Address by Governor Carlos da Silva Costa at World Manufacturing Forum - 2012: "Financial policy foundations for innovation and growth"
“Innovation is the specific instrument of entrepreneurship...the act that endows resources with a new capacity to create wealth”.
(Peter Drucker, Innovation and Entrepreneurship, 1985)
From the Great Moderation to the current crisis
Good morning Ladies and Gentlemen. It is both a pleasure and an honor to be here.
My purpose today is to talk about “Financial policy foundations for innovation and growth”. With financial stability and growth on top of the international policy agenda, this is undoubtedly a timely and very challenging subject. By way of introduction, let me recall, very briefly, how the world economy has arrived at the current situation.
The mid-1990s marked the start of a decade of sustained economic growth and low inflation – a period that came to be known as “the Great Moderation”. Globalization favored benign macroeconomic conditions, creating the illusion of a new economic paradigm. Not only in Europe, but elsewhere in the world, growth was to a large extent financed by increasing private and public debt. This resulted in over-leveraged public and private sector balance sheets and in a build-up of systemic risk.
The collapse of Lehman Brothers triggered the biggest financial and economic crisis since the Great Depression, with deep, widespread and still largely uncharted consequences for the financial system, international trade and economic growth and employment. We are now in the 5th year since the beginning of the crisis and we still find it hard to “see the light at the end of the tunnel”. Nonetheless, by now it has become obvious that the current downturn is fundamentally different from previous recessions: the world is experiencing not merely another turn of the business cycle, but a structural fracture, a fundamental regime shift that will eventually lead to a “new paradigm of normality”.
The crisis has also highlighted the importance of financial stability and financial policy for sustainable growth, inter alia, by making more obvious the negative impact on economic growth resulting from the fragmentation and high volatility in financial markets and from increased difficulties in access to financing, in particular for small and medium size enterprises (SMEs).
Therefore, we have to put in place sound financial policy foundations to reduce uncertainty in the markets, to ensure financial stability and help to restart the growth engine in a smart, balanced and sustainable way. Overall, we must be able to transform the current crisis into an opportunity to address, not only short-term difficulties and challenges, but also long-term overdue problems.
2. Financing innovation, fostering growth
Growth on top of the agenda
Global economic activity remains weak and uneven, the medium-term outlook is highly uncertain and the balance of risks is clearly tilted to the downside. Boosting economic growth, and reducing high and rising unemployment in many advanced economies, while restoring financial stability and the sustainability of public debt levels, is the biggest challenge that we face today.
It is crucial that we put current challenges into perspective, so that actions to address urgent problems and serious short-term risks are complemented by broad-based long-term measures, able to boost confidence, shape new institutional frameworks, promote stability and spur global growth in a sustainable manner.
Innovation and growth
As we all know, economic growth is not a linear process. It involves a Schumpeterian process of “creative destruction”. The economic dynamics of any country is a permanent metabolism: there are units that die and units that are born, there are jobs that disappear and jobs that are being created. As an increase in productivity by definition destroys jobs, the productive capacity of the economy has to expand. We need investment that, on the one hand, increases productivity and, on the other hand, generates jobs to absorb those who lost their jobs as a result of that increase. To generate these jobs and foster economic growth, countries have to be much more ambitious on education, research and innovation policies. There is no innovation without education, without training and without research. But education, research and training, by themselves, do not ensure the success of any growth strategy if they are not adequately articulated and if there is no clearly established bridge between the economic fabric and the national innovation system. These bridges have to be built to respond to the needs of the economy.
In a context of strong global competition, where scientific and technological paradigms are rapidly being broken, in order to survive and to grow, firms need to adapt to ever changing conditions. Besides restructuring, this has to be largely done by carrying out research and development (R&D) activities, leading to new processes and to new products and services and to the opening up of new markets. Although in large existing companies most innovation is incremental (new models and new processes), small and medium size firms and start-ups need to come up with radical innovation (new products and new technologies) in order to stay relevant in their fields, to access new markets and to create new and more jobs. Indeed, radical innovation has the potential to dramatically change the firm’s businesses opportunities and there is increasing evidence of the importance of this type of innovation for firms’ long-term success.
In Europe we have some examples of success, with a few countries (Sweden, Denmark, Germany and Finland) already performing extremely well as innovation leaders in some areas, not only at the EU level, but also at global level. Nevertheless, overall, Europe is still lagging behind the United States, Japan or South Korea and more efforts are needed to boost innovation.
However, innovative, growth-oriented firms – like some high-tech manufacturing firms - typically require large amounts of financing to invest in R&D, marketing and training. Finding available sources of financing represents, especially for start-ups and knowledge-driven firms, a crucial and difficult first hurdle, which becomes even more challenging during recessions and financial crisis, due to liquidity and credit constraints. In addition, in the case of radical innovation, the outcome of investment is highly uncertain and it usually involves long maturing periods before bearing fruits: the life cycle of radical innovation is long term, with very high technical, organizational and market uncertainties and potential discontinuities.
This means that, while incremental innovation is usually bankable, traditional banking is not suited for financing radical innovation, except for existing large companies where, ultimately, it is their balance sheet that counts. Indeed, existing large companies, with adequate skills, a good track record, market access and ability to collateralize loans are able to finance innovation with bank loans. On the contrary, radical innovation for SMEs and start-ups is riskier and mostly not bankable. The risks involved are high and difficult to evaluate, when compared to those of “incremental” projects carried out in well-known markets, with proven technologies, and with established firms. Banks cannot perform their traditional return and risk assessment analyses and they normally do not have the necessary skills to appraise specific projects, with a significant degree of uncertainty and with few collateral.
