Policymakers have an opportunity to revive the public equity markets. We will need them to recapitalise the additional debt burdens following the Covid-19 crisis response.
Governments around the world are firing up time machines, pulling years of future growth and spending into the present to plug economic gaps left by the Covid-19 outbreak. France and Germany have proposed a €500bn aid package, for example, while in the UK the Office for Budget Responsibility expects the Treasury to need an extra £300bn to keep businesses on life support.
But simply hefting private liabilities on to the public balance sheets of generations to come will not be enough to make a clean getaway from this crisis. It would be better for governments to broaden opportunities for people to own a real stake in the recovery, whether through domestic sovereign wealth funds or retail investment products.
In the early stages of a crisis, debt has a natural head start on equity. Debt is quicker and simpler: everyone understands an IOU. But whether by design or not, financial policymakers have gradually increased incentives to continue to invest in debt at the expense of equity.
Factors such as the tax favourability of debt over equity and the additional costs of being a public company, rather than private, have discouraged companies from tapping public equity funding. Meanwhile potential investors are warded away from stock markets. For example, the European insurance sector, which has about €7tn under management, is hampered by regulatory capital rules that reduce the risk-adjusted rewards of equity investments.
For issuers, debt can offer a fast fix to an urgent liquidity problem. After all, the future is abstract and today’s cash needs are painfully tangible. But, used in isolation, it comes at the risk of strangling growth and productive capacity in the longer term as interest and repayments fall due. And that is a fairly optimistic scenario. Future generations may decide to reject an economic system weighed down by past promises, leading to extreme political and financial upheaval and social unrest.
There is a brief window of opportunity to put structures in place that allow the emergency debt funding to be refinanced through public equity investment. And before that window can be opened, the circumstances around the decline of public participation in equity markets need to be addressed.
The numbers are stark. On the supply side, overall equity financing has held stable at around 50 per cent of total funding for non-financial companies, but the share of public equity has declined from 75 per cent in 2000 to about 55 per cent now, according to a study we commissioned from KPMG.
And on the demand side, consider the UK, where there has been no increase in the number of “stocks and shares” savings account subscriptions among individual investors since 2008.
Public equity needs a level playing field to achieve the goals of recapitalisation, and it is within the power of policymakers to do this.
In Europe, the Capital Markets Union initiative is well placed to strengthen both the supply of, and demand for, public equity, but greater emphasis is needed on reforms to encourage retail savers to enter the market. There is an opportunity here to think big and use the CMU to create a bloc-wide Covid-19 retail investment product to stabilise corporate funding and share the benefits.
In the UK, meanwhile, the rules that underpin pension funds’ management of assets and liabilities should be scrutinised to ensure they do not discourage equity investments. For example, the regulatory environment encourages pension funds backed by financially weaker companies to switch equity holdings into debt when the ratio of their pension assets to liabilities declines. But that happens when markets fall — potentially locking in losses as well as increasing selling pressure on shares.
Finally, more radical proposals that address debt’s favourable tax treatment would tempt issuers into the market. Such changes have met with success in the past. For example, a study of Belgium’s notional interest deduction rule, which reduced the tax advantage of debt in 2005, found that it increased the level of total equity financing as a percentage of total corporate assets within a few years.
So rather than take from the future, policymakers might borrow from the past. In 1938, as the US was fighting its way out of the Depression, President Franklin D. Roosevelt highlighted the importance of a mass participation in equity. “The individual must be encouraged to exercise his own judgment and to venture his own small savings, not in stock gambling, but in new enterprise investment,” he said.
Now, as in the 1930s, capitalism needs to evolve to survive. Financial policymakers have an opportunity to direct that evolution in a way that gives future generations a stake in the recovery, rather than hold them to old promises made in their name.
This article first appeared in the Financial Times.
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