portfolio of investment, they believe, should have 15 to 20 percent of its funds abroad in order to hedge against long-term poor performance of the British economy.
But by hedging their bets, critics charge, they could be stacking the deck against a British economic recovery.
The Labor Party leaders argue that any long-term benefits from a diverse portfolio are heavily outweighed by the short term damage to Britain's already struggling economy. By allowing investment fund institutions to regard the world as their marketplace, they argue, the Conservatives have ruined the country's ability to provide employment for its citizens.
With a more restrictive policy, they argue the funds would stay in the United Kingdom in bank deposits or bonds, ' thus helping to depress interest rates, or they would be steered into industrial investment. And, industry's incentive to borrow would certainly be greater if interest rates were permanently lower.
Despite Labor's opposition to the lifting of exchange controls, it cannot call for a reintroduction of such controls. In the months before an election in which the reintroduction of controls was an issue, a flood of capital would go abroad and the Conservatives could then blame the collapse of the pound on Labois ill-conceived policies.
Shadow Chancellor Roy Hattersley, however, has devised an elegant plan which is acknowledged by the investing institutions of the City of London, Britain's financial district, as perfectly workable, though they object to it strongly.
Labor would set a rolling two to three year limit on the proportion of institutional funds invested abroad, which could be gradually reduced with the ultimate aim of getting back to the 5 percent level in effect before the controls were abolished. There would be no mandatory requirement to repatriate funds, which would be impossible to enforce.. To qualify for tax privileges institutions would have to keep their overseas investment below the rolling target level.
It is envisaged that this could return as much as $28 billion to Britain, without a drop in the rate of return to pension funds and other investors. As a corollary Labor is planning to channel some of the returned funds through a statecontrolled National Investment Bank, a considerably more controversial policy than the scheme proposed for repatriation of capital.
The beauty of the scheme from Labor's point of view is that it represents no more of an attack on institutional tax privileges than that already mounted by the Thatcher government. She has already removed extensive insurance company tax privileges and until a strong lobby changed her mind, nearly did the same for pensions. So in that sense, a promise of continued fiscal privilege only when meeting domestic investment targets is a practical policy. Less certain, all sides agree, is whether such a change in the law would produce purely financial investment by the institutions or a rapid rise in domestic industrial investment.
Peter Rodgers is the financial reporter for The Guardian of Great Britain.