An imperial subsidy?

176of all investment) is hardly surprising.10

What encouraged British investors to underwrite overseas development? Quantitative analysis has shown that, even after due allowances have been made for risk, British investment in this period did not appear to exhibit any overt irrational bias towards or against any particular type of project; rather, individual investor behaviour was governed by a calculated reading of comparative rates of return. On the whole, Britons invested overseas at the end of the nineteenth century primarily because, on comparable types of assets, such securities tended to perform better. Looking at first- and second-class investments in the period from 1870 to 1913, Edelstein thus found that on average overseas securities attracted a realised return of 5.72 per cent compared to the 4.60 per cent offered by domestic issues.11 These rates suggest that if British investors exhibited any bias at all, it was one that favoured the making of more money over less.12

An imperial subsidy? Did the same hold true for the empire? Davis and Huttenback’s econometric analysis of a sample of domestic, colonial and foreign government securities, as well as Edelstein’s dataset of first- and second-class

10 Edelstein, ‘Foreign investment’, pp. 194–5.

11 The disparity was even greater for those varieties of stock central to Britain’s nineteenth-

century capital export. Thus, debentures earned 3.21 per cent at home and 4.92 per

cent overseas, whereas in railway securities the differential was even more marked: 3.74

per cent in the UK, 6.03 per cent in the USA, 5.33 per cent in Latin America and 5.33

and 5.28 per cent in eastern and western Europe respectively.

12 Edelstein, ‘Foreign investment’, pp. 196–200.

177Information and investment

Table 5.3. Yields on colonial and foreign government securities, 1882–

1912 (as percentage points above the UK municipal government rate).

1882–1912

1882–1900

1901–12

Dominions

1.14

0.99

1.55

Dependent colonies

0.85

0.90

1.19

India

0.64

0.25

1.12

Independent developed countries

2.04

2.37

1.97

Independent undeveloped countries

4.26

4.24

4.53

Source: L. E. Davis and R. A. Huttenback, Mammon and the Pursuit of

Empire: The Poltical Economy of British Imperialism, 1860–1912 (Cambridge:

Cambridge University Press, 1986), p. 173.

securities, suggest not.13 Rather, British investors do appear to have discriminated between foreign and colonial stock. So much is evident from the average interest rates charged in London on public loans raised by different countries. Table 5.3 presents the key findings – the figures are expressed in terms of the spread: that is, the difference between the rates of interest charged on loans raised by certain types of countries and those floated by UK municipalities. What the table vividly shows is that, over the period 1882 to 1912, colonial governments consistently paid lower interest rates on capital raised in the UK than other governments. The effect was most marked before 1900, when the Indian government, for example, paid on average 4 per cent less on a loan than similarly underdeveloped nations outside the empire. Although India was the biggest beneficiary of these lower rates, the dominions also gained.14 Relative to comparably developed nations outside the empire, dominion governments were able to raise public loans at a noticeably discounted rate: 1.25 per cent and 0.42 per cent lower on either side of 1900 respectively. A similar picture emerges from analysis of the funding of social overhead securities. As Table 5.4 shows, the average realised returns on various colonial debentures and stocks lay significantly below comparable foreign assets. Ferguson and Schularick also provide quantitative evidence for an ‘empire effect’ in the British capital market. Using an even broader base of securities, and separating out the impact of monetary, fiscal and commercial policies, they place the average yield of colonial borrowers at 3.89 per cent compared to 6.30 per cent for those in independent

13 L. E. Davis and R. A. Huttenback, Mammon and the Pursuit of Empire: The Political Economy

of British Imperialism, 1860–1912 (Cambridge: Cambridge University Press, 1986).

14 The dominions gained by about 3.3 per cent between 1882 and 1900.

178Table 5.4. Average annual realised returns on various types

of stock, 1870–1913.

