The key chart

Introduction

This is the fourth in a series of five posts in which I develop a consistent “balance sheet framework” for understanding the relationship between the banking sector and the wider economy and apply it to the UK. The focus here is on the non-financial corporations (NFCs) and their key economic role as:

• Producers of good and services
• Investors in non-financial assets (which leads to the future production of good and services)
• Borrowers (or lenders) in financial markets

Summary

The balance sheet framework allows each of these roles to be considered in the context of the relationship between NFCs and other sectors of the economy.

NFCs are responsible for a large share of economic activity in most advanced economies and their role as producers of goods and services is captured neatly in the “monetary circuit concept” which links NFCs, households (HHs) and banks together (see “Everyone has one…”, earlier this month).

Investment in non-financial assets (NFAs) is critical to ensuring that the capital used in this production process is in place. Unsurprisingly, therefore, NFAs represent an important part in NFC balance sheets. The shift in balance sheet structures back towards NFAs (since the GFC) is also an important indicator that NFCs believe that the returns from investing in productive assets will exceed the returns from financial assets. Productive fixed assets remain the largest segment of non-financial assets but the value of land is an increasingly important driver of the net worth of UK NFCs.

Financial assets are comprised mainly of equity, deposits and loans and their breakdown suggests a increased desire to hold liquid assets. Financial liabilities are dominated by equities, loans and (increasingly) pension fund liabilities.

Between 1999 and 2009, there was a shift away from equities in favour of debt financing that saw debt-equity ratios reach unsustainable levels (111%). The unsustainability of these trends was also reflected in the NFC debt ratio hitting a high of 113% GDP, well above the 90% BIS “maximum” threshold level. Since then the debt-equity ratio has fallen significantly (65%) and the debt ratio has fallen below the BIS average and threshold level (79% GDP).

Non-financial investments are the link between NFCs’ “real accounts” and their “financial accounts”. The NFC sector is typically a net borrower reflecting the fact that they are unable to generate savings that match their investment needs. The NFC sector moved into financial surplus after the GFC but since 1Q11, NFCs have funded investment firstly by reducing this surplus and, since 4Q12, by returning to net borrowing. In contrast to the UK HH sector, debt levels in the NFC sector suggest scope for an increase in borrowing. 

These dynamics highlight the final key role of NFCs in the economy – an investment vehicle for investors from other sectors. They offer stakes in their earnings (dividends) or interest payments on debt. The end result, which links directly back to the balance sheet framework, is that claims on NFCs can be found on the balance sheets of other sectors in the economy. Hence, the wider question is, if NFCs widen their deficits further in order to fund investment, which sector will be increasing its financial surplus as an offset? I will return to this question in the fifth and final post in this series.

Role 1: Producers of goods and services

NFCs are responsible for a large share of economic activity in most advanced economies and their role as producers of goods and services is captured neatly in the “monetary circuit concept” which links NFCs, households (HHs) and banks together. In short, this circuit starts with expected demand which leads NFCs to pre-finance production. NFCs pay their employees by a transfer of deposits at banks. These employees demand goods and services which (partially or otherwise) validates the NFCs expectations of future demand. The deposits of the firm will be replenished by the spending of households.

Role 2: Investors in non-financial assets

Investment in non-financial assets (NFAs) is critical to ensuring that the capital used in the production process to meet the demand for goods and services is in place. Put simply, to remain viable, NFCs need to invest in productive assets (gross fixed capital formation or GFCF in national accounts.) In the UK, GFCF typically accounts for just under 20% of annual GDP.

Unsurprisingly, therefore, NFAs represent an important part in NFC balance sheets. At the end of 2018, UK NFCs balance sheets totalled £6.4 trillion, comprising £3.9 trillion (61%) NFAs and £2.5 trillion (39%) financial assets (FAs).

Note the contrast here with the HH sector (see “Poised to disappoint”). The UK HH balance sheet has total assets of £12.2 trillion, spilt between £6.5 trillion (54%) of FAs and £5.6 trillion (46%) of NFAs. UK HHs are more exposed to FAs and these FAs, in turn, are larger than the total NFC balance sheets.

The current breakdown of NFC balance sheets indicates that they believe that the returns from investing in productive assets will exceed the returns from FAs. NFCs will invest where they believe returns are highest. If they feel that investing in fixed assets (machines, buildings) will bring significant returns to their owners, they will focus on the acquisition of NFAs. Conversely, if their expectations about the demand for goods and services are weak or declining, they may decide that they can earn better returns by directing funds towards FAs rather than NFAs.

In the mid-1990s, the breakdown of NFC balance sheets was 70%:30% between NFAs and FAs respectively, indicating relatively high expectation of returns from investing in NFAs to support future production. By 2008, however, the split had changed to 56%:44% respectively, highlighting changed expectations of returns between different asset classes. Since then the balance has shifted again with funds increasingly directed towards investment in real assets.

