Tuesday, 26 February 2013

Corporate cash reserves are far from a myth

The Telegraph's Jeremy Warner has written a piece questioning whether the story about corporate cash hoarding holding back an economic recovery in the UK stands up to scrutiny.

Although he acknowledges that corporates have been steadily increasing their reserves over recent years he suggested this trend may not suggest that there is a tsunami of investment waiting in the wings. According to the ONS total cash reserves held on private non-financial company balance sheets accounted for £672 billion in the third quarter of last year, but Warner claims the figure is only "£50bn higher than they were before the crisis began and hardly enough to explain the great “compensating” leap in public indebtedness".

He goes on to say that the evidence for this being purely a reaction to the crisis and therefore easily reversible is not as strong as many, including members of the Coalition government, have suggested. Rather than a response to short-term uncertainty higher cash balances could instead prove to be "a semi-permanent corporate phenomenon". Only through serious entitlement and supply-side reforms, Warner concludes, can the government hope to pull the economy out its current malaise.

It seems only fair to start with an important point in which I agree with the piece. Firstly, it is absolutely true that the increase in corporate currency and deposit holdings began some time before the crisis. Below is a chart of the ONS data:

As you can clearly see, even a decade ago corporate reserves were on an upwards trajectory. Indeed the rate of increase in reserves was far faster in the five years before the start of the crisis than in the last five years. This suggests that, whatever the underlying causes of corporate cash hoarding are, they are not simply explained by pointing to uncertainty caused by the crisis.

This, however, is where is where I part ways with the author.

It is quite clear that irrespective of the drivers of the trend corporate cash balances remain high on historical standards, despite Warner's claim otherwise to me on Twitter. Moreover, it seems to me that either high reserve balances are a "semi-permanent corporate phenomenon" or they are not high by historical standards - they cannot be both.

Now the confusion here might well have arisen due to the impact of corporate borrowing. If corporates are running large capital reserves and taking on debt then net liabilities may not look unusually high. Indeed there does appear to be evidence that this is in fact the case:

The reason for this rise in borrowing can, in my opinion, be traced to a combination of ultra-low interest rates and the desire by corporates to improve returns on equity to keep management and investors happy (e.g. it could be understood as an unintended consequence of the central bank's response to the crisis). As Andrew Smithers, head of Smithers & Co, says:

"The data from the Office of National Statistics show that debt is high, compared to output or assets, whether measured gross of net of cash type assetsBonds are raised and repaid in lumps. Individual companies therefore tend to have high cash balances when they have just borrowed or are just about to repay debt. On average therefore companies will tend to have more cash when they have more debts."

In itself raising debt at low interest rates is not a big problem. The issue is that this money does not appear to be going to productive investment but instead funding corporate share buybacks:

As a recent Ernst & Young ITEM Club report suggests, while investment grew by 5.1% in the year to the end of Q3 2012 it was still some 11.6% lower than the peak of Q4 2007. This poses some potential problems as rather than invest in improving efficiency, for example through investing in new technology, or expanding business operations the figures suggest managers are instead focused on massaging equity returns. If the trend continues it could mean that profitability becomes increasingly squeezed and that firms are ill-prepared to take advantage if a recovery sets it.

It could also mean that companies with large debt piles could struggle to refinance if interest rates were to move upwards, leaving the central bank with the uncomfortable choice of leaving rates lower for longer risking further debt increases or raising rates risking disorderly deleveraging.

The falls in capital reserves since Q3 2011 may well point to a slight improvement in corporate investment, although we have not yet seen this reflected in the GDP numbers. Of course, they could also reflect falling profitability as firms dip into their reserve to meet current obligations.

I cannot fathom why Warner would wish to paint such a gloomy picture of the UK economy where a cautious, risk-averse private sector indefinitely holds back investment necessary for sustainable growth when the evidence suggests that good policy could alleviate many of the present barriers to recovery. Perhaps the UK's sovereign debt downgrade by Moody's has had the same effect on commentators that doomsayers suggested it would have on markets.

Yet if he is right that corporate cash hoarding represents a structural rather than a cyclical shift in corporate behaviour, it argues all the more strongly for the government to help plug the shortfall in investment rather than continue to cut capital spending as the Coalition has done.

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