Railway

Other infrastructure

debentures

equities

3.77

4.41

5.22

Colonial

4.48

5.00

7.50

Foreign

5.72

7.70

8.13

Source: Davis and Huttenback, Mammon and the Pursuit of Empire, p. 81.

countries. In other words, colonials paid on average 2.41 per cent less on capital raised in London than those of other nationalities. Once again, the biggest beneficiaries were the dependent colonies and India, whose membership of the British empire, it is contended, reduced their risk premiums by as much as 60 per cent between 1890 and 1913.15

Taken together, these econometric analyses provide strong evidence that colonial securities were treated differently by British investors in the later Victorian and Edwardian era, typically being financed in London at significantly lower rates of interest than comparable assets from independent foreign countries at similar levels of development. Contemporaries appear to have been well aware of this phenomenon. For example, Robert Benson, the Chairman of the Merchants’ Trust, exclaimed in 1906 that ‘the sentiment of the Mother Country predisposes the public to lend capital to our colonies at lower rates of interest and with less security than we exact from borrowers elsewhere’.16

It is therefore possible to speak of, and even to quantify, a ‘British subsidy’ to the colonies: relatively cheap capital from London gave a significant spur to their development. For the period 1882 to 1912, Davis and Huttenback estimate that, per capita, this gift amounted annually to £0.17 in the dominions, £0.04 in the dependent colonies, and £0.01 in India. Alternatively, the subsidy on public borrowing represented a transfer of £216,091,000 from the UK to the Empire, of which 39.7 per cent was received by the dominions, 41.4 per cent by India and 18.9 per cent by the dependent colonies.17

15 N. Ferguson and M. Schularick, ‘The Empire Effect: The Determinants of Country Risk

in the First Age of Globalization, 1880–1913’, Journal of Economic History 66 (2006),

pp. 290–312.

16 ‘Merchant Trust AGM’, The Economist, 10 March 1906.

17 Davis and Huttenback, Mammon and the Pursuit of Empire, pp. 175–6. For further evi-

dence of contemporary recognition of this subsidy, see George Paish’s comments quoted

179Information and investment Who was this investing public that so favoured colonial borrowers? By the end of the nineteenth century, stock market participation in Britain had widened well beyond the privileged few. Promoters of colonial investments targeted a much wider range of individuals who were willing to sink smaller sums of money either into the relative safety of government securities, or, conversely, into more speculative private stocks in the hope of making spectacular gains; mining markets, in particular, had few equals as an arena for speculation. Yet, while savers from all parts of British Isles invested in the empire, it was in London, the Home Counties, Scotland and the rural east of England that colonial securities were preferred. Socio-economically, the most committed empire invest ors were elites and peers (who invested heavily in banks; breweries; financial trusts; tea and coffee plantations; some heavy industries; and public utilities, like telephonic and telegraphic networks, and gas and light production and distribution) and the London-based businessmen (whose portfolios normally contained a healthy share of colonial financial and land development companies, as well as mining, railroads, canals, docks, trams, omnibuses and waterworks stock).18

Given there are no grounds to believe that the British investor at this time acted irrationally or was prepared to place imperial piety above profit, why, then, was he or she willing to accept a lower rate of return? Part of the answer may lie in the parliamentary guarantees that Indian government bonds attracted.19 Yet this alone cannot be the full story, since from the late 1870s dominion loans were freely raised without such guarantees. Similarly, direct Treasury control and scrutiny of colonial finances may have swayed investor perceptions but, once again, not in the dominions, where, with the advent of responsible government, the scope for such control was dramatically curtailed.

Another commonly cited explanation for an ‘empire effect’ in capital markets relates to the Trustee Acts, the legislation that regulated the types of assets that could be purchased by trustees in the UK. Prior to 1889 the list of assets that could be legally acquired was restricted to consols, Bank of England and East India stock, and the mortgages of freehold and copyhold in England and Wales. The Trustee Acts of 1889 and 1893, however, extended the range of acceptable assets to include the debentures of British and guaranteed Indian railways and a number of other

in A. R. Dilley, ‘Gentlemanly Capitalism and the Dominions: London Finance, Australia

and Canada’, unpublished D.Phil. thesis, University of Oxford (2006), p. 148.

18 Davis and Huttenback, Mammon and the Pursuit of Empire, pp. 211–17.

19 J. M. Hurd, ‘Railways’, in D. Kumar (ed.), The Cambridge Economic History of India, 2 vols.,

Vol. II: c. 1757–1970 (Cambridge: Cambridge University Press, 1983); W. J. Macpherson,

‘Investment in Indian Railways, 1845–75’, EcHR 8 (1955), 177–86.

