Corporations hoarding cash?
Why companies reluctant to spend despite enjoying record profits
By Chung Hee-hyung
A conundrum has been puzzling South Korean business experts in the past few years. Why are the country’s large companies reluctant to invest despite unprecedented profits?
This unwillingness to spend shows that the prediction by many critics of the previous Roh Moo-hyun administration was simply wrong ― namely, the advent of the business-friendly Lee Myung-bak administration will automatically prompt the big companies to splurge on facility investment.
Market observers point out that the global financial crisis in the late 2000s and the recent economic woes pulled some strings behind the scenes but there exists a structural problem hard to root out ― chaebol want to build a war chest due to bad memories of a decade ago.
The lesson is that the replacement of political leaders will not be enough to invigorate investment, the most important economic stimulant thanks to its multiplier effect _ although its strength has been sometimes challenged. Rather, Korea might have an alternative approach to shanghai conglomerates to make more investment.
It was not Roh’s fault
Back in Roh’s presidency, corporations put their fingers of blame on the “intrusive” and “leftist” administration. Roh, a former human rights lawyer who fought against corporations on behalf of laid-off workers in court, could never be accused of being overtly pro-business.
“It is the current government’s intervention that has discouraged the country’s entrepreneurs and led to a decrease in investment,” said a senior official of the Federation of Korean Industries (FKI) in 2004. “The government should let chaebol reform themselves instead of unduly interfering with them.”
The message of FKI, the mouthpiece of Korea’s largest conglomerates, was clear. If only the government threw away its anti-business stance that dissuaded the companies from investing, companies would gladly let loose their accumulated cash and invest it back into the economy.
Incumbent President Lee, himself a former CEO of the country’s largest construction company, seemed to heed to corporations’ appeal. As a “business-friendly” administration, Lee vowed to get rid of unnecessary regulations when he took the helm of government in 2008.
Lee’s government dismantled many hated regulations, including the much detested restriction on the level of total equity investment permitted by chaebol’s affiliates. It also kept the interest rate artificially low.
As most symbolic pro-business actions, many pick the approval of relocating the runway of a strategically important air force base near Seoul at the request of the Lotte Group. The conglomerate tried to build a 123-stories skyscraper in the flight path to the airbase.
The Air Force had strongly protested against the project, because the unusually tall structure could hamper pilots’ visibility flying in and around the area. As a result, the project had been stuck at the drawing board for more than a decade.
Thanks to President Lee’s personal intervention, however, Lotte eventually prevailed in 2009. The approval was widely interpreted as an indication that the current government would go to any length if it might be of help to business.
If Lee’s government expected increased investment from the companies in response to the much requested deregulation, it must have been in for a huge disappointment. In fact, the chaebol have shown little sign of discarding their practice of hoarding cash more than eight years after the FKI’s scathing remarks were made.
Recent statistics demonstrate that corporations are not keen to expend their cash even when their businesses are as profitable as ever, just as they had been during Roh’s administration.
Figures released by the Fair Trade Commission (FTC) show that corporations with assets of more than 5 trillion won ($4.28 billion) have increased their sales by 17.7 percent in 2011 compared to the previous year.
Other figures were even more remarkable. Their net profit increased more than 60 percent during the same period, while their debt-to-equity-ratio improved to 109 percent. Excluding public enterprises which are heavily indebted due to their large-scale government projects, private companies recorded an unprecedented debt-to-equity ratio of 94.6 percent. In other words, Korea’s big companies have more equity capital than debts in their balance sheets.
While swimming in record profit, however, companies have chosen to pile up their impressive stock of cash instead of spending them to expand their business. This is best shown in corporations’ retained earnings, or the sum of a company’s accumulated profit after dividend payments, and generally indicate how much cash is available for investment.
Normally, a higher ratio of retained earnings means that a company chose to “retain” its profit instead of paying them out as dividends. The assumption is that the corporation would reinvest such retained earnings to expand its business at a suitable time. In case of Korean firms, however, they simply chose to keep their pile of cash instead of investing it back to the economy.
According to the statistics of the Korea Exchange (KRX) and Korea Listed Companies Association (KLCA), the country’s ten largest conglomerates have seen an almost uninterrupted increase in its retained earnings ratio. The ratio has surged from 600 percent in 2004 to more than 1,200 percent in the third quarter of 2011, reported Rep. Lee Hye-hun of the ruling Saenuri Party.
“We need to find ways to funnel the retained earnings into investment,” said the lawmaker at the annual auditing session of the National Assembly last year. “I doubt whether it is desirable to keep so much cash sleeping on the balance sheet.”