This calls for dynamic and efficient financial markets, providing alternative and suitable sources of financing, so that viable firms can continue to borrow, invest, innovate and grow. This need is particularly acute for new firms and for SMEs, which are the main vehicle for radical innovation.
The role of SMEs
In Europe, SMEs are a key driver for economic growth and employment. They form the backbone of the European economic fabric and play a major role in the creation of new jobs: between 2002 and 2010, 85% of net new jobs were created by SMEs (2) (well above the 67% share of SMEs in total employment). While innovative firms represent a fairly small share of the total number of SMEs, they have the potential to generate high benefits in terms of new jobs, new products and new markets. They need to invest in knowledge generating activities and to enhance entrepreneurship, but they also need appropriate sources of finance. Nonetheless, despite some important steps that have been taken in order to provide innovative small businesses with easier access to financing, SMEs in the EU are still heavily dependent on traditional bank loans for both starting up and developing their activities. As a result of this dependence, they have been particularly hit by the current financial crisis, marked by a fall in lending to the real economy, which has made it increasingly difficult for them to access this type of funding, thus hampering their potential to grow.
The soundness and the efficiency of the financial system are key for sustained long-term growth, given the critical role the system plays in the financing of the economy. A well-functioning banking sector, in particular, plays an essential role in the efficient allocation of resources and in providing modern and reliable payment systems, thereby supporting economic growth. However, as I have mentioned earlier, the banking system is not designed to finance certain types of activities and investments (particularly those related to radical innovation), and it is therefore imperative to promote and develop alternative financial instruments and new forms of financing, including seed and venture capital. This need is particularly acute in the current context, where access to credit has become more difficult and with more stringent conditions for many companies, in particular for SMEs.
Access to suitable sources of finance is vital to enhance the competiveness and the growth potential of innovative and high-growth firms. Indeed, innovation is part of the process of metamorphosis of the business structures and requires adequate financing models. But it is not easy to find investors willing to finance innovative firms in the seed, early or growth stages. Disruptive early-stage technology firms typically offer excellent investment opportunities, but they usually face major challenges and uncertainties, and there is no guarantee of success. This means that there is a need to dramatically improve the business environment where they operate, diversifying their investor base, the sources of finance and the type of financial instruments available (e.g. grants, loans, mezzanine loans, seed capital, venture capital, guarantees).
Corporate self-financing, which is still very low in many countries, is another dimension that cannot be forgotten: strategies based on extreme leveraging and result-related distribution models are short-sighted, make firms more vulnerable and usually do not respond to the new market challenges. Self-financing has to be strengthened so that firms become more resilient and capable of delivering a stronger contribution to growth.
In Europe, it is particularly important to develop venture capital funds, which, on average, are much smaller than in the US, and bellow the size necessary to provide a meaningful capital input to individual firms and thereby to have an effective impact. Even though larger funds are not always the best performers (beyond a certain dimension diseconomies of scale arise), studies show that venture capital funds can make a real difference for the industries they invest in, once their size reaches a certain threshold (3).
There is much empirical evidence on the vital role of venture capital as a source of innovation and an engine of economic growth. Countries with little venture capital are usually good followers but they are not technological leaders, able to carry out “disruptive innovation”. Venture capital is particularly attractive and may be crucial for small, innovative and potentially high-growth companies, and is especially central during the early growth stages (start-up and development). It typically involves high risk but, in compensation for this risk, it carries the expectation of high returns. It is also worth noting that the role of venture capital goes beyond the mere provision of financial resources to firms and normally includes a variety of non-financial inputs (e.g. strategic advice; networking opportunities/connections; monitoring performance; management expertise).
It is thus very important to improve access to risk and seed capital finance for innovative SMEs and to overcome financial market failures so that their growth potential is not impaired and they can effectively contribute to spur on sustainable growth.
3. Concluding remarks
Let me conclude by underlining, once again, that we are facing very difficult times, with an unusually high degree of uncertainty and enormous challenges ahead, which will eventually lead us to a new paradigm of normality. The transmission mechanisms of macroeconomic policies have become more complex and, in some cases, they are not working. Moreover, the economic models we used to rely upon are no longer able to provide satisfactory and reliable answers in the current context.
We need to face the new realities with new instruments and new methods, whilst recognizing the increased inter-linkages and feed-backs both between policy objectives and between the effects of policies. In addition, it is necessary that the actions and initiatives that we take to address short-term challenges stemming from the current crisis never lose sight of medium and long term goals, so that the short-term solutions constitute steps towards sustainable growth, stability and a reduction in macroeconomic imbalances.
For the world economy to recover, grow and create jobs, it is important to improve the business environment conducive to investment, particularly to innovative investment. To this aim it is necessary to develop financing alternatives to traditional bank loans, in particular through the promotion of venture capital.
By ensuring that the financial system is sound, well regulated and adequately supervised, by safeguarding price and financial stability, by enhancing policies and instruments designed to fill the financing gaps and respond to the specificities of SMEs and high-growth firms, we will be providing sound financial foundations conducive to innovation and sustainable growth.
In this context, given the nexus between R&D and manufacturing, this sector is of vital importance to foster job creation and economic growth and has a pivotal role to play in prompting investment and innovation, in particular as a vehicle for the introduction of radical innovation.
Stuttgart, 16 October 2012(1) As prepared for delivery.
(2) European Commission Study on the SMEs' impact on the EU labour market, 16/01/2012
(3) Josh Lerner, Yannis Pierrakis, Liam Collins and Albert Bravo Biosca, "Atlantic Drift - Venture Capital performance in the UK and the US”, Research report June 2011