180securities. This approved list was further broadened by the Colonial Stock Act of 1900, which legally cleared the way for British trust funds to invest for the first time in the registered and inscribed stock of colonial governments. From their inception, the Trustee Acts proved controversial. One of their most vehement critics, John Maynard Keynes, found them doubly pernicious: first, because they provided ‘an artificial stimulus on a great scale to foreign investment within Empire’; second, because they lulled ‘trustees and others into a false sense of security’ by making them feel ‘that all such investments are, in a sense, beyond criticism’.20 Yet Keynes was overly pessimistic. By 1900 the list of approved assets was already quite extensive and not in itself sufficiently restrictive to create the type of bias claimed by its opponents.21 Nor can it be convincingly argued that the inclusion of colonial stock on approved trustee lists profoundly altered general investor perception of such assets: colonial securities were already extremely well-known to and popular with British savers by the time these Acts came into being. What the Acts did do, though, was to strengthen this existing perception of the safety of colonial stock and incorporate it within the law. Thus the impact of the Trustee Acts on colonial securities, while certainly positive, was in all probability rather small. Davis and Huttenback estimate, for example, that between 1882 and 1912 they lowered the interest rate on listed colonial securities by only 0.16 per cent, an amount that leaves the vast majority of the interest rate differential unaccounted for.22 What, then, is the missing piece in the puzzle? In 1986, Davis and Huttenback were unsure: ‘Nor does the distance of a century make the explanation of the British investor’s willingness to underwrite these activities any more apparent. One can never be certain what it was that motivated the investors to act as they did, but the explanation cannot lie in legal guarantees nor in effective Treasury control.’23 Subsequent work by Davis and others on the evolution of financial markets and institutions, however, points a way forward.24 In particular, this research ascribes a major role

20 J. M. Keynes, ‘Foreign Investment and the National Advantage’, The Nation and the

Athenaeum 35 (9 August 1924), 585–6.

21 A. K. Cairncross, Home and Foreign Investment (Cambridge: Cambridge University

Press, 1953); A. R. Hall, The London Capital Market and Australia, 1870–1914 (Canberra:

Australian National University Press, 1963), p. 58; D. N. McCloskey, ‘Did Victorian Britain

Fail?’, EcHR 23 (1970), 446–59; and Dilley, ‘Gentlemanly Capitalism’, pp. 157–61.

22 Davis and Huttenback, Mammon and the Pursuit of Empire, pp. 171–4.

23 Ibid., p. 170.

24 See for example Davis, ‘Late-Nineteenth-Century British Imperialist’; L. E. Davis and

R. E. Gallman, Evolving Financial Markets and International Capital Flows: Britain, the

Americas, and Australia, 1865–1914 (Cambridge: Cambridge University Press, 2001);

181Information and investment to institutional innovation in improving the dissemination of information. Since rational choice operates according to the quality and quantity of data available to decision-makers, the continued development of financial institutions is understood to have been an important factor in the emergence of ever more efficient and encompassing capital markets. As W. Hayes Fisher explained in his investment manual of 1912, ‘the effective supervision of investments demands a knowledge of how all investments of each class held are progressing, for without such information the requisite system of comparison between actual and possible results cannot be maintained’.25

In other words, for investors to judge the merits of investment projects, adequate and reliable information was (and remains) vital – information not just about the safety and likely profitability of an investment, but about the financial instruments through which their claims on assets could be established. Left unknown or misunderstood, even the most promising of investment opportunities were likely to attract a very high uncertainty discount. Hence the choices made by investors, and the ability of certain investment projects and countries to mobilise sufficient quantities of capital cheaply, were heavily influenced by the nature of informational flows at particular points in time.26

Much investment-related information in the nineteenth century came through personal experience, word of mouth, or from what was published in the local and specialist press. In his analysis of the behaviour of late-nineteenth-century British savers, Davis noted that: not everyone received the same information; savers were more confident about the information they received about investments in places and industries with which they were more familiar . . . As a result, ceteris paribus, when the British saver calculated the potential gains from each of a set of alternative investment choices, he or she applied a lower uncertainty discount to information about the better-known alternatives.27

and B. DeLong, ‘Did Morgan’s Men Add Value?’, in P. Temin (ed.), Inside the Business

Enterprise: Historical Perspectives on the Use of Information (Chicago: University of Chicago

Press, 1991), pp. 205–49.