Even the president himself admonished corporations for not investing enough, saying that the amount of cash retained by them was “excessive.”
Despite accusations from all quarters that large corporations are sitting on a huge stock of cash while the rest of the economy is starving, however, companies may still be reluctant to spend them.
Three reasons why chaebol don’t invest
The first and the biggest reason pertain to the persistent economic uncertainty, both within and without. “The uncertainty surrounding the euro-zone crisis and the sluggish U.S. recovery is the most significant factor in corporate decision making,” said Kim Min-jung of Hyundai Research Institute.
Angel Gurria, the secretary-general of the OECD, lowered the country’s prospective annual growth for 2012 from 3.8 percent to 3.3 percent in a spate of two months. “The possibility of a global recession caused by euro-zone crisis, combined with an increased domestic interest rate which might hurt indebted households, could put a dent on economic growth,” reported Gurria in his visit to Seoul two months ago.
Moreover, the country elects a new president in December, and corporations are understandably wary of being spendthrift in an election year. “Whenever the government changes, a lot of policy shifts follow,” said Chung Sun-sup, CEO of chaebul.com which provides data on large businesses here. “Companies would not make big decisions shortly before the election, only to see them evaporate as a result of policy changes.”
A survey conducted by the Korean Chamber of Commerce and Industry (KCCI) on April 5 showed that out of 300 companies covered by the poll, 56.2 percent answered that the 2012 presidential election will have a more negative impact than the previous one. Only 31.5 percent said it will have a more positive effect, while 12.3 percent replied that the effect will likely be neutral.
Secondly, large corporations are heaping cash to guard against any potential hostile takeovers. The attempt by Sovereign, a Dubai-based asset management firm, to buy a majority stake in Korea’s top-tier telecommunications and oil-refining conglomerate SK in 2002 left an indelible mark on the country’s business.
The bid eventually failed, but SK was forced to expend precious cash and even borrow from banks to buy back shares of SK Holdings, the group’s holding company. It was a costly affair, and the lesson apparently led Chey Tae-won, the group’s CEO, to invest in highly volatile futures transactions last year in another frantic move to secure yet more precious cash. When the investment incurred a loss of 400 billion won, Chey misappropriated company funds to cover up his mess.
Fortunately, other conglomerates so far have not resorted to such desperate and illegal measures. But the need to stack “live ammunition” to buy back its own shares in an attempt to ward off hostile takeovers is still significant.
“Currently, foreign investors have the largest stake in most chaebol groups,” Chung explained. “If the value of the won or the price of the conglomerates’ shares drops substantially, that will make buying shares a lot cheaper. Then foreigners might move for a hostile takeover or at least try to build a controlling stake. The chance is not very high at the moment, but it is still a real possibility.”
The last reason why companies are so timid in spending cash may be their reluctance to increase their capital investment amid the gloomy prospects. Capital investment refers to a firm’s acquisition of fixed assets, such as manufacturing plants or machinery. It shows a company’s willingness to spend its cash in expanding its production capacity, and its level is directly related to a country’s growth potential.
Low level of capital investment, therefore, gives a worrying signal that the country’s overall investment, not to mention its growth potential, might be permanently curtailed. Relevant statistics support this notion. A report by Hyundai Research Institute in March showed that the country’s capital investment marked its first fall in the fourth quarter of last year since the dark days of 2009.
In particular, the dim growth prospect in the crucial electronics and petrochemical industries indicates that the country is not likely to see a significant increase in capital investment in the foreseeable future.
The two industries took a direct hit when Europe and America, their two biggest source of exports, has suffered from ongoing recession since the financial crisis. Electronics and petrochemical industries respectively make up 51 percent and 14 percent of Korea’s overall capital investment in the manufacturing sector.
The report emphasizes the importance of capital investment. “If South Korea’s capital investment decreases by 1 percent, the country’s overall growth will diminish by 0.1 percent.” There is little sign, however, that companies will suddenly go on for a spending spree and purchase plants and equipment to boost their production capacity.
Whether such failure to invest more aggressively is desirable may be another story.
“It is understandable that corporations are less than enthusiastic in spending their cash, given the bleak economic outlook,” notes Hong Song-jun of Spec Watch Korea, a non-profit watchdog keeping track of chaebol’s economic activities. “Entrepreneurs, however, are supposed to be aggressive. Their lack of initiatives is therefore critical.”
“More problematic, corporations are sometimes more interested in investing in real estate or betting on financial products when they do choose to spend their cash,” Hong continued. “Chey Tae-won’s speculative trading is a case in point, and such questionable investment would not help to boost productivity.”