5.2  Capital

Financial market institutions oversee the operation of the financial system.[15] These institutions affect the availability of finance by influencing the confidence that savers and lenders have in the financial system.

Institutions need to protect the soundness of the financial system and ensure that financial organisations do not undermine the functioning of the market. Capital markets are particularly sensitive to the problems of asymmetric information and high transaction costs and are prone to fail in environments without the appropriate legal and regulatory institutions (Saleh 2004). A sound financial system provides savers and lenders with confidence that their funds are adequately safeguarded within the system by establishing a framework of rules on the obligations of financial organisations as well as setting parameters around the types of activities they can engage in and consequences for non-compliance.

Institutions also need to protect the freedom of financial organisations to exercise professional judgement about investment opportunities and provide savers and lenders with financial products with a range of risk/return profiles. Institutions that allow for flexibility enable financial organisations to invest in projects where there are high levels of uncertainty and high potential returns. The level of uncertainty associated with the returns to innovation is high, particularly with inventions, as little is known in advance that can indicate their likely success (Tong and Xu 2004).

Institutions that effectively balance the flexibility available to financial organisations while providing savers and lenders with confidence in the stability of the financial system are particularly important for the development of new technologies and the contribution they can make to economic growth. Confidence in the financial system ensures funds are generally available for investment in an economy while flexibility ensures that some of these funds are available for innovative ventures.

Firms in an open economy can access finance internationally if they are not able to access them domestically. However, the availability of international finance is likely to be affected by the quality of financial institutions within the country, meaning that restrictions on the availability of finance may still exist.

5.2.1  Resource allocation

Financial market institutions that are either too weak (do not ensure the stability of the financial system as a whole) or too strong (overly restrict the flexibility of financial markets) are likely to reduce the funds available to firms for investment in physical capital. In such cases, firms will have to use different, and potentially suboptimal, combinations of inputs to produce their output. For example, where a firm needs a large injection of financial capital to purchase physical capital, institutions that undermine the availability of capital or increase its cost will make the purchase of physical capital more difficult. In these circumstances, firms may attempt to substitute other factors for physical capital. Alternatively, they may choose not to expand operations in ways that require more physical capital.

5.2.2  Innovation and human capital

The availability of financial capital will determine the opportunities for innovation that firms can take up. Thus, institutions that improve the availability of finance can enable firms to increase productivity by expanding operations or introducing innovative improvements. Financial institutions play a role in the growth process because they are important to the provision of funding for capital accumulation and the diffusion of new technologies (OECD 2003).

Firms often adopt new technology embedded in new plant and machinery in the process of increasing physical capital. The adoption of new technology can contribute to greater firm productivity by increasing the output each worker can produce. The application of new technology often requires complementary investments in human capital, leading to increases in labour productivity and thereby higher firm productivity. Advances in technology often have strong links with education, meaning education makes a contribution to growth via innovation (OECD 2003).[16]

Firms will undertake innovation only when the return on the investments in physical and human capital is greater than the cost of the investments. This may not be the case if financial market institutions make finance too costly to obtain or if labour market institutions mean labour receives more of the benefits of investments than the firm.[17] In such instances, firms may not undertake projects that could otherwise be beneficial to lenders, workers and firms.

5.2.3  Productivity gains across firms

Financial market institutions influence the productivity of a country’s overall capital investment as well as productivity at the individual firm level. Financial systems that are more developed may have a greater capacity to channel resources towards projects with higher returns (OECD 2003).

McMillan (2004) notes the importance of financial market institutions for assisting firms to grow. Firms need finance to grow and they are unable to obtain this if financial markets are underdeveloped from a lack of market-supporting institutions. McMillan notes that if information sources are lacking and investment uncertainties are prevalent, banks may be reluctant to lend to small firms, preventing them from growing into medium-sized firms. He also notes that information asymmetries for shareholders means that savers/lenders may be reluctant to buy stocks, meaning that the stock market may be less active than it could be and that firms may be unable to acquire the capital they need. This can prevent medium-sized firms from becoming large firms.

5.2.4  New Zealand capital institutions

New Zealand’s financial market institutions mainly rely on information disclosure from financial market participants. While there is mandatory public disclosure of financial and prudential information, there is no deposit insurance or government guarantee of banks. In the banking sector, there are low levels of active regulation. New Zealand relies on more active interventions being carried out in other jurisdictions where the banks operating in New Zealand are domiciled.

New Zealand’s labour market institutions in combination with its financial market institutions have had an impact on physical capital accumulation in New Zealand. Institutions in both areas were changed significantly during the 1980s and 1990s. Treasury (2004) suggests that New Zealand’s low capital/labour ratio may be due to changes in capital and labour regulations leading firms to utilise more labour relative to capital.

The World Bank (2004) gives New Zealand the highest possible rating for its protection of creditors in its Doing Business measures and IMD International (2004) ranked New Zealand 7^th out of 60 countries in terms of the adequacy of the legal regulation of its financial institutions for financial stability. McMillan (2004) notes that on measures of investor protections, New Zealand protects its savers/lenders at least as well as most other industrialised countries[18].

McMillan notes that promising small firms appear to be able to attract the capital and other resources they need to grow in New Zealand. IMD International ranks New Zealand 11^th out of 60 on the availability of access to its capital markets.