25 W. Hayes Fisher, Investing at Its Best and Safeguarding Invested Capital (London: Financial

Review of Reviews, 1912), p. 23.

26 In Evolving Financial Markets, Davis and Gallman argue persuasively that the differ-

ent information sets possessed by each variety of saver can explain both the existence

of a ‘dual capital market’ in the UK (where a domestic market provided safe invest-

ments for the middle class and an international market catered for the needs of the

nation’s merchants, financiers, gentlemen and peers) and the varying timing and rates

of financial development (and need for institutional innovation) experienced by differ-

ent nations in the long nineteenth century. See also Davis, ‘Late-Nineteenth-Century

British Imperialist’, p. 109 for discussion of the role played by information in financial

development.

27 Davis, ‘Late-Nineteenth-Century British Imperialist’, p. 107.

182Such informational asymmetry could have important international dimensions too: a British country gentleman might have thought he was better informed about investments in Delhi, where his cousin worked, than about . . . Midland textile firms; and a London merchant may have felt more confident about commercial investments in Buenos Aires, where his firm had an office, or about the bonds of the Grand Trunk Railway – his City-based broker, partner in Baring Brothers and fellow club member, had told him that those bonds had some (explicit or implicit) government guarantee – than about coal mines in Scotland.28 What needs to be emphasised here is that modern capital markets and the information required to make them function do not appear ex nihilo. Rather, they evolve gradually in response to current perceived needs and failings. Thus, the emergence of the Anglo-American investment banks, which came to dominate the foreign and domestic financing of railroad construction in the second half of the nineteenth century, had their origins in the earlier need of British merchant banks for more onthe-spot information on American issues. Similarly, the bond houses, whose imprimatur of quality from the end of the nineteenth century convinced both Canadian and British savers of the merits of unguaranteed local government securities, emerged as a creative solution to the initial difficulties that communities such as Saskatoon, Calgary and Edmonton experienced in securing financial backing for their public works.29 How does the British World fit into this story of steadily improving capital markets? For one thing, we know from the 1870s that the majority of British investors regarded colonial securities as safe bets. Protected by the Royal Navy and governed by British laws and standards, they were ‘on a different plateau of reliability’ from most foreign countries.30 Indeed, for the most part, colonial securities did prove reliable: there was little question – and even less experience – of default by a colonial government.31 From the investor’s perspective, they were a known quantity. Well-informed of the borrower’s track record and trustworthiness, even the most risk-averse middle-class investor could confidently take the plunge. As a result, by the latter half of the nineteenth century these

28 Ibid., p. 107.

29 Davis and Gallman, Evolving Financial Markets, pp. 333–4, 459–60, 814–17.

30 A. J. Purkis, ‘The Politics, Capital and Labour of Railway Building in the Cape Colony,

1870–1885’, unpublished D.Phil. thesis, University of Oxford (1978), p. 268.

31 The only instance of an empire issue going into default between 1870 and 1914 was

the New Zealand Harbour Loan; Davis and Huttenback, Mammon and the Pursuit of

Empire, p. 171.

183Information and investment ‘gilt-edged’ colonial ‘consols’, as they were called, had become a mainstay of the investment portfolio of many British savers and institutions.32

The ease with which investors underwrote colonial assets was partly a product of the comparative abundance of information that they had at their disposal.33 At a time when capital markets still had limited global reach, and were subject to significant informational asymmetries, the familiarity of colonial securities offered British savers a sense of relative security.34 Although there were always exceptions, from the perspective of the British investors, the effects of informational asymmetry were generally felt most acutely in comparisons between projects in the British World and those outside it. Ceteris paribus, savers were more likely to know and invest in railroad construction in Canada than in a similar plan proposed by promoters in China. The choice of the Canadian project could be more readily made on the basis of a well-informed analysis of probable rates of return, with much less regard for the trustworthiness of the borrowers. So well-endowed with information about the British World was the British investor that it has been suggested that in the half century preceding the First World War ‘there was little need for Anglo- Australian or Anglo-Canadian institutions to solve problems of asymmetric information’.35

32 Hall, London Capital Market, pp. 6–7; Purkis, ‘Politics’, p. 264; and Investors Monthly

Manual, 1873, p. 411.