Productive fixed assets remain the largest segment of NFAs but the value of land is an increasingly important driver of the net worth of UK NFCs. NFAs comprise “produced assets” including fixed assets (building, machinery, IP) and inventories and “non-produced assets” (largely land). At the end of 2018, produced assets represented 57% of total NFAs and non-produced assets 43%. This compares with respective splits of 70%:30% in 2002 and 67%:33% in 2008. In other words, the value of land has played an increasingly important part in the net worth of UK NFCs.

Financial assets are comprised mainly of equity, deposits and loans, and their breakdown indicates a propensity to hold more liquid assets. At the end of 3Q 2019, NFC financial assets totalled £2.6 trillion, with equities of £1.2 trillion (47%), deposits of £745 billion (29%) and loans of £345 billion (13%). The breakdown of financial assets has remained relatively constant over the past twenty years, other than an increase in holdings of more liquid assets. Deposits currently account for 29% of total financial assets compared with 24% ten years ago and 21% twenty years ago.

Financial liabilities are dominated by equity, loans and (increasingly) pension fund liabilities. At the end of 3Q19, NFC financial liabilities totalled £6.2 trillion, with equity of £3.1 trillion (50%), loans of £1.4 trillion (22%) and pension fund liabilities of £1 trillion (16%).  

Between 1999 and 2009 there was a shift away from equities in favour of loans and debt financing. Balance sheet gearing rose sharply over the period. Using the ONS definition of outstanding debt (debt, loans and receivables) the aggregate NFC debt to equity ratio rose from 52% in September 1999 to 91% in September 2009 (below the March 2009 peak of 111%) before falling back to 65% at the end of September 2019.

The unsustainability of these trends was reflected in the NFC debt ratio over the same period. In September 1999, the NFC debt ratio was 84% GDP. By March 2009, this had risen to a high of 113% GDP. Since then the debt ratio has fallen back to 90% GDP.

Using the narrower BIS definition, it is noteworthy that the current NFC debt ratio of 79% (2Q19) is below the level of 95% for all reporting countries and, more importantly, below the 90% threshold that the BIS considers is the level of NFC debt above which debt becomes detrimental to future growth (see graph above).

Net financial worth – financial assets minus financial liabilities – hit a new low of £3.6 trillion in 3Q19. Interestingly, and coincidently, the net worth of UK HHs and NFCs hit new highs and new lows respectively in 3Q19.

Role 3: Borrowers in financial markets

Non-financial investments are the link between NFCs’ “real accounts” and their “financial accounts”. If NFCs are able to generate savings in excess of their non-financial needs, in a given period, they become net lenders or net financial investors. In contrast, if they are unable to generate savings that match their investment needs, they become net financial borrowers. The relevant balancing item is the net lending/net borrowing position. Non-financial investments can be financed through the use of internal funds (current and retained earnings) or by borrowing funds from other sectors.

To link this back to “Everyone has one”, in the event that NFCs require external funding, other sectors must be willing to provide them with funds.

The NFC sector is typically a net borrower reflecting the fact that they are unable to generate savings to match their investment needs. However, as in the HH sector, there were dramatic shifts in their position since the GFC. Since 1989, the UK NFC sector has run an average financial deficit equivalent to 0.5% of GDP. In response to the GFC, NFC increased their net savings from -2.6% GDP in June 2008 to 2.4% GDP in March 2011. This substantial negative shift equivalent to 5% of GDP occurred at exactly the same time as a similar shift in the HH sector. Since then, there has been a reversal of a similar scale to bring the current financial deficit to -2.1% GDP, below the LT average.

Since 1Q11, the NFC sector has been funding investment firstly, by reducing its financial surpluses and since 4Q12 by becoming a net financial borrower. Up until June 2015, UK NFCs were deleveraging. The debt ratio fell from 103% GDP to 87% GDP over the period and aggregate debt equity ratios fell from 77% to 69%. A complicating factor over this period has been the rise in NFC pension liabilities. In March 2011, pension fund liabilities were £339 billion accounting for 8% of total financial liabilities. By June 2015, they had risen to £748 billion accounting for 16% of total financial liabilities. Today, pension fund liabilities account for the same percentage (16%) of total liabilities.

In contrast to the UK HH sector, NFCs have scope to increase their borrowing. Debt ratios are below the BIS threshold and debt servicing ratios are below their long term average. Indeed, real NFC growth is now at the highest level recorded in the current (mini) credit cycle.

Conclusion

These dynamics highlight the final key role of NFCs in the economy – an investment vehicle for investors from other sectors. They offer stakes in their earnings (dividends) or interest payments on debt. The end result, which links directly back to the balance sheet framework, is that claims on NFCs can be found on the balance sheets of other sectors in the economy.

Hence, the wider question is, if NFCs widen their deficits further in order to fund investment, which sector will be increasing its financial surplus as an offset? I will return to this question in the fifth and final post in this series.

Please note that the summary comments above are abstracts from more detailed analysis that is available separately