By Anoop Singh
As Asia starts down the path to recovery, it is going to have to tackle two issues which are constraining its long-term growth potential: firms that save but do not invest and wealthy households that are reluctant to consume.
At first glance, such behavior seems inexplicable and counter-intuitive. Let’s imagine for a moment you are an investor—you may well be— you put quite a bit of money into a company to back its expansion plans. Initially, these plans prove successful, and the company makes quite a bit of money. But then the firm ran out of investment ideas. What would you expect them to do?
Surely, you would expect them to return the money you provided, for example by paying it out as dividends. But in the past, prosperous decade before the current downturn this hasn’t been happening in emerging Asia. Firms have been sitting on their profits, not investing them, but not paying them out in dividends, either. That is a puzzle, and a problem.
It’s a puzzle because it’s not obvious why firms should sit on money when they don’t have any need for it. When firms initially started doing this after the Asian crisis of the late-1990s, they had a ready rationale. They wanted to pay down their excessive levels of debt, which during the crisis had brought some of Asia’s largest companies low. But as the years went on, and debts fell, first to safe and then to low levels, it was clear that something else must be going on.
There’s a further puzzling aspect. Economic theory states that households can “pierce the corporate veil” and extract value from a company even if it doesn’t actually pay out profits as dividends. That’s because the retained earnings would increase the firm’s net worth, which would be reflected in its share price. Households could then sell the shares, or borrow against them.
Either way, they could spend more. This theory has been tested in empirical research and found to hold in advanced countries, and some emerging markets. But it doesn’t hold true in China or the rest of emerging Asia. Households simply do not consume more, despite holding valuable financial assets.
Why does this matter? It matters because Asia’s corporate savings puzzle lies at the heart of its economic imbalances. It is precisely the substantial and growing excess of savings over investment in the corporate sector, coupled with subdued household consumption, that over the past decade has produced the region’s large external current account surpluses.
We tried to analyze this mystery in Chapter III of the Asia-Pacific Regional Economic Outlook.
We discovered two vital clues:
- Corporate governance. The higher the level governance, the more shareholders are able to exercise their rights and prevent firms from hoarding cash.
- Financial sector development. The more liberalized the financial market, the less firms hoard cash, because they have easier access to funding and are less worried about being shut out of financial markets. Financial liberalization also allows households to consume against their corporate wealth, because they can borrow using their financial assets as collateral.
These finding have profound implications for policy. For example, the econometric estimates imply that if Asia were to reach the average level of corporate governance in advanced economies, it would be able to lessen corporate savings by as much as 2½ percent of GDP. Similar advances in financial sector liberalization could reduce savings by 5 percentage points.
Resolving the conundrum of firms that save but do not invest, and households that hold this wealth but cannot consume may enable Asia to finally catalyze domestic demand. It could help to restore rapid growth, even in a “new world” of softer advanced country demand. Improved corporate governance and further financial sector development may be two remedies worth exploring.