33 A. Offer, ‘Costs and Benefits, Prosperity and Security’, in A. N. Porter (ed.), The Oxford

History of the British Empire, 5 vols., Vol. III: The Nineteenth Century (Oxford: Oxford

University Press, 1999), pp. 690–711 (pp. 700–1). Similarly, in A. G. Ford, The Gold

Standard, 1880–1914: Britain and Argentina (Oxford: Oxford University Press, 1962),

p. 86, it is argued that a lot of the British investment in Argentina at the end of the nine-

teenth century was due to the accumulation of first-hand knowledge of conditions there

by British businessmen. This information made them more aware of the prospects for

profits. The role of informational asymmetry finds a parallel in contemporary finance lit-

erature, where it is contended that in many stock markets ‘foreign’ investors incur higher

trading costs than ‘domestic’ because of the informational disadvantages they face. See

H. Choe, H. Kho and R. Stulz, ‘Do Domestic Investors Have an Edge? The Trading

Experience of Foreign Investors in Korea’, Review of Financial Studies 18:3 (2005), 795–

829; T. Dvorak, ‘Do Domestic Investors Have an Information Advantage? Evidence from

Indonesia’, Journal of Finance 60:2 (2005), 817–39; and H. Hau, ‘Location Matters: An

Examination of Trading Profits’, Journal of Finance 56 (2001), 1951–83.

34 This informational asymmetry was probably less marked for direct investment, since

such projects placed more onus on investors having detailed knowledge of the specifics

of the investment in question. While widespread belief in the inherent safeness of colo-

nial debentures may have been sufficient knowledge for many investors to acquire a par-

ticular security, they presumably would have needed to have more first-hand knowledge

of the firm or project seeking their direct investment (than would have been typically

available to them) before committing their savings to it. Such considerations also partly

explain why direct investment assumed such a low proportion of all British overseas

investment at this time.

35 Davis and Gallman, Evolving Financial Markets, p. 765.

184How did such a situation arise? The answer lies in the manner in which information was created and diffused in the later Victorian and Edwardian era. The British World, by availing the British investor of rich streams of information about the nation’s overseas possessions and investment opportunities therein, afforded colonial borrowers distinct advantages in their search for external development capital. Such informational asymmetries stemmed from occupational background (peers and gentlemen, wherever they lived, showed a preference for empire investment, sometimes because they themselves or a family member were in colonial or military employment); region of residence (London businessmen were much more likely to invest in the formal empire than provincial businessmen – the latter had plenty of domestic opportunities and did not need to send their capital abroad); mobility and migration (people recognised profitable openings for capital on their travels); and social or kinship ‘webs’ and the shared values and expectations that these engendered (as we shall see, such webs played a major if not always acknowledged role in the buying of stocks and shares). These informational advantages enabled financial institutions and individual investors wishing to diversify their portfolios to turn first to colonial stock, then to US securities, and finally to other foreign stock some time later when knowledge of these unfamiliar markets was more broadly available in the UK. This process of portfolio diversification played itself out over decades rather than years, and was made possible by two inter-related developments: greater awareness of a wider range of investment opportunities, and the emergence of a better functioning capital market.36 As Davis and Gallman noted, in the 1860s and 1870s ‘no one, not even well established merchant bankers, knew if there were any sound American, let alone Argentine railroads’.37 While this state of affairs was not to endure, initially it enhanced the status and appeal of colonial securities. Moreover, given the intrinsic ‘public good’ properties of knowledge (which once available can be relatively costlessly utilised by other potential investors), there is a potential for such informational asymmetries in favour of empire investments to intensify with the passing of time. After all, the very act of investing in the empire ensured that a further influx of colony-specific information would be forthcoming.38

36 R. C. Michie, ‘The Social Web of Investment in the Nineteenth Century’, Revue inter

nationale d’histoire de la banque 18 (1979), 158–61.

37 Davis and Gallman, Evolving Financial Markets, p. 756.

38 In other words, once individuals choose to invest in a colony, they acquire as a by-

product deeper experience and knowledge of that location. In turn, some of that experi-

ence and knowledge would be passed on to other potential investors, who as a result

become better informed. In a world of imperfect information, such streams of feedback

about the merits and potential of a certain place or type of asset tend to sharpen, rather

than reduce, informational asymmetry.