Untapped potential

Large scale public investment by governments has rescued the global economy from a prolonged depression. But public investment has run out of steam. With public debt, at both national and sub-national levels, unsustainably high in many countries and faced with nervous capital markets, governments know they must now reign in deficits. Sustained recovery will thus become dependent on private investment stepping in. Fortunately, companies are awash with cash. Unfortunately, however, they so far seem reluctant to part with it.

Firms have not yet taken up their customary lead role as drivers of global investment growth. Especially multinational firms, major sources of private investment in both their home markets and abroad, are slow to restart the investment engine. GDP growth is back in positive territory worldwide and is on the whole buoyant in emerging markets. World trade is back to its pre-crisis levels, and the income multinationals earn on their foreign investments is close to 2007 highs, but foreign direct investment (FDI) flows are still some 25 percent below their pre-crisis average, and nearly 50 percent below their 2007 peak.

Capital hoard 
So how much cash do firms need? Companies across the developed world are currently sitting on record amounts. US firms are holding an estimated $1.3tn worth of cash, EU and Japanese firms are holding even more, at around $2tn each. The increase of these cash holdings in the last two years has been astronomical. Federal Reserve data indicates that cash holdings by (non-bank) US companies rocketed after a steep drop in 2008 to almost twice the pre-crisis levels in 2010.

The part of this cash held overseas by multinationals in their foreign affiliates is also increasing. According to UNCTAD estimates, foreign affiliates of US firms keep around $400bn, or some 30 percent of the total. Japanese multinationals hold an estimated $950bn overseas, or nearly half the total. The share of retained earnings by foreign affiliates has increased significantly for multinationals originating in almost all mature markets, rising from less than 30 percent of overseas profits in 2001 to nearly 50 percent in 2010 in OECD countries.

Looking at the difference between FDI flows and actual capital expenditures by foreign affiliates (a proxy for the increase in overseas cash reserves) over the last 10 years show, for US multinationals, a spike in 2004, a steep drop in 2005 and an ascent to new heights in 2008 – with estimates for 2009 and 2010 equally high. The 2004 peak and 2005 trough can be explained by the Homeland Investment Act which provided a tax break on repatriated profits in 2005. Anticipating the tax break firms hoarded cash in their overseas affiliates in 2004 and brought back several years worth of retained earnings in 2005, some $360bn. For the last three years, levels have been similar to the anomalous 2004 spike, leading to the conclusion that cash reserve levels in foreign affiliates currently well exceed what is required for normal operations.

The sensitivity of overseas cash reserves to the tax rate on fund repatriation can also be observed in Japan, which also taxes the worldwide profits of its multinational firms. The 2009 tax change on the repatriation of foreign earnings is estimated to bring back an additional $40bn in overseas funds annually.

Cash rich
There are many reasons why firms have more cash in their coffers. Uncertainty in global financial markets and increased risk aversion, scarcity of viable investment opportunities during the crisis and the expectation of better opportunities around the corner. Furthermore, the continuing low cost of capital and consequently reduced pressure to deploy capital or pay dividends, all combined with the strong recovery of corporate profits and a drive to de-leverage, helps to boost firms’ cash reserves.

However, the sensitivity of overseas cash holdings to tax changes, as well as some observed portfolio-investment-like behaviours of FDI flows – such as the anticipation of exchange rate movements, hot-money flows and speculative investments in booming emerging economy real estate markets – seem to suggest that multinationals have some flexibility in managing cash reserves.

The policy implications are significant: there are untapped funds that could be gainfully employed at this critical moment to stimulate the global economy and finance development – or to help assist and re-build earthquake devastated Japan.

For mature market policymakers, and especially for US legislators, it appears that the fiscal tools to stimulate the economy have not yet been fully exhausted, contrary to popular belief. If cash reserves held in multinational firms can be productively employed, and overseas cash repatriated, the boost to the US economy could be significant. Even considering that it is difficult to guarantee that firms actually reinvest the money, as critics of the Homeland Investment Act allege, distribution of the gain to shareholders would still constitute a consumer stimulus.

Such an action by the US would not necessarily constitute a ‘beggar-thy-neighbour’ policy and the impact on developing countries would not necessarily be negative, for three reasons. First, if the money held by foreign affiliates in their countries is not productively employed, the opportunity cost is limited. Second, the flow of repatriated earnings would alleviate current fears of excessive depreciation of the dollar. Third, the alternative, continued quantitative easing by US authorities would be far more harmful to other countries, especially developing ones.

Future investments
However, it is not just mature market economies that are in need of stimulus. Lower-income countries are in equally dire need of development finance. They are waking up to the fact that foreign firms are not reinvesting all their retained earnings in productive capacity. They will increasingly ask themselves how they can transform stocks of reserves in investment for development, and how they can avoid the harmful side effects that cash floats can bring in their economies.

Clearly, the policy response should be about more than just ‘cash-grabbing’ and tax levers. Ensuring a stable and favorable climate for investment and creating new investment opportunities are equally, if not more, important. There are many options to do this: for example, concluding negotiations on climate change will give firms the certainties they need to build their future productive capacity and will create new low-carbon investment opportunities.

Finally, it is in the interest of policymakers from all countries that direct investment flows are included in discussions on future global economic governance, alongside other financial flows more commonly considered as culprits for global imbalances and exchange rate tensions. More and more policymakers see the overseas performance of their firms as part and parcel of their international competitiveness (and rightly so, as repatriated earnings contribute to GNP and often more than compensate for trade deficits). They can surely be convinced that stimulating the conversion of overseas cash reserves in productive assets through outward investment promotion efforts makes as much sense as incentivising repatriation. But they will want such efforts to be embedded in investment rules that protect their interests while promoting development.